Chapter- 1

INTRODUCTION TO
FINANCIAL MANAGEMENT

Learning Objectives:

After careful review of this chapter, you should be able to understand the:

 Meaning and concept of financial management.

 Financial management and financial managers

 Importance of Financial management

 Finance functions

 Objectives or Goals of Financial management

 Agency Problems
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MAIN IDEAS

Under this chapter, my dear students of BHM fourth semester will get
knowledge required to become a financial manager. This chapter provides the
clear-cut meaning and concept of financial management, the financial managers,
his/her roles and functions importance of financial management, objectives of the
firms and the development. Furthermore, the readers can understand how the
financial management is related to economics, accountancy and other disciplines
as well as the problems occurring in the agencies and its remedies.

MEANING & CONCEPT OF FINANCE

‘Financial management’ is the composition of two words ‘finance’ and
‘management’. The term ‘finance’ indicates theo art as well as science to identify the
sources of funds, collection of money, identification of potential investment
opportunities, select the best alternative for investment, distribute certain percentage
of earnings to the sources as a cost of capital and enjoy the rest of earnings and
plough back of profit and again and again. Similarly, the term 'management' refers to
the art of managing resources efficiently and effectively. Hence, the financial
management can be defined as the art and science of managing the financial
resources which involves raise of needed fund at the minimum cost of capital,
efficient utilization of funds proper management of assets and allocation of profit in
order to maximize the market value of shareholder equity.

Financial management is basically utilization of the functions of management –

planning, organizing, controlling, directing/leading to the financial resources, in
order to create value and wealth for the investors and basically ultimate owners of
the corporate house viz. shareholders. Organizationally, it’s the function that’s
related with the financial planning and operations. In a very simple form, it can be
defined as “Management of any financial activity, which deals with the organization
and its financial resources”

The Financial management focuses on short term and long term decision making
with proper analysis of risk and return implications of each for the long term value
generation in the organization. It means the Financial management deals with capital
investment decision: Which project or projects should be accepted?; Capital
Structure Decision: Whether to finance by debt or equity?; Dividend or Distribution
Decision: When, whether and How to pay the dividends? Similarly it also focuses on
working capital management decisions: How much of current asset to keep in the
form of cash? How much inventory should be ordered? How the credit granting
 INTRODUCTION TO FINANCIAL MANAGEMENT |3
function can be managed? It deals with balancing the current assets and current
liabilities; managing cash, receivables, inventories, short term borrowings etc.

In the word of Moyer: The term ‘Financial management’, ‘corporate finance,

‘managerial finance’ and business finance are virtually synonymous and are used
interchangeably. Most financial managers, however, seems to prefer either financial
management.

Hampton defines the finance as: The term finance can be defined as the management
of the flows of money through an organization, whether it is a corporation, school,
bank or government agency. Finance concerns itself with the actual flows of money
as well as any claims against money.

In our words,

Each letter of the term "FINANCE" precisely enlightens as:

F= Fund raising decision

I= Investment decision

N= Negotiation between surplus unit and deficit unit

A= Art and science of managing financial resources

N= New but the best concept in the world of business

C= Capital structure & risk management decision and Corporate social responsibility

E= Earning, Evaluation and Continual Improvement

FINANCIAL MANAGEMENT AND FINANCIAL

MANAGERS
The person who is responsible for all financial decision is known as financial
manager but it is not so simple to define the financial manager. The financial
managers, its functions and roles depend upon the nature and size of business. The
financial manager indicates to all; the Chief Financial Officer (CFO), Treasurer,
Controller, Insurance and Risk manager, Cash and Credit manager etc.

Finance as a function in an organization, can be segregated into two sub-functions –

Treasurer Ship and Controllership. Treasurer ship is more related with the planning
and relation management function, while controllership is more related with
monitoring, controlling, maintaining, evaluating and reporting function.
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Normally a treasurer, a person who is responsible for rising of capital, managing the
cash and credit, maintaining the relationship with banks and financial institutions is a
financial manager. Similarly the controller, a person who focuses on quantitative data
like cost benefit analysis, financial values, tax effects etc. is also known as the
financial manager. Similarly, the cash and credit officers who try to balance the
inflows and outflows of cash, loan situation, mortgages etc. are also financial
managers. Furthermore, the CFO who coordinates with the CEO, treasurers and
controller is involved in the planning and implementing the financial decisions.
Hence, all those people in an organization, who are involved in financial activities,
are the financial managers.

The financial manager is the person who is mainly responsible and accountable for
the management of agency problem. There are chances of agency problems arising
where there’s agency relationship being created. Any individual, organization or
entity, when hires some other individual, organization or entity to do work on their
behalf for their welfare, we say that the agency relationship has been initiated
between the two. The first party, who hires, is called Principal and the second one,
who is hired, is called Agent. Hence, in an organization, shareholders and managers
are principals and agents respectively. Other agency relationships in organization
arise between managers and employees, shareholders and creditors, board and top
management, management and labor unions etc.

Whenever the agent doesn’t work for the welfare of principle or hampers it, and
instead works for its own welfare, agency problem arises. Common agency problems
cited are – managers increasing their remuneration and perks/benefits to unjustifiable
limit, managers taking decisions which are not targeted towards the organizational
welfare but their own. Similarly, if the level of risk increases in the business due to
financial decisions then also the agency problem between Shareholders (through
manager) Vs Creditors exists.

Hence, the financial manager and Financial management complement each other like
nail and fish. So, the financial manager in any organization must be competent,
honest, far-sighted, and broad-minded to adopt the changes, understand the
environments and solve all the related issues.

Mainly, a financial manager is responsible for

 Planning for raising of funds
 Forecasting the future possibilities
 Identifications of sources of funds
 Evaluating all possible investment alternatives
 Selecting the best alternative for investment
 Maintaining the smooth relationship with other disciplines
 INTRODUCTION TO FINANCIAL MANAGEMENT |5
 Managing the risk of the business
 Maintain the appropriate capital structure
 Maintaining the good governance and social responsibility
 Commitment on wealth maximization
 Controlling the funds and taking care of assets.
 Instilling financial discipline in all the functions of organization
 Making finance case in every managerial decisions of organization
 Managing cost and financial control aspects

Knowledge Box:
Types of Transactions
In the larger picture of the advanced corporate world, Financial management function is more
related to the planning, financing and investment aspects. Below are some of the high-level
transactions of the corporate world, which are managed and handled by Financial management
function

 Raising seed, start-up, development or expansion capital

 Mergers, demergers, acquisitions or the sale of private companies

 Mergers, demergers and takeovers of public companies, including public-to-private deals

 Management buy-out, buy-in or similar of companies, divisions or subsidiaries - typically

backed by private equity

 Equity issues by companies, including the flotation of companies on a recognized stock

exchange in order to raise capital for development and/or to restructure ownership

 Raising capital via the issue of other forms of equity, debt and related securities for the
refinancing and restructuring of businesses

 Raising capital for specialist corporate investment funds, such as private equity, venture
capital, real estate and infrastructure funds

 Financing joint ventures, project finance, infrastructure finance, public-private partnerships

and privatizations

 Secondary equity issues, whether by means of private placing or further issues on a stock
market, especially where linked to one of the transactions listed above

 Raising debt and restructuring debt, especially when linked to the types of transactions listed
above

FINANCIAL MANAGEMENT FUNCTIONS

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The finance function consists of the people, technology, processes, and policies that
dictate tasks and decisions related to financial resources of a company. Depending on
the organization and the industry in which it operates, this function may be simple or
complex. Some finance functions are overstaffed that is, they rely on individuals to
perform both advanced and simple tasks while others are highly automated relying
on people for decision making and policy setting exclusively. Regardless of the ratio
of people to technology, the goal of the finance function is to serve the organization's
financial/accounting needs while laying a platform for the future. This means
handling clerical tasks, providing information to the organization and setting
financial policies and strategies that will serve the company in the future. To succeed
in these three broad areas, the small and emerging business must be prepared to
develop a finance function that both suits its needs and can adapt to the growth and
changes of the business. The first step is to develop an adequate finance function. To
do this, it is important to understand the component parts.

The basic financial management functions are described as those functions related to;

A) Main Functions:
Raising of Capital
The first function of finance is rising of capital to support company operations and
investments. It is also known as financing function. Once profitable project is
identified then the required capital must be raised on time. Similarly, the composition
of capital structure should also be decided and raised accordingly. It is also one of
the challenging tasks of finance. The management of company cash flow and
balancing the ratio of debt and equity financing to maximize company value. The
value maximization refers to the net worth and share price maximization.. An
emerging area in finance theory is right-financing whereby investment banks and
corporations can enhance investment return and company value over time by
determining the right investment objectives, policy framework, institutional
structure, source of financing (debt or equity) and expenditure framework within a
given economy and under given market conditions. One last theory about this
decision is the Market timing hypothesis which states that firms look for the cheaper
type of financing regardless of their current levels of internal resources, debt and
equity.
This function is also known as Capital Structure Management function, which
basically is concerned with raising of long term capital – in the form of equity or
debt or any hybrid financing sources (viz. preference capital, debt capital with
convertible option or warrant etc). The whole aim of the function is to raise capital in
order to maximize the shareholder’s wealth (firm value, share price) which also
 INTRODUCTION TO FINANCIAL MANAGEMENT |7
means minimizing the cost of capital. Capital raised from market do not come for
free, as the investors take risk by investing in the firm, they’ll have to be
compensated by return, whose mirror image is the cost of capital for the firm.
Finance manager needs to understand the following aspects when exercising this
function of finance:
 From which source to raise long term capital
 Implications of raising capital from a particular source on the value of the
firm (shareholder’s wealth)
 Types of capital instruments (equity, bonds, term loans, debentures,
convertibles, preference shares etc) should be used to raise capital
 Condition of the market – is it the right time to raise capital from market
 Market efficiency
 Risks associated with various forms of capital (financial & business risk)
 Costs and Benefits of issuing capital instruments in the market
 Pros and Cons of getting equity listed in the stock exchange
 Effect on brand and reputation value of the particular capital instrument
issuance

Investing in profitable projects

Before making investment in any projects, all the possible alternative investment
projects should be identified and evaluated in terms of cost benefit ratio, timing
of returns, and selecting those projects based on risk and expected return that are
the best use of a company's resources. It is also known as capital budgeting
functions. Similarly, the several capital budgeting tools like Payback period
(PBP) to find the time of investment payback, Net Present Value (NPV) to find
the wealth increase, Profitability Index (PI) to analyze the cost benefit ratio,
Internal Rate of Returns (IRR) to find the actual investment rate etc. can be used
to analyze in different aspects and take the best investment decision.

This function is also known as investment decisions. Any organization has a

particular business line to invest on, for which it commits its capital for the long
term – in expectation of return that ultimately leads to cash flow generation that
can be returned to shareholders in the form of dividends (other forms of
distributions are stock dividend, bonus shares, stock repurchase) or capital gain
(benefit that the shareholders derive by selling their shares at higher price than
their purchase price). By exercising this function, organization generates long
8| FINANCIAL MANAGEMENT
term fixed assets in their balance sheet, which yields long term profit. This
function is crucial because of following reasons:

 Long term investment decisions involve commitment of larger portion of

long term capital of the firm.

 Such decisions once taken are generally irreversible without incurring

significant loss.

 The commitment of the funds should be made at present while the cash flow
return of the investment will keep coming through farther future.

Finance Manager gets confronted with many investment alternatives while exercising
this function. Risk and return implication of each of the alternatives should be
estimated and weighted properly in order to take the final decision. The major aspect
of this function is to choose the right investment project to invest the scarce capital
resource of the organization, for which, the organization incurs cost. The basic rule is
to choose the investment project which yields return higher than the cost of capital
for the firm – the cost of capital acting as hurdle rate for every investment project
that the firm undertakes.

Finance manager needs to understand the following aspects when exercising this
function of finance:

 Best alternative investment in the line of business

 Risk Return implication of each of the alternatives.

 Estimation of the size and timing of the cash flow

 Uncertainty associated with the cash flow of the investment

 Cost of capital of the firm and its composition

 Portfolio Management of various investment projects

 Business Risk and Financial Risk associated with the investment

 Adjustment of the hurdle rate reflecting various risks in the investment.

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 Market Risk associated with the trading function of the investment

The dividend decision

The dividend is calculated mainly on the basis of the company's undistributed profit
and its business prospects for the coming years. If there are no profitable investment
opportunities (positive NPV projects), i.e. where returns exceed the hurdle rate, then
management must return excess cash to investors. These free cash flows comprise
cash remaining after all business expenses and investment needs have been met.
This is the general case, however there are exceptions. For example, investors
investing in a "Growth stock", expect that the company will, almost by definition,
retain earnings so as to fund growth internally. In other cases, even though an
opportunity is currently NPV negative, management may consider “investment
flexibility” / potential payoffs and decide to retain cash flows.
Management must also decide on the form of the distribution, generally as cash
dividends or via a share buyback. There are various considerations: where
shareholders pay tax on dividends, companies may elect to retain earnings, or to
perform a stock buyback, in both cases increasing the value of shares outstanding;
some companies will pay "dividends" from stock rather than in cash. Today, it is
generally accepted that dividend policy is value neutral.
Also known as distribution decision, it’s not as simple as the philosophy of “earn and
distribute” as there can be value implications of the size, form and style of
distribution. An organization with a good amount of retained earnings and reserves is
confronted with two choices: either to distribute it or to re-invest in the profitable
investments in order to create more value (some sort of combination of both is also
an option). However the judgment of the degree of repercussion on the value of the
firm of the decision taken is not as easy. On one hand, generally shareholders in the
market love distribution of some form, while on the other hand, there are also
shareholders who want return through capital gain, which is possible if the
organization invests internally in growth ventures. Finance Manager has to maintain
a proper balance among the both (of course, depending upon many factors like
industry situation, market demand, organizational growth plan, available resource
etc) so as to maximize the value of the firm.
Also that there are many forms of distribution for e.g; stock dividend, share
repurchase etc which have different tax considerations, accounting considerations
and value repercussion for the organization and investors.
Finance manager needs to understand the following aspects when taking this
decision:
 Organizational growth plan versus shareholder’s return composition
 Market psychology and its liquidity position
 Shape of the organization’s investment plan and policies
 Segments of shareholders and their expectations with the organization
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 Capital market condition and its need

B) Other Functions
Working capital management
Decisions relating to investment in working capital and short term financing are
referred to as working capital management. These involve managing the relationship
between a firm's short-term assets and its short-term liabilities.

The goal of financial management/financial management being maximization of firm

value, in the context of long term, capital investment decisions, and firm value is
enhanced through appropriately selecting and funding NPV positive investments.
These investments, in turn, have implications in terms of cash flow and cost of
capital.

The goal of Working capital management to ensure that the firm is able to operate,
and that it has sufficient cash flow to service long term debt, and to satisfy both
maturing short-term debt and upcoming operational expenses.

An organization aiming for longer term maximization of shareholder’s wealth should

be good in its day to day operation and that’s closely related to working capital
management. Organization needs to achieve conflicting aims of profitability and
liquidity while taking care of risk inherent in operations. During the course of its
business, it needs to order, keep and manage inventory, cash, and credits while being
prudent in management of current liabilities.

Two most important decisions to be taken in this context are: managing the timing of
the entry and exit of the constituents of working capital (current assets and current
liabilities) and deciding on the levels of working capital.

Corporate Governance function

The definition of corporate governance most widely used is "the system by which
companies are directed and controlled" (Cadbury Committee, 1992). More
specifically it is the framework by which the various stakeholder interests are
balanced, or, as the IFC states, "the relationships among the management, Board of
Directors, controlling shareholders, minority shareholders and other stakeholders".
 INTRODUCTION TO FINANCIAL MANAGEMENT |11
The OECD Principles of Corporate Governance states:

"Corporate governance involves a set of relationships between a company’s

management, its board, its shareholders and other stakeholders. Corporate
governance also provides the structure through which the objectives of the company
are set, and the means of attaining those objectives and monitoring performance are
determined."

The corporate financial manager should also work for good governance system to
comply with the rules and regulations of the regulatory body and thus increase the
reputation of the company. So, developing a corporate governance structure to encourage
ethical behavior and actions that serve the best interests of its stockholders and society as
well is also one of the major functions of financial management manager.

Knowledge Box:
Main Conclusions from the report
“The Corporate Governance Lessons from the Financial Crisis” (This
report is published on the responsibility of the OECD Steering Group on Corporate Governance
which agreed the report on 11 February 2009. The Secretariat’s draft report was prepared for the
Steering Group by Grant Kirkpatrick under the supervision of Mats Isaksson.)

This article concludes that the financial crisis can be to an important extent attributed to failures
and weaknesses in corporate governance arrangements. When they were put to a test, corporate
governance routines did not serve their purpose to safeguard against excessive risk taking in a
number of financial services companies. A number of weaknesses have been apparent. The risk
management systems have failed in many cases due to corporate governance procedures rather than
the inadequacy of computer models alone: information about exposures in a number of cases did
not reach the board and even senior levels of management, while risk management was often
activity rather than enterprise-based. These are board responsibilities. In other cases, boards had
approved strategy but then did not establish suitable metrics to monitor its implementation.
Company disclosures about foreseeable risk factors and about the systems in place for monitoring
and managing risk have also left a lot to be desired even though this is a key element of the
Principles. Accounting standards and regulatory requirements have also proved insufficient in some
areas leading the relevant standard setters to undertake a review. Last but not least, remuneration
systems have in a number of cases not been closely related to the strategy and risk appetite of the
company and its longer term interests.
The Article also suggests that the importance of qualified board oversight, and robust risk
management including reference to widely accepted standards is not limited to financial
institutions. It is also an essential, but often neglected, governance aspect in large, complex
nonfinancial companies. Potential weaknesses in board composition and competence have been
apparent for some time and widely debated. The remuneration of boards and senior management
also remains a highly controversial issue in many countries.
12| FINANCIAL MANAGEMENT

Risk management function

The wealth maximization will not be an appropriate goal until and unless the risk is
managed. The management of risk exposure is to maintain optimum risk-return
trade-off that maximizes shareholder value. So, the quantifying the risk is also an
important finance functions. The managers should always try to work in favor of
stakeholders (Shareholders and Creditors – all investors) so that the agency problem
could not exist in the business whether in the form of Shareholders (through
managers) Vs Creditors or Shareholders Vs managers.
Risk management is a central part of any organization’s corporate financial
management. It is the process whereby organizations methodically address the risks
attaching to their activities with the goal of achieving sustained benefit within each
activity and across the portfolio of all activities. The focus of good risk management
is the identification and treatment of these risks. Its objective is to add maximum
sustainable value to all the activities of the organization. It marshals the
understanding of the potential upside and downside of all those factors which can
affect the organization. It increases the probability of success, and reduces both the
probability of failure and the uncertainty of achieving the organization’s overall
objectives.

Derivatives are the instruments most commonly used in financial risk management.
Because unique derivative contracts tend to be costly to create and monitor, the most
cost-effective financial risk management methods usually involve derivatives that
trade on well-established financial markets. These standard derivative instruments
include options, futures contracts, forward contracts, and swaps.

OBJECTIVES OR GOALS OF FIRM

Due to the gradual development of finance and evolution in the financial market and
its disciplinary requirements, the goals of firms are also changing. So, we can get the
several views of financial experts and professionals. Generally cited objectives of a
firm can be any one or combination of the followings:

1. Survive
2. Avoid financial distress
3. Beat the competition
4. Maximize sales of market share
5. Minimize costs
6. Maintain steady earnings growth
 INTRODUCTION TO FINANCIAL MANAGEMENT |13
However, any of these cannot be the ultimate goal of the firm, as each of them either
speaks about the need to control risk or desire for higher return. But the basic
principle of finance is based on the premises of risk and return, both considered at
the same time while evaluating any decision or alternative. For e.g. The objective of
“survival” cannot be the ultimate goal of the organization, because, if so, then what
about the long term growth and development of the organization? Similarly the
objective of “minimizing cost” if is taken as the goal by finance manager, it might
lead him to the decisions like cutting salaries, perks benefits, insurance of employees,
which will be detrimental to the motivation level of the employees, or he might not
go for the regular maintenance of plant and machineries, which later leads to the
breakdown of them. Hence, each of these can only serve as objectives but do not
qualify to be the one for which the whole firm is aiming.
Goal of finance should comprise of both the aspects – risk and return. Typically, the
following goals are being famous in the world:
1. Profit maximization
2. Shareholders’ wealth maximization
3. Others: Managerial reward maximization; Behavioral goal and Social
responsibility.
Initially, the goal of firm was supposed only as profit maximization. They used to
focusing only on money but later the history shows that the goal of making money
only does not work in long run and it can create unfair competition. The Modern
managerial finance theory operates on the assumption that the primary goal of the
firm is to maximize the wealth of its stockholders, which translates into maximizing
the price of the firm’s common stock. The other goals mentioned above also
influence a firm’s policy but are less important than stock price maximization. Note
that the traditional goal frequently stressed by economists: ‘profit maximization’ is
not sufficient for most firms today. The focus on wealth maximization continues in
the new millennium. Two important trends: the globalization of business and the
increased use of information technology are providing exciting challenges in terms of
increased profitability and new risks. Fundamentally, we focus our discussions on
two basic goals of firms: Profit maximization and Wealth maximization.

Profit Maximization
The basic principle of finance is to manage the money so; this goal focuses on
making huge amount of money at any cost. Profit maximization is basically a single-
period or, at the most, a short-term goal. It is usually interpreted to mean the
maximization of profits within a given period of time. A firm may maximize its
short-term profits at the expense of its long-term profitability and still realize this
goal.
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Pros and cons of Profit Maximization Goal
Pros
1. It is easy to understand and to calculate profits as well. The term profit indicates
the excess of income over the cost. So, all the people can easily understand it.
2. Easy to determine the link between financial decisions and profits: One can easily
take the project selection decision; if a project is profitable should be accepted
and vice versa.

Cons
There are several things which brought the profit maximization goal to the criticism
even it is easily understandable as well as easy to link up with the investment
decision.

1. Vague & ambiguous

The goal is not clear to all because the term ‘profit’ itself is not clear whether the
profit is for short run or long run; after tax profit or before tax profit. So, it is
vague and ambiguous.
Is it short term profit or long term profit?
Short term profits may endanger the long term survival.
Is it before tax profit or after tax profit?
In the case it is profit after tax, the profit can be enhance by tax manipulation
rather than better performance.
Is it total operating profit or the percentage profit per share?
The bottom-line can be made to look good by large scale golden handshakes and
other sudden cost cutting measures which will lead to problems later on .

2. Ignores risk or uncertainty

The goal of profit maximization does not consider the risk and future
uncertainties. It is not necessarily mean that two projects providing same amount
of profit must have same amount of risk. Similarly, it is also not necessary that
project with higher profit should be accepted because the comparative risk per
unit can also be greater as compare to the other which provides lower profit.
 INTRODUCTION TO FINANCIAL MANAGEMENT |15
Example: 1
Profit maximization does not consider risk or uncertainty, whereas wealth
maximization does. Consider two products, A and B, and their projected earnings
over the next 5 years, as shown below:

Year Product A Product B

1 Rs. 10,000 Rs. 11,000
2 Rs. 10,000 Rs. 11,000
3 Rs. 10,000 Rs. 11,000
4 Rs. 10,000 Rs. 11,000
5 Rs. 10,000 Rs. 11,000
Rs. 50,000 Rs. 55,000

 A profit maximization approach would favor product B over product A. However, if

product B is more risky than product A, then the decision is not as straightforward as
the figures seem to indicate. It is important to realize that a trade-off exists between
risk and return. Stockholders expect greater returns from investments of higher risk
and vice versa. To choose product B, stockholders would demand a sufficiently large
return to compensate for the comparatively greater level of risk.

Example:2
Projects ABC XYZ
Expected Return 10% 13%
Standard deviation 6% 9%
Risk per unit(C.V.) 0.6 0.692

Here, project XYZ provides higher rate of return as compared to project ABC – thus
favoring project XYZ, while the risk of ABC is lower than that of XYZ – thus
favoring project ABC. However, the risk per unit measured by Coefficient of
Variation (C.V.) of project ABC is lower than XYZ. Hence the profit maximization
goal only focuses on return part of the evaluation, completely ignoring risk part of
which, with comes as a price of return that investors expect.

3. Ignores the timing of returns

The goal profit maximization ignores the time value of money or timing of
returns – very basic principle of economics, on which finance relies for its tools
and techniques. It means two projects producing the same profit may not be
equally acceptable because, the present values of cash flow cannot be equal at
certain required rate of returns.
Example: 3
Time/ Projects Products(Profit) Service(Profit)
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1 20,000 50,000
2 30,000 40,000
3 40,000 30,000
4 50,000 20,000
Total 140,000 140,000

In the above example, the total profit of both product and service projects are equal hence
both are equal from the consideration of “Profit Maximization”; but the project “Service”
provides higher benefits as compared to project “Product” because, once the timing of the
return (cash flow in this case) is considered the worth of project “Service” is higher than
the other one, as the higher cash flows are coming from this project earlier.

STOCKHOLDER WEALTH MAXIMIZATION GOAL

After the careful examination and practice, stockholder wealth maximization is a
long-term goal, since stockholders are interested in future as well as present profits.
The main objective of this goal is to maximize the Wealth of the firm. It means, the
firm’s Net Present Value should be maximum so that the organization can get
success in short and long run. When the NPV maximizations focused the profit will
automatically be maximized. Wealth maximization objective gives emphasis an
maximization of earning price per share. Theoretically, when earning price per share
increases then market price per share also increases. Similarly, when marker price
per share increases then share holder market value of equity also increases; Hence,
all the financing, investing and dividend decisions should be oriented to maximize
the earning price per share and net present value.

NPV = Total PV of future cash inflows – Net cash outlay

 CF1 CF2 CFn 
Mathematically, NPV=    ......   I0
 (1  k ) (1  k )
1 2
(1  k ) n 
Where,
CF= Cash inflows
K= Discount rate or, required rate of return
N= Time period
I0= Initial Investment or, Net cash outlay.
Wealth maximization is generally preferred because it considers:
(1) Wealth for the long term
(2) Risk or uncertainty
(3) The timing of returns and
(4) The stockholders’ return
Pros and Cons of Shareholder wealth Maximization Goal
Pros
 INTRODUCTION TO FINANCIAL MANAGEMENT |17
1. It recognizes risk or uncertainty because; the NPV is calculated using the required
rate of return which is essentially the opportunity cost of capital invested in the
firm. So, the decisions are based on the cost of capital. Hence, this goal is an
appropriate.
2. It recognizes the timing of returns because when we calculate the NPV, we
consider all the cash flows of the projects. So, the timing of returns consideration
automatically comes with the NPV.
3. It also considers the stockholder’s return. Generally, the stockholders’ gets return
in two ways: one from the dividend another from the increase in market price. So,
this objective seems clear.

Cons
Even though the wealth maximization seems more attractive than the profit goal still
some criticizer has started criticizing it in the following ways:
1. It offers no clear cut relationship between financial decisions and stock price.
Similarly, it is not easy to understand as profit goal to all investors.

2. When the people are honest then there is no value of any rules but when people come
to the tough competition then they can promote aggressive and creative accounting
practices.

PROFIT MAXIMIZATION Vs SHAREHOLDER'S

WEALTH MAXIMIZATION
Profit maximization can be achieved in the short term at the expense of the long-term
goal, that is, wealth maximization. For example: a costly investment may experience
losses in the short term but yield substantial profits in the long term. Also, a firm that
wants to show a short-term profit may, for example, postpone major repairs or
replacement, although such postponement is likely to hurt its long-term profitability.

Frequently, maximization of profits is regarded as the proper objective of the firm,

but it is not as inclusive a goal as that of maximizing stockholder wealth. For one
thing, total profits are not as important as earnings per stock. A firm could always
raise total profits by issuing stock and using the proceeds to invest in Treasury bills.
Even maximization of earnings per stock, however, is not a fully appropriate
objective, partly because it does not specify the timing or duration of expected
returns. Is the investment project that will produce a Rs.500,000 return 5 years from
now more valuable than the project that will produce annual returns of Rs. 75,000 in
18| FINANCIAL MANAGEMENT
each of the next 5 years? An answer to this question depends upon the time value of
money. Few existing stockholders would think favorably of a project that promised
its first return in 200 years, no matter how large this return. We must take into
account the time pattern of returns in our analysis.

Another shortcoming of the objective of maximizing earnings per stock is that it does
not consider the risk or uncertainty of the prospective earnings stream. Some
investment projects are far more risky than others. As a result, the prospective stream
of earnings per stock would be more uncertain if these projects were undertaken. In
addition, a company will be more or less risky depending upon the amount of debt in
relation to equity in its capital structure. This financial risk is another uncertainty in
the minds of investors when they judge the firm in the marketplace. Finally, earnings
per stock objective do not take into account any dividend the company might pay.

For the reasons given, an objective of maximizing earnings per stock may not be the
same as maximizing market price per stock. The market price of a firm's stock
represents the value that market participants place on the firm Shareholder wealth
(more commonly referred to as shareholder ‘value’) is talking about the value of the
company generally expressed in the value of the stock. Profit maximization refers to
how much dollar profit the company makes. It might seem like making as much
profit as possible would yield the highest value for the stock but that is not always
the case.

When investors look at a company they not only look at dollar profit but also profit
margins, return on capital and other indicators of efficiency. Say there are two
companies doing the same thing. Company A had sales of Rs.500 million and profit
of Rs.50 million. Company B had sales of Rs. 1000 million and profit of Rs. 60
million. Wall Street could look at Company B and say they are less valuable because
they clearly do no operate as efficiently as Company A. So even though Company B
had more profit Company A will have more shareholder value.

And to answer the next question, yes companies often decide to forgo marginal increases
in profit if they feel the lower margins on the incremental gains in profit will have a
negative impact share price. They actually increase shareholder value by NOT making
more profit.
Goal Objective Advantages Disadvantages
 INTRODUCTION TO FINANCIAL MANAGEMENT |19
(i) Emphasizes the short
term
(i) Easy to calculate profits (ii) Ignores risk or
Large
Profit (ii) Easy to determine the link uncertainty
amount of
maximization between financial (iii) Ignores the timing of
profits
decisions and profits. returns
(iv) Requires immediate
resources.
(v) Offer no clear
(i) Emphasizes the long
relationship
term
between financial
Shareholders (ii) Recognises risk of
Highest decisions and share
Wealth uncertainty
market value price.
Maximizatio (iii) Recognises the timing of
of shares (vi) Can lead
n returns
management
(iv) Consider shareholders’
anxiety and
return.
frustration.
The wealth maximization objective is consistent with maximizing the owners economic
welfare .As for the shareholders the wealth created by the firm reflects in the market
value of the share. Thus the fundamental objective of the financial manager is to
maximize the market value of the shares of the company.

AGENCY PROBLEMS
Agency theory suggests that the firm can be viewed as a nexus of contracts (loosely
defined) between resource holders. An agency relationship arises whenever one or more
individuals, called principals, hire one or more other individuals, called agents, to
perform some service and then delegate decision-making authority to the agents. The
primary agency relationships in business are those
(1) Between stockholders and managers and
(2) Between debt holders and stockholders (through managers).
These relationships are not necessarily harmonious; indeed, agency theory is concerned
with so-called agency conflicts, or conflicts of interest between agents and principals.
This has implications for, among other things, corporate governance and business ethics.
When agency occurs it also tends to give rise to agency costs, which are expenses
incurred in order to sustain an effective agency relationship (e.g., offering management
performance bonuses to encourage managers to act in the shareholders' interests).
Accordingly, agency theory has emerged as a dominant model in the financial economics
literature, and is widely discussed in business ethics texts.
Agency theory in a formal sense originated in the early 1970s, but the concepts behind it
have a long and varied history. Among the influences are property-rights theories,
organization economics, contract law, and political philosophy, including the works of
20| FINANCIAL MANAGEMENT
Locke and Hobbes. Some noteworthy scholars involved in agency theory's formative
period in the 1970s included Armen Alchian, Harold Demsetz, Michael Jensen, William
Meckling, and S.A. Ross.

CONFLICTS BETWEEN MANAGERS AND

SHAREHOLDERS
Agency theory raises a fundamental problem in organizations—self-interested behavior.
A corporation's managers may have personal goals that compete with the owner's goal of
maximization of shareholder wealth. Since the shareholders authorize managers to
administer the firm's assets, a potential conflict of interest exists between the two groups.

Hires to perform

Shareholder
Managers (Agent)
s
(Principal)

Performs for reward

Self-interestPerforms for remuneration Self-interest

SELF-INTERESTED BEHAVIOR
Agency theory suggests that, in imperfect labor and capital markets, managers will seek
to maximize their own utility at the expense of corporate shareholders. Agents have the
ability to operate in their own self-interest rather than in the best interests of the firm
because of asymmetric information (e.g., managers know better than shareholders
whether they are capable of meeting the shareholders' objectives) and uncertainty (e.g.,
myriad factors contribute to final outcomes, and it may not be evident whether the agent
directly caused a given outcome, positive or negative). Evidence of self-interested
managerial behavior includes the consumption of some corporate resources in the form
of perquisites and the avoidance of optimal risk positions, whereby risk-averse managers
bypass profitable opportunities in which the firm's shareholders would prefer they invest.
Outside investors recognize that the firm will make decisions contrary to their best
 INTRODUCTION TO FINANCIAL MANAGEMENT |21
interests. Accordingly, investors will discount the prices they are willing to pay for the
firm's securities.
A potential agency conflict arises whenever the manager of a firm owns less than 100
percent of the firm's common stock. If a firm is a sole proprietorship managed by the
owner, the owner-manager will undertake actions to maximize his or her own welfare.
The owner-manager will probably measure utility by personal wealth, but may trade off
other considerations, such as leisure and perquisites, against personal wealth. If the
owner-manager forgoes a portion of his or her ownership by selling some of the firm's
stock to outside investors, a potential conflict of interest, called an agency conflict, arises.
For example, the owner-manager may prefer a more leisurely lifestyle and not work as
vigorously to maximize shareholder wealth, because less of the wealth will now accrue to
the owner-manager. In addition, the owner-manager may decide to consume more
perquisites, because some of the cost of the consumption of benefits will now be borne
by the outside shareholders.
In the majority of large publicly traded corporations, agency conflicts are potentially
quite significant because the firm's managers generally own only a small percentage of
the common stock. Therefore, shareholder wealth maximization could be subordinated to
an assortment of other managerial goals. For instance, managers may have a fundamental
objective of maximizing the size of the firm. By creating a large, rapidly growing firm,
executives increase their own status, create more opportunities for lower- and middle-
level managers and salaries, and enhance their job security because an unfriendly
takeover is less likely. As a result, incumbent management may pursue diversification at
the expense of the shareholders who can easily diversify their individual portfolios
simply by buying shares in other companies.
Managers can be encouraged to act in the stockholders' best interests through incentives,
constraints, and punishments. These methods, however, are effective only if shareholders
can observe all of the actions taken by managers. A moral hazard problem, whereby
agents take unobserved actions in their own self-interests, originates because it is
infeasible for shareholders to monitor all managerial actions. To reduce the moral hazard
problem, stockholders must incur agency costs.

COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT.

Agency costs are defined as those costs borne by shareholders to encourage managers to
maximize shareholder wealth rather than behave in their own self-interests. The notion of
agency costs is perhaps most associated with a seminal 1976 Journal of Finance paper
by Michael Jensen and William Meckling, who suggested that corporate debt levels and
management equity levels are both influenced by a wish to contain agency costs. There
are three major types of agency costs:

(1) Expenditures to monitor managerial activities, such as audit costs

22| FINANCIAL MANAGEMENT
(2) Expenditures to structure the organization in a way that will limit
undesirable managerial behavior, such as appointing outside members to
the board of directors or restructuring the company's business units and
management hierarchy

(3) Opportunity costs which are incurred when shareholder-imposed

restrictions, such as requirements for shareholder votes on specific issues,
limit the ability of managers to take actions that advance shareholder
wealth.
In the absence of efforts by shareholders to alter managerial behavior, there will typically
be some loss of shareholder wealth due to inappropriate managerial actions. On the other
hand, agency costs would be excessive if shareholders attempted to ensure that every
managerial action conformed to shareholder interests. Therefore, the optimal amount of
agency costs to be borne by shareholders is determined in a cost-benefit context agency
costs should be increased as long as each incremental money spent results in at least a
money increase in shareholder wealth.

Remedies to solve the conflict between shareholders Vs Managers

There are two polar positions for dealing with shareholder-manager agency conflicts. At
one extreme, the firm's managers are compensated entirely on the basis of stock price
changes. In this case, agency costs will be low because managers have great incentives to
maximize shareholder wealth. It would be extremely difficult, however, to hire talented
managers under these contractual terms because the firm's earnings would be affected by
economic events that are not under managerial control. At the other extreme,
stockholders could monitor every managerial action, but this would be extremely costly
and inefficient. The optimal solution lies between the extremes, where executive
compensation is tied to performance, but some monitoring is also undertaken. In addition
to monitoring, the following mechanisms encourage managers to act in shareholders'
interests:
(1) Performance-based incentive plans
(2) Direct intervention by shareholders
(3) The threat of firing, and
(4) The threat of takeover.

Performance-based incentive plans

Most publicly traded firms now employ performance shares, which are shares of stock
given to executives on the basis of performances as defined by financial measures such as
earnings per share, return on assets, return on equity, and stock price changes. If
 INTRODUCTION TO FINANCIAL MANAGEMENT |23
corporate performance is above the performance targets, the firm's managers earn more
shares. If performance is below the target, however, they receive less than 100 percent of
the shares. Incentive-based compensation plans, such as performance shares, are
designed to satisfy two objectives. First, they offer executives incentives to take actions
that will enhance shareholder wealth. Second, these plans help companies attract and
retain managers who have the confidence to risk their financial future on their own
abilities which should lead to better performance.

Direct intervention by shareholders

An increasing percentage of common stock in corporate America is owned by
institutional investors such as insurance companies, pension funds, and mutual funds.
The institutional money managers have the clout, if they choose, to exert considerable
influence over a firm's operations. Institutional investors can influence a firm's managers
in two primary ways. First, they can meet with a firm's management and offer
suggestions regarding the firm's operations. Second, institutional shareholders can
sponsor a proposal to be voted on at the annual stockholders' meeting, even if the
proposal is opposed by management. Although such shareholder-sponsored proposals are
nonbinding and involve issues outside day-to-day operations, the results of these votes
clearly influence management opinion.

The threat of firing

In the past, the likelihood of a large company's management being ousted by its
stockholders was so remote that it posed little threat. This was true because the ownership
of most firms was so widely distributed, and management's control over the voting
mechanism so strong, that it was almost impossible for dissident stockholders to obtain
the necessary votes required removing the managers. In recent years, however, the chief
executive officers at American Express Co., General Motors Corp., IBM, and Kmart
have all resigned in the midst of institutional opposition and speculation that their
departures were associated with their companies' poor operating performance.

The threat of takeover

Hostile takeovers, which occur when management does not wish to sell the firm, are
most likely to develop when a firm's stock is undervalued relative to its potential because
of inadequate management. In a hostile takeover, the senior managers of the acquired
firm are typically dismissed, and those who are retained lose the independence they had
prior to the acquisition. The threat of a hostile takeover disciplines managerial behavior
and induces managers to attempt to maximize shareholder value.
STOCKHOLDERS VERSUS CREDITORS
In addition to the agency conflict between stockholders and managers, there is a second
class of agency conflicts—those between creditors and stockholders. Creditors have the
primary claim on part of the firm's earnings in the form of interest and principal
payments on the debt as well as a claim on the firm's assets in the event of bankruptcy.
24| FINANCIAL MANAGEMENT
The stockholders, however, maintain control of the operating decisions (through the
firm's managers) that affect the firm's cash flows and their corresponding risks. Creditors
lend capital to the firm at rates that are based on the riskiness of the firm's existing assets
and on the firm's existing capital structure of debt and equity financing, as well as on
expectations concerning changes in the riskiness of these two variables.

The shareholders, acting through management, have an incentive to induce the firm to
take on new projects that have a greater risk than was anticipated by the firm's creditors.
The increased risk will raise the required rate of return on the firm's debt, which in turn
will cause the value of the outstanding bonds to fall. If the risky capital investment
project is successful, all of the benefits will go to the firm's stockholders, because the
bondholders' returns are fixed at the original low-risk rate. If the project fails, however,
the bondholders are forced to share in the losses. On the other hand, shareholders may be
reluctant to finance beneficial investment projects. Shareholders of firms undergoing
financial distress are unwilling to raise additional funds to finance positive net present
value projects because these actions will benefit bondholders more than shareholders by
providing additional security for the creditors' claims.

Managers can also increase the firm's level of debt, without altering its assets, in an effort
to leverage up stockholders' return on equity. If the old debt is not senior to the newly
issued debt, its value will decrease, because a larger number of creditors will have claims
against the firm's cash flows and assets. Both the riskier assets and the increased leverage
transactions have the effect of transferring wealth from the firm's bondholders to the
stockholders.

Shareholder-creditor agency conflicts can result in situations in which a firm's total value
declines but its stock price rises. This occurs if the value of the firm's outstanding debt
falls by more than the increase in the value of the firm's common stock. If stockholders
attempt to expropriate wealth from the firm's creditors, bondholders will protect
themselves by placing restrictive covenants in future debt agreements. Furthermore, if
creditors believe that a firm's managers are trying to take advantage of them, they will
either refuse to provide additional funds to the firm or will charge an above-market
interest rate to compensate for the risk of possible expropriation of their claims. Thus,
firms which deal with creditors in an inequitable manner either lose access to the debt
markets or face high interest rates and restrictive covenants, both of which are
detrimental to shareholders.

Management actions that attempt to usurp wealth from any of the firm are other
stakeholders, including its employees, customers, or suppliers, are handled through
similar constraints and sanctions. For example, if employees believe that they will be
 INTRODUCTION TO FINANCIAL MANAGEMENT |25
treated unfairly, they will demand an above-market wage rate to compensate for the
unreasonably high likelihood of job loss.
Assignment (Last Date of Submission:17th Sep. 2020,
2:PM)
1. What is financial management? What are the responsibilities of corporate
financial manager? Explain
2. Explain the different finance functions.

3. What are the difference between the profit maximization goal and shareholders
wealth maximization goal? Explain.
4. Why the wealth maximization goal is supposed to be superior goal as compare to
profit maximization.
Or,
Critically explain the profit maximization and wealth maximization goals of
firms.
5. What is agency problem? How does it exist in the business? Explain.
6. What are the different forms of agency problems? Explain.
7. Why the conflict between manager and shareholders exists? Is there any
mechanism to solve it? Explain.

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