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CHAPTER 1

An Overview of Financial
Management
 Functions of Managerial
Finance
 Issues of the New
Millennium
 Forms of Businesses
 Goals of the Corporation 1-1
Functions of Managerial
Finance
 1. Procurement of funds: There are alternative sources of fund
like a company can take loan or it can issue common stock to
raise the fund required. Taking loan can also be of different
forms like bank loan, bond or debentures. Preference shares
can also be another source. In case of debt, bond and
debentures the company must pay a fixed rate of interest
which is a compulsory obligation. In case of preference shares
the preference dividends are fixed and compulsory payments
for profitable firms. In case of ordinary stock the firm is
expected to pay the return expected by the share holders.
These kinds of payments of interest or dividends refer to the
cost of capital. Cost minimization is the goal of financing.
Finance managers need to select the best possible sources of
funds among the different alternatives called Capital structure
Decision. Ordinary stock holders are the owners of the firm (like
they have voting rights) but debtors are not the owners. So,
common stock is called Internal source; and bond, debenture
and loan are called external sources. Purpose is also important
in the choice of funds. 1-2
Functions of Managerial
Finance (Contd)
2. Utilization of funds: Capital Budgeting decision. Long
term investment decision is made on the basis of risk
and return. The goal is profit maximization. This is the
most important and challenging function of finance.
To predict future profit is difficult as Profit=Total
Revenue-Total Cost. TR=P.Q. TC=FC+TVC.
3. Short term asset management: Working capital
management. Liquidity vs. profitability.
4. Distribution of funds: Dividend policy decision.
Dividend policy, repurchase of shares and
amortization of debt.

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Career Opportunities in
Finance
 Financial Market and Institution bridges the
gap between net borrowers and net savers.
Money and capital markets include bank,
insurance & leasing, investment companies,
development institutions, and stock exchange.
 Investments: Investors are risk averse. Best
possible risk-return combination can be found
by financial analysis, security analysis and
portfolio (optimal mix of securities) selection.
 Managerial Finance: Financial aspects of all
kinds of profit-seeking firms may it be
manufacturing or trading firms.

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Evolution of Finance
 A study of mergers (1900-1920)
 A study of bankruptcy & reorganization (1930s)
 Institutional subject of cash budgeting &
management (1940s-1950s)
 Evaluation of profitable investments (1960s)
 Modern Finance of risk-return approach (1970s)
 Inflation and innovation effects, and deregulations.
(1980s)
 Globalization effects (1990s)

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Alternative Forms of
Business Organization
 Sole proprietorship
 Partnership
 Corporation

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Sole proprietorships &
Partnerships
 Advantages
 Ease of formation
 Subject to few government regulations
 No corporate income taxes
 Disadvantages
 Difficult to raise capital
 Unlimited liability
 Limited life
 Lack of liquidity

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Corporation
 Advantages
 Unlimited life
 Easy transfer of ownership
 Limited liability
 Raising huge capital
 Formal monitoring by government agencies
 Disadvantages
 Double taxation
 Cost of set-up and report filing

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Financial Goals of the
Corporation
 The conventional goal of a firm is profit-
maximization. However, since profit is
reported by the management so it can be
manipulated. Moreover, accounting profit is
not estimated on cash basis. So, the
modern goal of firm is shareholders’ wealth
maximization, which refers to maximizing
stock prices at the market.

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A graphical approach to
wealth maximization

S2
S1
Market Price of Shares

W2=P2
W1=P1

D2
D1

Q1 Quantity of stock
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Determinants of wealth

CF1 CF2 CF3 CF∞ CFt
Po = + + + ∞
=∑ .
(1 + k) (1 + k) (1 + k)
1 2 3
(1 + k) t =1 (1 + k)
t

 CF means cash flow from the firm to the shareholder. This


depends on profit, EPS and dividend policy. Tax plays a role as the
shareholder is interested in after-tax income.
 k is the cost of capital required by the shareholders to leave the
share price unchanged. It is proportional to risk. If risk increases k
increases and the contribution of CF to Po goes down. So, Po is
inversely related with risk.
 t or timing matters. A distant cash flow is less valuable than an
immediate cash flow.

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Goal of a firm:
Profit Maximization Vs.
Wealth Maximization
 Vagueness in definition: There are many definitions
of Profit and so it is vaguely defined. Wealth is the
present value of all future dividends which is readily
observed in current share price at the market.
 Profit is an annual concept and so it is a short term
concept but wealth is a long term concept.
 Profit can be manipulated by the management (like
window dressing) but wealth is beyond the direct
manipulation of management.
 Risk consideration. The theory of risk says that risk
and return is proportional. Profit can not be
increased without increasing risk.

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