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UNIT 1 Financial function: Concepts and Objectives.

Financial Management:
The Finance Function:
Concept: The finance function is the process of acquiring and utilizing funds
of a business . Finance functions are related to overall management of an
organization. Finance function is concerned with the policy decisions such as
1. Kind of business
2. Size of firm
3. Type of equipment used
4. Use of debt
5. Liquidity positions
All these determine the size and the profitability and risk of the business of
the firm. Prof. K.M. Upadhyay has outlined the concept of finance function as
follows.
1. In most of the organizations, financial operations are centralized. This
results in economies.
2. Finance functions are performed in all business firms, irrespective of
their sizes legal forms of organizations.
3. They contribute to the survival and growth of the firm.
4. Finance function is primarily involved with the date analysis and used
for decisions makings.
5. Finance functions are concerned with the basic business activities of a
firm in addition to external environmental factors which affect basic
business activates, and also production and marketing.
6. Finance functions comprise control functions also.
7. The central focus of finance function is valuation of the firm.
The areas of responsibility covered by finance functions may be regarded as
the content and concept of finance function. These areas are specific
functions of finance. Famous authors of financial management have
explained the concept and contents of finance function as under.
1. James. C. Van Horne has opined the concept and content of financial
function as a. Investment Decision b. Financing Decision c. Dividend
Decisions.
2. Earnest W. Walker has opined the concept and content of the financial
function as a financial Planning b. Financial Co-ordination C. Financial
Control.

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3. J. Fred Weston and Eugene F. Brigham has opined the concept and
content of financial function as consisting of a. Financial Planning and
control. B. Management of working Capital. C. Investment in Fixed
Assets. D. Capital Structure Decisions. E. Individual Financial Episodes.
The Concept and the content of finance functions can be grouped as under.
1. Financial Planning.
2. Financial Control.
3. Financing Decisions.
4. Investment decisions.
5. Management of income and dividend decisions.
6. Incidental functions.
OBJECTIVES OF FINANCE FUNCTION:
The objective of finance function is to arrange as much funds for the
business as are required from time to time. This function has the following
objectives.
1. ASSESSING THE FINANCIAL REQUIREMENTS.
The main objective of finance function is to assess the financial needs of an
organization and finding out suitable sources for raising them. The sources
should be commensurate with the needs of the business. If funds are
needed for longer period then long term sources like share capital,
debentures, tem loans may be explored.
2.

PROPER UTILIZATIONS OF FUNDS:

Though raising of funds is important but their effective utilization is more


important. The funds should be used in such a way that maximum benefit is
derived from them. The returns of their use should be more than their cost.
It should be ensured that funds don not remain idle at any point of time.
Those projects should be preferred which are beneficial to the business.
3. INCREASING PROFITABILITY:
Proper planning and control of finance function aims at increasing
profitability of the concern. It is true that money generates money. To
increase profitability sufficient funds will have to be invested. Finance
function should be so planned that the concerned neither suffers from
inadequacy of funds nor wastes more funds than required. A proper control
should also be exercised so that scarce resources are not filtered away on
uneconomical operations. The cost of acquiring funds also influences
profitability of the business.
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4. MAXIMISING VALUE OF FIRM:


Finance function also aims at maximizing the value of the firm.
generally said that a concerns value is linked with its profitability.

It is

Logic of Wealth Maximization:


Wealth Maximization refers to all the efforts put in for maximizing the net
present value ( i.e. wealth ) of any particular course of action which is just
the difference between the gross present value of its benefits and the
amount of investment required to achieve such benefits.
Wealth maximization principle is also consistent with the objective of
maximizing the economic welfare of the proprietors of the firm. This, in turn
calls for an all-out bid to maximize the market values of shares of that firm
which are held by its owners. As Van Horne aptly remarks, the market price
of the shares of a company (firm) serves as a performance index or report
card of its progress. It indicates how well management is doing on behalf of
the shareholders.
The wealth maximization objectives serve the interests of suppliers of loaned
capital, employees, managements and society. This objective not only serves
shareholders interests by increasing the value of holding but also ensures
security to lenders also. According to wealth maximization objective, the
primary objective of any business is to maximize shareholders
wealth. It implies that maximizing the net present value of a course of
action to shareholders.
According to Solomon, net present value or wealth of a course of action
is the difference between the present value of its benefits and the present
value of its costs. The objective of wealth maximization is an appropriate and
operationally feasible criteria to choose among the alternative finical actions.
It provides an unambiguous measure of what financial management should
seek to maximize in making investment and financing decisions on behalf of
shareholders. However, while pursing the objective of wealth maximization
all efforts must be employed for maximizing the current present value of any
particular course of action. It implies that every financial decision should be
based on cost-benefit analysis. The shareholders, who obtained great
benefits, would not like a change in the management. The shares market
price serves as a performance index. It also reflects the efficacy of the
management.
The Necessity of a Valuation Model Portended has shown how the attainment
of objective of maximizing the market values of the firms shares (i.e. wealth
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maximization) requires an appropriate Valuation model to assess the value of


the shares of the firm in Question. Financial Manger should know which
factors are capable of increasing the market price of his companys share. If
he cannot, he will not able to maximize the value of his companys share.
Financial Management is concerned with mobilization of financial resources
and their effective utilization towards achieving the organization its goals. Tis
main objective is to use funds in such a way that the earnings are
maximized. Financial management provides a framework, for selecting a
proper course of action and deciding a viable commercial strategy. A
business firm has a number of objectives> Peter Driven has outlined the
possible objectives of a firm as follows.
1.
2.
3.
4.
5.
6.
7.
8.

Market standing.
Innovation
Productivity
Economical use of physical and financial resources.
Increasing the profitability
Improved performance
Development of workers performance and co-operatives
Public responsibility

The wealth maximization criterion is based on the concept of cash flows


generated by the decisions rather than according profit which is the basis of
the measurement of benefits in the case of profit maximization criterion.
Measuring benefits in terms of cash flows avoids the ambiguity associated
with accounting profits. Wealth maximization is more important than profit
maximization
Presently, maximization of present values ( or wealth) of a course of action is
considered, appropriate operationally flexible goal for financial decisionsmaking in an organization. The net present values or wealth can be defined
more explicitly in the following way.
Net Present values (wealth)
A1
A2
A3
AN
W=
+
+
+ .. .+
C 0
1
2
3
( 1+ K ) ( 1+ K ) ( 1+ K )
( 1+ K )N
W =

At
(1+ K)t

C0

(At is sum of A total i.e. A1 to An)

W= At (-) Co/ (L+K)t


A Represents benefits expected from some action
C represents cost of action
K is appropriate discount rate
W is net present worth (wealth)
Goal of Justification for maximizing present net values ( wealth ).
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The Management of an organization maximizes the present values not only


for shareholders but for all including employees, customers, suppliers and
community at large. The goal for the maximum present values is generally
justified on the following grounds.
1. It is consistent with the object of maximizing owners economic
welfare.
2. It focuses on the long run picture.
3. It considers risk.
4. It recognizes the values of regular dividend payments.
5. It maintains market price of its shares
6. It seeks growth is sales and earnings.
Maximizing the shareholders economic welfare is equivalent to maximizing
the utility of the consumption every time. With their wealth maximized,
shareholders can afford their cash flows in such a way as to optimize their
consumption. From the shareholders point of view, the wealth created by a
company through the actions is reflected in the market values of the
companys shares.

UNIT 2: The Financial System


The financial system comprises a variety of intermediaries, markets and
instruments that are related. The financial system provided the principal
means by which savings are transformed into investments. Efficient
functioning of financial system is critical to a modern economy.
While an understanding of the financial system is useful to all informed
citizens, it is particularly relevance to the financial managers because
i)
He negotiates loans from financial intermediaries
ii)
Raises resources in the financial markets
iii)
Invests surplus funds in financial instruments.
Functions of financial system
The financial system performs the following interrelated functions which are
essential to a world economy.
1. It provides a payment system for the exchange of goods and services.
2. It enables the pooling of funds for undertaking large scale enterprises.
3. It provides a mechanism for spatial and temporal transfer of resources.
4. It provides a way for managing uncertainty and controlling risk.
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5. It generates information that helps in coordinating decentralized


decision making.
6. It helps in dealing with the incentive problem when one party has an
informational advantage.
The above functions are described in brief hereunder:
1. Payment System
Depository financial intermediaries such as banks are the pivot of the
payment system. Credit card companies play as supplementary role. To
realize the importance of the payment system one should look at the
hardship and inconvenience caused when the payment system breaks down.
2. Pooling of Funds
Modern business enterprise requires large investment which is often beyond
the means of an individual or even of hundreds of individuals. Mechanisms
like financial market, financial intermediaries, financial institutions which are
an integral ape of the financial system facilitate the cooling of household
savings for financing business. The financial system thus enables household
to participate in large indivisible enterprises.
3. Transfer of Resources
The financial system facilitates the transfer of economic resources across
time and space. As Rober Merton says, a well-developed , smooth
functioning financial system facilitate the efficient life cycle allocations of
household consumption and efficient allocation of physical capital to its most
productive use in the business sector.
A well developed, smooth functioning capital market also makes possible the
efficient separation of ownership from management of the firm. This in turn
makes feasible efficient specialization in production according to the
principle of comparative advantage.
4. Risk Management
A well-developed financial system offers a variety of instrument that
enables economic agents to pool, price and exchange risk. It provides
opportunity for risk pooling and risk sharing for both household and business
firm.
The three basic methods for managing risk are i) Hedging ii) Diversification
and iii) Insurance.
5. Price Information and Decentralized Decision Making
Apart from the manifest function of facilitating individuals and businesses to
trade in financial assets, financial markets served an important latent
function as well. They provide information that helps in coordinating
decentralized decision making. Rober Merton puts it thus; interest rates and
security prices are used by household or their agents in making their
consumption- savings decisions and in choosing the portfolio allocations of
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their wealth. These same prices provide important signals to manage firm in
their selection of investment projects and financing.
6. Dealing with incentive problem
When one party to a transaction has information that the other does not
have informational asymmetry exists. This leads to the problems of moral
hazards and adverse selection which are broadly referred to as agency
problem. The nature of these problems may be illustrated with reference to
insurance. A person who has taken a fire insurance policy is likely to become
somewhat negligent. This is moral hazard faced by the insurance company. A
person who is more likely to experience fire losses will be inclined to take fire
insurance. This is adverse selection problem faced by the insurance
company.
Financial intermediaries like banks and venture capital organizations can
solve the problem of informational asymmetry by handling sensitive
information discreetly and developing a reputation for profitable activity.
Financial Markets
A financial market is a market and exchange of financial asset. If you buy or
sell financial assets you will participate in financial market in some way or
other.
Functions of financial markets:
Financial markets play a very pivotal role in allocating recourses in an
economy by performing three important functions and thereby play a very
important role in allocating resources.
1. Financial markets facilitate price discovery: The continuous
interaction among numerous buyers and sellers who throng financial
markets helps in establishing or discovering the prices of financial
assets. Well organized V markets say; if you want to know what value
of financial assets is simply look at its price in the financial markets.
2. Financial markets provide liquidity to financial assets: Investors
can readily sell their financial assets through the mechanism of
financial markets. In the absence of financial markets which provides
such liquidity, the motivation of investor to hold financial assets will be
considerably diminished. Thanks to negotiability and transferability of
securities through the financial markets, it is possible for companies
(and other entities) to raise long term funds from investors with short
term and medium term horizons. While investor is substituted by
another when a security is transacted the company is assured of long
term availability of funds.
3. Financial markets considerably reduce the cost of transacting: The
two major costs associated with transacting are search cost and
information cost. Search cost comprise explicit costs such as expense
incurred on advertising when one wants to buy or sell an assets and
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implicit cost such as time and effort one has to put in to locate a
customer. Information cost refers to costs incurred in evaluating the
investment merits of financial assets.
Classification of financial markets: There are different ways of classifying
financial markets.
One way is to classify financial markets by the type of financial claim. The
debt market is the financial market for fixed claims (debt instrument) and the
equity market is the financial market for residual and varying claims (equity
instrument).
A second way is classifying financial market by the maturity of claims. The
market for short financial claims is refers to as money market and market for
long term financial claims is called capital market. Traditionally the cut off
between short term and long term has been one year- though this dividing
line is arbitrary, it is widely accepted. Since short term financial claims are
almost invariably debt claims, the money market is the market for short term
debt instruments. The capital market is the market for long term debt
instruments and equity instruments.
A third way to classify financial markets is based on whether the claims
represent new issue or outstanding issue. The market where issuer
sells new claim is referred to as the primary market and the market where
investor trade outstanding securities is called the secondary market.
A forth way to classify financial markets is by the timing of delivery. A
cash or spot market is one where the delivery occurs immediately and
forward or future market is one where delivery occurs at predetermined time
in future.
The Fifth way to classify financial markets is by the nature of its
organizational structure. An Exchange traded market is characterized by
a centralized organization with standardized procedures. An over the counter
market is a decentralized with different procedures suitable for different
people/party.
The exhibit presents a summary of the classification of financial markets:

Summary of classification of Financial Markets:


Nature of Claim

1. Debt Market (Fixed Claims)


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2. Equity Market ( Residual Claims)


Maturity of Claim

1. Money Market (Short term Securities one year)


2. Capital Market (Long term Securities over one
year)

Seasoning of Claims
Timing of Deliver

1.Primary Market (New issues)


2. Secondary Market (Existing issues)
1. Cash or Spot Market (Immediate)
2. Forward or Future Market (Future date)

Organizational Structure
organized/centralized

1.

Exchange

Traded

Market

(well

Organization/standardized procedure )
2. Over the counter
Market (decentralized
organization/
Customized procedure)
Rise of Formal Financial Markets: The role of formal financial markets
has expanded rapidly in recent years. The key factors which have
contributed to this are as follows:
1. Robust mechanism for ensuring that traders are completed according
to agreed terms.
2. Adequate legal procedure to settle dispute
3. Low transaction cost
4. Transparent availability of information on trade and prices
5. Adequate protection tp investors
6. High liquidity
Forces of Changes: Financial markets have undergone significant
transformation since the mid-1980s, thanks to following factors:
1. Technological advances in computing and telecommunications.
2. The wave of deregulation and liberalization that has been sweeping the
world.
3. Consolidation and globalization in the wake of heightened competition

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Financial Intermediaries/ Institutions


Financial intermediaries/institutions are firms that provide services and
products that customers may not be able to get more efficiently by
themselves in financial market. A good example of a financial intermediaries/
institutions is a mutual fund which pools the financial resources of many
people and invests in a basket of securities. It enjoys economic of scale in
conducting research, in maintaining records and in executing transactions.
Hence it offers its customer a more efficient way of investing than what they
can generally do on their own. The important products and services of
financial intermediaries/institutions includes checking accounts, saving
accounts, loan mortgages ,mutual find schemes, insurance contracts, credit
rating and so on.
Rationale for financial intermediaries/institutions
Before we learn about various financial intermediaries/ institutions in India,
let us understand the rationale for financial intermediaries/ institutions.
What are the benefits of individual investors by investing through financial
intermediaries/ institutions?
It seems there are several advantages as follows:
1. Diversification: The pool of funds mobilized by financial intermediaries/
institutions is invested in a broadly diversified portfolio of financial assets
(stocks, Money market and instruments), bonds and loans. Individual
investor can scarcely achieve such diversification on their own.
Remember that a diversified portfolio reduces the risk.
2. Lower transaction cost: The average size of a transaction of a financial
intermediaries/ institutions is much higher than that of an individual
investor. The transaction cost in percentage terms tends to decrease as
the transaction size increases. Hence financial intermediaries/ institutions
compared to individual investor incur much lower transaction costs.
3. Economies of Scale: Buying and holding securities (or for that matter
granting loans ans supervising them) calls for information gathering and
processing and regular monitoring. These functions entail cost. Financial
intermediaries/ institutions, thanks to their bigger size and [professional
resources enjoys economic of scale in performing these functions and
hence they have comparative advantage over individual investor.
4. Confidentiality:
Companies seeking funds or the continuing support of existing investors
are required to disclose information that they like to keep confidential for
competitive purpose. They would feel more comfortable in dealing with
few financial intermediaries/ institutions rather than numerous individual
investors. Information shared with financial intermediaries/ institutions
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may be kept confidential whereas information disclosed to numerous


individual investors falls in domain of public knowledge.
5. Signaling: With greater professional expertise at their command, financial
than numerous individual investors can pick up and interpret signals and
clues provided by companies which are likely to move towards them. In
this manner financial intermediaries/ institutions performs signalling
function for the investing community. Financial intermediaries/ institutions
are highly professionals and because of their expertise they can pick up
and interpret signals from the companies that may affect the investors
interest. Thus financial intermediaries/ institutions perform the signalling
function for the investors.
Key Financial intermediaries/ institutions
The key financial intermediaries/ institutions in India are commercial banks,
financial institutions, insurance companies, mutual funds, non-banking
financial companies and non-banking financial service companies.
Commercial Banks
Commercial banks (public sector banks, foreign banks and private sector
banks) represent the most important financial intermediaries/ institutions in
the Indian financial system.
Public sector banks led by the State Bank of India came into being largely on
account of nationalization of privately-owned commercial banks. Presently
they dominate the banking scene in the country. They have contributed
immensely to wider geographical spread and deeper penetration in rural
areas, higher mobilization of deposits and reallocation of bank credit to
priority sectors hitherto neglected sector.
Foreign banks such as Citi Bank have been in India for a long time and have
been steadily expanding their operations. The newer entrants in commercial
banking have been the private sector banks like HDFC bank, ICICI bank which
were set up in mid-1990s in the wake of banking liberalization. This segment
has shown remarkable growth and vitality since the beginning.
The banking sector in India has grown at a compound rate of growth of about
20 % in the first decade of this millennium. Total deposits have grown 4.8
times, assets 6.6 times, interest income 9.5 times and net worth 4.5 times.
Over the same period the employee strength has just grown by 5 %. This
radical transformation has been facilitated by massive computerization that
has led to anywhere anytime banking across various channels. Most
reassuringly, this metamorphosis has been achieved at an incredible low
cost. According to RBI the total cost of computerization for PSU banks has
been around Rs 17900 crores or less than $ 4 billion, an amount that a global
tier-1 bank spends annually.

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Financial institutions
Since independent a number of financial institutions have been set up to
cater to the long term financing needs of the industrial sector and meet
specialized financing requirements. An elaborate structure of financial
institutions consisting of all India term-lending institutions like IFCI, ICICI and
IDBI. (The last two have transformed themselves into banks.) State financial
Corporations and State Industrial Development Corporations has come into
being.
There are many specialized financial institutions like Small Industries
Development Bank of India (SIDBI), Export-Import Bank (EXIM bank), National
Bank for Agriculture and Rural development (NABARD), Shipping credit and
Investment Corporation of India (SICCI), Power Finance Corporation (PFC),
Rural Electrification Corporation (REC), Infrastructure Development Finance
Corporation (IDFC) and National Housing Bank (NHB).
Insurance Companies
Till recently there were just two insurance companies in India: the Life
Insurance Corporation of India (LIC) and the General Insurance Corporation of
India(GIC), the latter being a holding company with four fully owned
subsidiary companies in its fold. With the liberalization of the insurance
sector, many private sector players like ICICI-Prudential, Tata-AIG, Bajaj
Allianz, Birla Sunlife and HDFC Standard have set up insurance business in
India. Insurance companies LIC in particular have massive resources at their
command because insurance policies usually have a substantial element of
saving and insurance premiums are payable in advance.
Mutual Funds
A mutual fund is a collective investment vehicle .It mobilizes resources from
investors in various types of securities. While there was only one mutual fund
in India viz. The Unit Trust of India, till 1986, presently there are a number of
mutual funds in public and private sector. In last decade or so, private
mutual funds like ICICI-Prudential Mutual Fund, Reliance Mutual Fund, HFDC
Mutual Fund and Templeton Mutual Fund have grown impressively.
Non-Banking Financial Companies
From Mid-1980s many non-banking financial companies have come into
being in the public sector as well as private sector. Some of the well-known
name are HDFC, Sundaram Finance, Kotak Mahindra Finance, Industrial
Development and Financial Corporation(IDFC), ICICI ventures, Infrastructure
Leasing and Finance and SBI Factors. These companies engage in a variety of
activities like leasing finance , hire purchase finance, housing finance,
infrastructure finance , venture capital finance factoring and investment
securities.

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Non-Banking Financial Services Companies


This group consists of merchant banks, credit rating agencies, depositories
and others. Merchant banks also called investment banks are firms which
help business, government, and other entities in raising finance. They also
facilitate mergers, acquisition and divestitures. DSP Merril Lynch, JM Morgan
and SBI Capital Market are among the leading merchant banks in India.
Credit rating agencies rate debt and other investments. CRISIL, CARE, and
ICRA are the leading credit rating agencies in India. Depositories are
institutions which de-materialize physical securities and effect transfer of
ownership by electronic entries. Presently there are two depositories in India
viz. the National Securities Depositories Limited (NSDL) and the Central
Securities Depositories Limited (CSDL)

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Profit
Maximization
Maximization

versus

Shareholder

Wealth

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 the goal. In contrast
shareholder wealth maximization is a long term shareholders are interested
in future as well as present profits. Wealth maximization is generally
preferred because it considers
1.
2.
3.
4.

wealth for long term


risk of uncertainty
the timing of returns
The Shareholders return

The following table provides a summary of


disadvantages of these two often conflicting goals.

the

advantages

and

Table 1.1- Profit Maximization versus Shareholder wealth maximization


Goal
Profit

Shareholde
r
wealth
maximizati
on

Objective
Large
amount
profits

Advantages
Disadvantages
Easy to calculate Emphasize short term
of profits.
Ignores
risk
or
Easy to determine uncertainty
the link between
financial decisions Ignores the timing of
and profits
returns

Highest
market value
of common
stock

Requires
immediate
resources
Emphasize
long Offers
no
clear
term
relationship
between
financial decisions and
Recognizes risk or stock price
uncertainty
Can lead to management
Recognizes
the anxiety and frustration
timing of returns
Considers return
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