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Corporation finance emerged as a distinct field of study only in the early part of
this century as a result of consolidation movement and formation of large sized business
undertakings.
In the initial stages of the evolution of corporation finance, emphasis was placed
on the study of sources and forms of financing the large sized business enterprises. The
grave economic recession of 1930’s rendered difficulties in raising finance from banks
and other financial institutions. Thus, emphasis was laid upon improved methods of
planning and control, sound financial structure of the firm and more concern for liquidity.
The ways and means of evaluating the credit worthiness of firms were developed.
The post World War II era necessitated reorganization of industries and the need
for selecting sound financial structure. In the early 50’s the emphasis shifted from the
profitability to liquidity and from institutional finance to day to day operations of the
firm. Thus, the scope of financial management widened to include the process of
decision-making within the firm.
The modern phase began in mid-fifties and the discipline of corporation finance
or financial management has now become more analytical and quantitative. 1960’s
witnessed phenomenal advances in the theory of ‘portfolio analysis’ by Microwitz,
Sharpe, Lintner etc. Capital Asset Pricing Model (CAPM) was developed in 1970’s. The
CAPM suggested that some of the risks in investments can be neutralized by holding of
diversified portfolio of securities. The ‘Option Pricing Theory’ was also developed in the
form of the Binomial Model and the Block-Scholes Model during this period. The role of
taxation in personal and corporate finance was emphasized in 80’s. Further, newer
avenues of raising finance with the introduction of new capital market instrument such as
PCD’s, FCD’S, etc. were also introduced. Globalisation of markets has witnessed the
emergence of ‘Financial Engineering’ which involves the design, development and
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implementation of innovative financial instruments and the formulation of creative
optimal solutions to problems in finance. The techniques of models, mathematical
programming and simulations are presently being used in corporation finance and it has
achieved the prime place of importance. We may conclude that financial management
has evolved from a branch of economics to a distinct subject of detailed study of its own.
Finance is the life blood and nerve centre of a business, just as circulation of
blood is essential in the human body for maintaining life, finance is very essential to
smooth running of the business.
The above three factors have further increased the importance of corporation
finance. As the owners (shareholders) in a corporate enterprise are widely scattered and
the management is separated from the ownership, the management has to ensure the
maximization of owner’s economic welfare. The success and growth of a firm depends
upon adequate return on its investment. The investors or shareholders can be attracted
by a firm only by maximization of their wealth through the application of principles and
procedures.
The knowledge of the Finance is important not only to the managers, but also to
investors, lenders, bankers, creditors, etc., as there is always a scope for the management
to manipulate and ‘window dress’ the financial statements.
In the present day capitalistic regime, the size of the business enterprises is
increasing resulting into corporate empires empowered with a lot of social and political
influence. This makes corporation finance all the more important.
This subject is important and useful for all types of ownership organizations.
Where there is a use of finance, financial management is helpful. Every management
aims to utilize its funds in a best possible and profitable way. So this subject is acquiring
a universal applicability.
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AIMS OF FINANCE FUNCTION
The primary aim of finance function is to arrange as much funds for the business
as required from time to time. This function has the following aims:
1. Acquiring Sufficient Funds. The main aim of finance function is to assess the
financial needs of an enterprise and then finding out suitable sources for raising them.
The sources should be suitable with the needs of the business. If funds are needed for
longer periods then long-term sources like share capital, debentures, term loans may be
explored. A concern with longer gestation period should rely more on owner’s funds
instead of interest-bearing securities because profits may not be there for some years.
2. Proper Utilization of Funds. Though raising of funds is important but their
effective utilization is more important. The funds should be used in such a way that
maximum benefit is derived from them. The returns from their use should be more than
their cost. It should be ensured that funds do not remain idle at any point of time. The
funds committed to various operations should be effectively utilized.
3. Increasing Profitability. The firm’s ability to earn profit must be increased.
There must be higher profit measured in terms of ROI. The management practices must
be so designed to increase its profitability.
4. Maximising Firm’s Value. Finance function also aims at maximizing the
value of the firm. It is generally said that a concern’s value is linked with its profitability.
Even though profitability influences a firm’s value but it is not all. Besides profits, the
type of sources used for raising funds, the cost of funds, the condition of money market,
the demand for products are some other considerations which also influence a firm’s
value.
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then share capital may be most suitable. Long-term funds should be employed to finance
working capital also partially. A decision about various sources for funds should be
linked to the cost of raising funds.
3. Selecting a Source of Finance. After preparing a capital structure, an
appropriate source of finance is selected. Various sources, from which finance may be
raised, include; share capital, debentures, financial institutions, commercial banks,
public deposits, etc. If finances are needed for short periods then banks, public deposits
and financial institutions may be appropriate; on the other hand, if long-term finances are
required then share capital and debentures may be useful. The need, purpose, object and
cost involved may be the factors influencing the selection of a suitable source of
financing.
4. Selecting a Pattern of Investment. When funds have been procured then a
decision about investment pattern is to be taken. The selection of an investment pattern is
related to the use of funds. The decision-making techniques such as Capital Budgeting,
Opportunity Cost Analysis etc. may be applied in making decisions about capital
expenditures. One may not like to invest on a project which may be risky even though
there may be more profits.
5. Proper Cash Management. Cash management is also an important task of
finance manger. He has to assess various cash needs at different times and then make
arrangements for arranging cash. Cash may be required to (a) purchase raw materials, (b)
make payments to creditors, (c) meet wage bills; (d) meet day-to-day expenses. The cash
management should be such that neither there is a shortage of it and nor it is idle. It will
be better if Cash Flow Statement is regularly prepared so that one is able to find out
various sources and applications.
6. Implementing Financial Controls. An efficient system of financial
management necessitates the use of various control devices. Financial control devices
generally used are,; (a) Return on investment, (b) Budgetary Control, (c) Break
Even Analysis., (d) Cost Control, (e) Ratio Analysis (f) cost and Internal Audit. The
use of various control techniques by the finance manager will help him in evaluating the
performance in various areas and take corrective measures whenever needed.
7. Proper Use of Surpluses. The utilisation of profits or surpluses is also an
important factor in financial management. A judicious use of surpluses is essential for
expansion and diversification plans and also in protecting the interests of shareholders.
The ploughing back of profits is the best policy of further financing. A finance manager
should consider the influence of various factors, such as; (a) trend of earnings of the
enterprise, (b) expected earnings in future, (c) market value of shares, (d) need for funds
for financing expansion, etc. A judicious policy for distributing surpluses will be essential
for maintaining proper growth of the unit.
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9. Cost-Volume-Profit Analysis. Cost-volume-profit analysis is an important
tool of profit planning. It answers questions like, what is the behavior of cost and volume.
At what point of production a firm will be able to recover its costs? How much a firm
should produce to earn a desired profit?
The first concern of a finance manager will be to recover all costs. It will aspire to
achieve break-even point at the earliest. It is a point of no-profit no-loss. Any production
beyond break-even point will bring profits to the concern. This analysis is very helpful in
deciding the volume of output or sales. The knowledge of cost-volume profit analysis is
essential for taking important decisions about production and profits.
12. Profit Planning and Control. Profit planning and control is an important
responsibility of the financial manager. Profit is determined by the volume of revenue
and expenditure. The excess of revenue over expenditure determines the amount of profit.
Profit planning and control directly influence the declaration of dividend, creation of
surpluses, taxation etc. Break-even analysis and cost-volume-profit relationship are some
of the tools used in profit planning and control.
13. Dividend Policy. Dividend is the reward of the shareholders for investments
made by them in the shares of the company. The company should distribute a reasonable
amount as dividends to its members and retain the rest for its growth and survival.
Dividend policy is an important area of financial management because the interests of the
share holders and the needs of the company are directly related to it.
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OBJECTIVES OF FINANCIAL MANAGEMENT OR GOALS OF BUSINESS
FINANCE
Financial management is concerned with procurement and use of funds. Its main
aim is to use business funds in such a way that the firm’s value / earnings are maximized.
Financial management provides a frame work for selecting a proper course of action and
deciding a viable commercial strategy. The main objective of a business is to maximize
the owner’s economic welfare. This objective can be achieved by;
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considered inadequate. Even as an operational criterion for maximizing owner’s
economic welfare, profit maximization has been rejected because of the following
drawbacks;
(i) The term ‘profit’ is vague and it cannot be precisely defined. It means
different things for different people. Should we consider short-term profits or long-term
profits? Does it mean total profits or earnings per share?
Even if, we take the meaning of profits as earnings per share and maximize the
earnings per share, it does not necessarily mean increase in the market value of share and
the owner’s economic welfare.
(ii) Profit maximization objective ignores the time value of money and does not
consider the magnitude and timing of earnings. It treats all earnings as equal when they
occur in different periods. It ignores the fact that cash received today is more important
than the same amount of cash received after, three years.
(iii)It does not take into consideration the risk of the prospective earnings stream.
Some projects are more risky than other.
(iv) The effect of dividend policy on the market price of shares is also not
considered in the objective of profit maximization.
Symbolically, Wo = N x Po
This objective helps in increasing the value of shares in the market. The share’s
market price serves as a performance index or report card of its progress. It also indicates
how well management is doing on behalf of the shareholder. We can conclude that:
refers to refers to
Maximum Utility Maximum stockholder’s wealth Maximum current
Stock price per share
However, the maximization of the market price of the shares should be in the long
run. Every financial decision should be based on cost-benefit analysis. If the benefit is
more than the cost, the decision will help in maximizing the wealth.
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Implications of Wealth maximization. There is a rationale in applying wealth
maximizing policy as an operating financial management policy. It serves the interests of
suppliers of loaned capital, employees, management and society. Besides shareholders,
there are short-term and long-term suppliers of funds who have financial interests in the
concern. Short-term lenders are primarily interested in liquidity position so that they get
their payments in time. The long-term lenders get a fixed rate of interest from the
earnings and also have a priority over shareholders in return of their funds.
Wealth maximization objective not only serves shareholder’s interests by
increasing the value of holdings but ensures security to lenders also. The economic
interest of society is served if various resources are put to economical and efficient use.
In spite of all the criticism, we are of the opinion that wealth maximization is the
most appropriate objective of a firm and the side costs in the form of conflicts between
the stockholders and debenture holders, firm and society and stock holders and managers
can be minimized.
FINANCIAL DECISIONS
We can classify these decisions into three major groups:
1. Investment decisions.
2. Financing decisions.
3. Dividend decisions.
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assets, research and development project costs, and reallocation of funds, in case,
investments made earlier do not fetch result as anticipated earlier.
2. Financing Decisions. Once the firm has taken the investment decision and
committed itself to new investment, it must decide the best means of financing these
commitments. It is concerned with the best overall mix of financing for the firm.
A finance manager has to select such sources of funds which will make optimum
capital structure. The financial manager has to strike a balance between various sources
so that the overall profitability of the concern improves. If the capital structure is able to
minimize the risk and raise the profitability then the market prices of the shares will go
up maximizing the wealth of shareholders.
The finance function is very vital for every type of business enterprise. There is a
need to set up a sound and efficient organization to achieve its goals. However,
organization of finance function is not standardized one. It varies from enterprise to
enterprise, depending upon its nature, size and other requirements. In a small concern,
whose operations are simple and there is little delegation of authority no separate
executive is appointed to handle finance function. It is the owner who performs all these
function himself. But in medium and large scale concerns, a separate department to
organize all financial activities may be created at top level under the direct supervision of
Board of Directors or a highly placed official. This function may be headed by a
committee or a top management executive. All important financial decisions are taken by
the committee or the executive but routine decisions are left to the lower levels of
management.
The finance function is centralized because of its importance. The financial
decisions are crucial for the survival of the concern. Any bad decision on financial
aspects will adversely affect the reputation of the concern. The centralization of finance
function will result in certain economies in raising funds, purchasing of fixed assets, etc.
In large concerns, for organizing finance functions, the Controller and Treasurer
are appointed. The organization of finance function may be diagrammatically Shown as
below:
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Board of Directors
Managing Director
Finance Committee
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