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Forms of Business Organisations
Financial Decisions in a Firm Goal of Financial Management The fundamental Principle of Finance
FORMS OF ORGANISATION
Public Limited Company
Many owners Somewhat complex Limited liability Distinct legal person
Capital Budgeting
Capital Structure
The quest for value drives scarce resources to their most productive uses and their most efficient users. The more effectively resources are deployed, the more robust will be the economic growth and the rate of improvement in our standard of living. Adam Smiths invisible hand is at work when investors private gain is a public value.
Centre for Financial Management , Bangalore
The balancers argue that a firm should seek to balance the interests of various stakeholders Advocates of social responsibility argue that a business firm must assume wider social responsibilities
Dhirubai Ambani : In everything that we do, we have only one supreme goal, that is to maximise your wealth as India's largest investor family.
Anand Mahindra : All of us are beginning to look at companies as owned by shareholders. The key is to raise shareholder returns
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ALTERNATIVE GOALS
Maximisation of Profit This goal is not as inclusive a goal as maximisation of shareholders wealth. Its limitations are: Profit in absolute terms is not a proper guide to decision making. It should be expressed either on a per share basis or in relation to investment. It leaves considerations of timing and duration undefined. It glosses over the factor of risk Maximisation of EPS or ROE
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The proposal generates cash returns to investors A business proposalregardless of whether it is a new investment or acquisition of another company or a restructuring initiative raises the value of the firm only if the present value of the future stream of net cash benefits expected from the proposal is greater than the initial cash outlay required to implement the proposal.
EVOLUTION OF FINANCIAL
MANAGEMENT
The study of financial management as a distinct
field of study emerged in the early 20th Century. The evolution of the same can be divided into three phases:
Traditional Phase (Early 1900s to 1940): Focused on Formation, issuance of Capital, major expansion, merger, reorganization and liquidation in the life cycle of the firm. Transitional Phase (1940 to 1950): Similar to Traditional Phase, focused shifted to working capital management. Modern Phase (Mid 1950s): Focused shifted to rational matching of funds to their uses so as to maximize the wealth of shareholders. The approach has become more analytical and quantitative.
Financial management emerged as a distinct field of study at the turn of the 20th century. Its evolution may be divided into three broad phases - the traditional phase, the transitional phase, and the modern phase. The modern phase began in mid-1950s and has been marked by infusion of ideas from economic theory and application of quantitative methods The distinctive features of the modern phase are: Central concern : Shareholder wealth maximisation Approach : Analytical and quantitative
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prices change over time in speculative markets. Portfolio theory: Formation of an optimal portfolio of securities. Capital asset pricing theory: Determination of asset prices under conditions of uncertainty. Option pricing theory: Determination of the prices of contingent claims such as call options. Agency theory: Analysis of incentive conflicts in contractual relations. Behavioral Finance: Consideration of social, cognitive, and emotional factors that influence decisions.
Dividend Decisions
Working Capital Decisions
AGENCY PROBLEM
While there are compelling reasons for separation of
ownership and management, a separated structure leads to a possible conflict of interest between managers and shareholders. The lack of perfect alignment between the interests of managers and shareholders results in the agency problem. To mitigate the agency problem, effective monitoring has to be done and appropriate incentives have to be offered.
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positively correlated.
Given the subjective nature of ethics, in many cases the choice between the ethics and profits is not unambiguous.
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The engineer, who proposes a new plant, shapes the investment policy of the firm The marketing analyst provides inputs in the process of forecasting and planning The purchase manager influences the level of investment in inventories The sales manager has a say in the determination of the receivables policy Departmental managers, in general, are important links in the finance control system of the firm
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Treasurer
Controller
Cash Manager
Credit Manager
Tax Manager
Portfolio Manager
Internal Auditor
Macroeconomic environment defines the setting within which the firm operates. GDP growth rate, savings rate, fiscal deficit, interest rates, inflation rate, exchange rates, tax rates, and so on have an impact on the firm Microeconomic theory provides the conceptual underpinnings for the tools of financial decision making. Finance, in essence, is applied microeconomics
finance is aimed at value maximising. The accountant prepares the accounting reports based on the accrual method. The focus of the financial manager is on cash flows. Accounting deals primarily with the past. Finance is concerned mainly with the future.
Economic uncertainty
Tax law changes Ethical concerns over financial dealings
Shareholder activism
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EMERGING ROLE OF THE FINANCIAL MANAGER IN INDIA The key challenges for the financial manager appear to be in the following areas: Investment planning and resource allocation Financial structure
Risk management
Corporate governance Investor relations
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SUMMING UP
There are three broad areas of financial decision making, viz., capital budgeting, capital structure, and working capital management. Finance theory, in general, rests on the premise that the goal of financial management should be to maximise the wealth of shareholders. A business proposal raises the value of the firm only if the present value of the future stream of net cash benefits expected from the proposal is greater than the initial cash outlay required to implement the proposal. A confluence of forces appears now to be prodding Indian companies to accord greater importance to the goal of shareholder wealth maximisation. In general, when you take a financial decision, you have to answer the following questions : What is the expected return ? What is the risk exposure ? Given the risk-return characteristics of the decision, how would it influence value ?
Centre for Financial Management , Bangalore
The important forms of business organisation are : sole proprietorship, partnership, private limited company, and public limited company. While each form of organisation has certain advantages and limitations, the public limited company form of organisation generally appears to be the most appropriate form from the point of view of shareholder wealth maximisation. While there are compelling reasons for separation of ownership and management, a separated structure leads to a possible conflict of interest between managers and shareholders. The lack of perfect alignment between the interests of managers and shareholders results in the agency problem. To mitigate the agency problem, effective monitoring has to be done and appropriate incentives have to be offered.
Fraud involves violating the law, whereas unethical behaviour involves breaching the code of ethics or moral behaviour.
The treasurer is responsible mainly for financing and investment activities and the controller is concerned primarily with accounting and control. Financial management has a close relationship to economics on the one hand and accounting on the other.
Thanks to the changes in the complexion of the economic and financial environment in India from early 1990s, the job of the financial manager in India has become more important complex, and demanding.