Financial Decisions

Factors Influencing Financial

Decision
These factors are divided into two parts

1. Micro economic factors

Nature and Size of the Firm

Level of Stability in Risk and Earnings
Liquidity Position
Asset Structure and Pattern of Ownership
Attitude of Management

2. Macro economic factors

The state of the Economy
Government Policies

Financial Objectives of a Firm

1. Profitability
Is the ability to earn a profit.
Many start-ups are not profitable during their first one
to three years, however a firm must become
profitable to remain viable and provide a return to its
owners.
2. Liquidity
Is a companys ability to meet its short-term financial
obligations.
Even if a firm is profitable, it is often a challenge to
keep enough money in the bank to meet its routine
obligations.
3. Efficiency
How productively a firm utilizes its assets relative to its
revenue & its profits.
4. Stability

Financial Manager Role

1.
2.
3.
4.

Funds Raising
Funds Allocation
Profit Planning
Understanding Capital Markets

Fundamental Objective

All the management decisions should help to

accomplish the goal of the firm
What should be the goal of a firm?
Maximize profit?
Minimize costs?
Maximize Earning per share?
Maximize the current value of the companys stock?

Profit Maximization

Profit is a test of economic efficiency.

Its limitations are
1.Profit is a vague and ambiguous concept.
2.Timing of Benefits: It ignores the differences in the
time pattern of the benefits received over the working
life of the asset, irrespective of when they were received.
Time

Alternative A (Rs in
Lakh)

Alternative B (Rs in
Lakh)

Period I

50

Period II

100

100

Period III

50

100

200

200

Alternative A (Rs in
Lakh)

Alternative B (Rs in
Lakh)

Normal (Period II)

10

10

Boom (Period III)

11

20

Total

3.It ignores risk.

Time
Recession (Period I)

Maximizing Earning Per Share

EPS is the total earning divided by total number of
shares.
Ignores timing and risk of the expected benefit.
Market value is not a function of EPS. Hence
maximizing EPS will not result in highest price for
company's shares.
Maximizing EPS implies that the firm should make no
dividend payment so long as funds can be invested
at positive rate of returnsuch a policy may not
always work.

Shareholders Wealth
Maximization
Wealth Maximization
criterion is based on the concept

of cash flows generated by the decision rather than

accounting profit.
It incorporates the time value of money and risk.
Two important issues related to
value/price
maximization
Economic value added is
= after tax profits - cost of funds used to finance
investments.
Stakeholders include group such as employees,
customers, suppliers, creditors, owners and others
who have a direct link to the firm.

Agency Relationship

Principal hires an agent to represent their interest.

What About Risk

How would the stockholder of a small business react if
they were told that their manager canceled all
casualty and liability insurance policies so the money
spent of premium could go to profit instead.
Even though the expected profits increased by this
action, it is likely that stockholders would be
dissatisfied because of the increase risk they would
bear.
When the stockholders are dissatisfied they will simply
sell the stock of the company.
Why is Market Value more important than Book Value?
Book value are often based on dated values. They
consist of the original cost of the asset from the
past time minus the accumulated depreciation

Agency Problem
Agency Problem is the likelihood that managers may
place personal goals ahead of corporate goals.
Agency Problem can be minimized in following ways:i. Monitoring
ii. Stock option: Purchase share at concessional price.
iii. Incentive Plans: Tie management compensation to
share price.
iv. Performance Shares - Given for meeting the stated
performance goals.
v. Hostile Takeovers / Firing of management

Social Responsibility

Wealth maximization does not preclude the

firm from being socially responsible.
responsible

Corporate Governance
Corporate
governance:
represents
the
system by which corporations are managed
and controlled.
- Includes shareholders, board of directors,
and senior management.
Then
shareholder
wealth
maximization
remains the appropriate goal in governing
the firm.

Ten Principles That Form

The Foundations of
Financial Management
although it is not necessary to understand finance in order to
understand these principles, it is necessary to understand these
principles in order to understand finance.

Principle 1: The RiskReturn Trade-off

We wont take on additional risk unless
we expect to be compensated with
additional return.
Investment alternatives have different
amounts of risk and expected returns.
The more risk an investment has, the
higher its expected return will be.

Principle 2: The Time

Value of Money
A dollar received today is worth more
than a dollar received in the future.
Because we can earn interest on money
received today, it is better to receive
money earlier rather than later.

Principle 3: CashNot
ProfitsIs King
Cash Flow, not accounting profit, is
used as our measurement tool.
Cash flows, not profits, are actually
received by the firm and can be
reinvested.

Principle 4: Incremental
Cash Flows
It is only what changes that counts
The incremental cash flow is the
difference between the projected cash
flows if the project is selected, versus
what they will be, if the project is not
selected.

Principle 5: The Curse of

Competitive Markets
It is hard to find exceptionally profitable
projects
If an industry is generating large profits, new
entrants are usually attracted. The additional
competition and added capacity can result in
profits being driven down to the required rate
of return.
Product Differentiation, Service and Quality
can insulate products from competition

Principle 6: Efficient
Capital Markets
The markets are quick and the
prices are right.
The values of all assets and
securities at any instant in time
fully reflect all available
information.

Principle 7: The Agency

Problem
Managers wont work for the owners
unless it is in their best interest
The separation of management and the
ownership of the firm creates an agency
problem.
Managers may make decisions that are not
in line with the goal of maximization of
shareholder wealth.

Principle 8: Taxes Bias

Business Decisions
The cash flows we consider are
the after-tax incremental cash
flows to the firm as a whole.

Principle 9: All Risk is Not

Equal
Some risk can be diversified away,
and some cannot
The process of diversification can
reduce risk, and as a result,
measuring a projects or an assets
risk is very difficult.

Principle 10: Ethical Behavior Is Doing the

Right Thing, and Ethical Dilemmas Are
Everywhere in Finance

Each person has his or her own set

of values, which forms the basis for
personal judgments about what is
the right thing