INTRODUCTION OF FINANCIAL MANAGEMENT
Q.1. What are the two main aspects of a finance function ? Explain .
The two basic aspects of Financial Management are:
(a) Procurement of funds.
(b) Effective utilization of funds to achieve business objective.
(a) PROCUREMENT OF FUNDS:
(1) Funds can be obtained from different sources e.g. equity. Preference capital, debentures term loans etc.
(2) Funds procured from different sources have different characteristics in terms of risk, cost and control.
(3) The cost of funds should be minimum. Hence, a proper balancing of risk and control factors becomes essential.
(4) Thus, Procurement of funds involves the following :
(a) Identification of sources of finance.
(b) Determination of finance mix.
(c) Raising of funds.
(d) Division of profits between dividends and retention of profits i.e. internal fund generation.
(b) EFFECTIVE UTILIZATION OF FUNDS:
(a) Funds are procured at a cost. Hence it is crucial to employ them properly and profitable.
(b) The Finance Manager is responsible not only for procurement of funds but also for its effective utilization.
(c) He identifies where the funds remain idle and where they are not used properly.
(d) He analyses the financial implications of each decision–to invest in fixed assets. The need for adequate working capital etc
Q.2. Write short note on the rationale of wealth Maximisation.
There is a controversy the precise objectives of financial management. Many people argue that the finance manager should always attempt to maximize the profits of enterprise; therefore, the main objective of financial management is profit Maximisation in other words. While considering all financing, investment & other relevant decisions, the finance manager should examine each alternative with reference to whether or not would maximize profits. There is another view that profit maximization can at best be a limited objective and that, in many situations, Maximisation of profits may not be conductive to long-term interest of the company. This is because of following reasons:
(a) Maximization of profits, as an objective, ignores the risk factor. There is a direct relationship between risk and profit. Higher the risk higher is the possibility of returns. The financial manager must, therefore, consider the risk factor. Actually, he must attempt to optimize risk and return.
(b) Profit maximization as an objective is too narrow, since it fails to take into account the social, considerations as also the obligations of the enterprise to various interests like workers, consumers and the society at large. Similarly, maximization of the profits, without any regard for ethical practices, can never be the objective of the business. It is quite obvious that if a business concern ignores its social or moral obligations, it cannot hope to survive for long.
(c) Profit maximization in absolute terms ignores the time pattern of retus. In view of the arguments given above, many authors argue that the finance manager should keep wealth maximization as his objective. In other words, the finance manager should attempt to maximise the value of the enterprise to its shareholders. “Value”, according to Van Home, “is represented by the market
price of the company’s common stock.” This price takes into account the present and prospective future earnings per share. The timing and the risk of these earnings, the dividend policy of the enterprise and many other factors. It is thus an overall reflection of the investment, financing and dividend decisions of the enterprise. According to Van Home. The market price of a company’s shares represents the focal judgement of all participants in the market as to what is the value of the particular company. The finance manager should attempt to maximize this value.
In this context, it would be interesting to mention that, whereas in the short run the prices on the share market are the result of a mixture of factors, on the long-term basis, the share market value is a function of two basic factors:
(a) The likely rate of earnings or earnings per share of the company; and
(b) The capitalization rate
The capitalization rate reflects the likeness of the investors for the company. It shows the amount of risk that the investors attach to its shares. This in turn, depends upon a large number of factors and on the various policies of the company. It can, thus, be seen that wealth maximization includes in itself the element of profit and also takes into account a large number of other factors.
Q.3. Explain as to how the wealth maximization objective is superior to the profit maximization objective.
It is commonly believed that maximization of profit is the basic objective of a business enterprise. In other words, a finance manager while considering all financing, investment and other relevant decisions, should examine each alternative with reference to whether or not it would maximize profit. But in a study of business finance, it is agreed that profit maximization is too narrow as an objective, since it does not take into account the extent of risk, the timing of returns, society etc. Wealth maximization objective appears to be superior to the profit maximization .
The term wealth maximization means maximizing shareholders wealth in terms of its economic value as represented by the present value of all the future cash flows in the form of divide and or other benefits expected from the firm. The market price of the share reflect this present value.
According to Van Horne “the market price of a firm’s stock represents the final judgement of all market participants as to what the value of the particular firm is. It takes into account present and prospective future earnings per shares, the timing and risk of these earnings, the dividend policy of the firm and many other factors that bear upon the market price of the stock. The market price serves as a performance index or report card of a firm’s progress. Therefore, wealth maximization is superior to profit maximization objective which can be considered as a part of wealth maximization strategy.