The subject notes to fundamentals of financial management (theory of finance) BBS 2nd year

The subject notes to "Fundamentals of financial Management"

Chapter- 1 

Financial Management

What is financial Management? Describes its importance.

A firm always exists in a economy, it performs various operation to achieve its objectives. All the activities of a firm is directed by its goal such as to acquire profit, to create value to its owner etc. A firm run and perform its operation through its various resources and funds like, raw material, capital, assets, human resource etc. Thus financial management deals with acquiring resources/ fund and allocating those resources effectively to achieve its objectives efficiently. Till last decade financial Management was considered as a branch of economics, but now because of dynamic business environment, changing technology and the effect of globalization in economics comes to separate the subject matter of financial management. Financial Management plays a vital role in business decision making. Mostly it is concerned with investment decision, financing decision, dividend decision and working capital management. It is not only concerned with running of a firm but also concerned with maintaining its profit learning to the shareholder and financer i.e debenture holder.

In short financial management is concerned with acquisition , financing and management of resources in order to maximize the wealth of the shareholder.

Financial management is very important in different aspects of business, they are given below.

i) Helpful in Setting goal: As we know that all activities of a firm is directed at its goal. Though financial management manager can defines the goal of the firm more clearly in terms of maximization of the shareholders wealth. Financial management helps in setting goal and give a chance to judge the decision and co ordinates other function of firm on achieving its goal efficiently.

ii) Optimum utilization of Resources: Firm use fixed as well as current assets and a huge amount of investment is made on such assets. If wrong decision are made regarding the purchase and disposal of fixed assets can cause threat to the firm. So one of the major important..........................
application of financial management is to help on deciding which assets to buy, when to buy and whether to replace the existing assets with the new one or not as well as the management of current assets to be maintained in the firm.

iii) Help in deciding sources of financing: Firm need long term fund for its operation and source of such fund may be equity share, preference share, bond, loan etc. The firm need to decide the appropriate mix of these sources and amount of long term fund, otherwise the firm will have to bear higher cost and expose to higher risk. Thus financial management like capital structure theories helps in selecting the sources of financing among different alternatives mentioned above .

iv) To get success in competition: This time is the time of globalization and we know that even a small firm must compete in a global economy. Due to fast change in technology, economy and business environment, it creates a tuff competition and firm should make  good decision to stay exists in economy. So many financial management techniques help a firm to compete in such dynamic economy.

Goals of financial Management                                        (I.Q)

Profit Maximization Goal:  

According to this goal, only those financial action which increase profit of firm should be taken and those which decrease profit must be avoided. This type of goal is profit oriented and it focuses on those financial function which maximize profit. The profit maximization goal argue that profit is a test of economic efficiency, it leads to effective utilization of scarce economic resources in every business firm and ultimately it leads to total economic welfare since it increase economic efficiency of every firm.

Argument in favor of profit maximization

i) Understandable and simple

ii) Decision Principle: profit maximization is considered to be a basic principle for financial decision making.

iii) Measurement of efficiency

iv) Maximize social welfare

Criticism

i) Vague  and ambiguous( hard to interpret)

ii) Ignore time value of money

iii) Ignore the quality of  benefit ( ignore social responsibility)

iv) Ignore risk element

v) Unsuitable in modern business environment

Wealth Maximization Goal:

According to this goal, the firm should only take those decision which maximize the shareholders wealth, and wealth is defined as the net present value which is the difference between present value of the benefits of a project and present value of its  cost. A financial action which result negative present value should be avoided, and which result positive present value should be accepted. When a firm's net present  value is high which belongs to shareholders hence increase their wealth. Ultimately investor pay high price for a share of firm having higher net present value. Wealth maximization always reflected in the market price of share. Thus stock price maximization is considered superior to profit maximization goal because it consider risk of earning, dividend policy, present and expected earning per share, time value of money and other factor that bear on the market price of stock.

Argument in favor of Wealth maximization

i) Clear to understand and interpret

ii) It consider time value of money

iii) It consider quality of benefit

iv) It reduces the conflict of interest between stockholder of firm.

Agency Problem Between shareholders and manager
            Agency problem is the conflict of interest between the principal( shareholder) and the agent ( managers ).

In a company, the agency relationship exists between shareholders and managers characterized as the passive principals and active agents. Shareholders are the real owner of a company however they can't manage a company themselves. So to manage an organization number of managers are employed to manage a firm to achieve its objectives effectively. As we  know that the ultimate objectives of a firm is to maximize shareholders wealth, but in practice, the manager are concerned with their personal wealth, salary, job security etc. Thus managers may make compromise between their own satisfaction and shareholders wealth maximization. The management may play safe and create satisfactory level of wealth for shareholders instead of maximizing it which create the agency problem between shareholder and manager. So the lesser percentage of share the management owns, the higher becomes the agency problem because the management may tend to act for achieving his/ her own goal instead of maximizing shareholders wealth.

 Mechanism used to motive managers to act in stockholder's best interest

i) Management compensation

ii) Intervention

iii) Replacement

iv) Reconstruction

Also SEE Probable question from this chapter. click below