32 DE-1996 Financial Management

1. Discuss the nature of financial management.

Finance management is a long term decision making process which involves lot of planning, allocation of
funds, discipline and much more. Let us understand the nature of financial management with reference of
this discipline.

1. Finance management is one of the important education which has been realized word wide. Now a day’s
people are undergoing through various specialization courses of financial management. Many people have
chosen financial management as their profession.

2. The nature of financial management is never a separate entity. Even as an operational manager or
functional manager one has to take responsibility of financial management.

3. Finance is a foundation of economic activities. The person who Manages finance is called as financial
manager. Important role of financial manager is to control finance and implement the plans. For any
company financial manager plays a crucial role in it. Many times it happens that lack of skills or wrong
decisions can lead to heavy losses to an organization.

4. Nature of financial management is multi-disciplinary. Financial management depends upon various other
factors like: accounting, banking, inflation, economy, etc. for the better utilization of finances.

5. Approach of financial management is not limited to business functions but it is a backbone of commerce,
economic and industry.

2. What are the characteristics of a sound financial planning?

Sound financial planning is necessary for the success of any business enterprise.
(1) Simplicity:
A sound financial structure should provide simple financial structure which could be managed easily and
understandable even to a layman. “Simplicity’ is an essential sine qua non which helps the promoters and
the management in acquiring the required amount of capital. It is also easy to work out a simple financial
plan.

(2) Foresight:
Foresight must be used in planning the scope of operation in order that the needs for capital may be
estimated as accurately as possible. A plan visualised without foresight spells disaster for the company, if it
fails to meet the needs for both fixed and working capital. In simple words, the canon of foresight means
that besides the needs of ‘today’ the requirements of ‘tomorrow’ should also be kept in view.

(3) Flexibility:
Financial readjustments become necessary often. The financial plan must be easily adaptable to them. There
should be a degree of flexibility so that financial plan can be adopted with a minimum of delay to meet
changing conditions in the future.

(4) Optimum use of funds:

Capital should not only be adequate but should also be productively employed. Financial plan should
prevent wasteful use of capital, avoid idle capacity and ensure proper utilisation of funds to build up earning
capacity of the enterprise.

There should be optimum utilisation of available financial resources. If this is not done, the profitability will
decline. There should be a proper balance between the fixed capital and the working capital.
(5) Liquidity:
It means that a reasonable percentage of the current assets must be kept in the form of liquid cash. Cash is
required to finance purchases, to pay salaries, wages and other incidental expenses. The degree of liquidity
to be maintained is determined by the size of the company, its age, its credit status, the nature of its
operations, the rate of turnover etc.

(6) Anticipation of contingencies:

The planners should visualise contingencies or emergency situations in designing their financial plan. This
may lead to keeping of some surplus capital for meeting the unforeseen events. It would be better if these
contingencies are anticipated in advance.

(7) Economy:
Last but not the least, the financial open be made in such a manner that the cost of capital procurement
should be minimum. The capital mobilised should not impose disproportionate burden on the company. The
fixed dividend on preference shares, the interest on loans and debentures should be related to the earning
capacity. The fixed interest payments should not reduce the profits of the company and hamper its sustained
growth.

3. Write a desciptive note on "International capital market."

International capital market is that financial market or world financial center where
shares, bonds, debentures, currencies, hedge funds, mutual funds and other long term securities are
purchased and sold.

International capital market is the group of different country's capital market. They associate with each other
with Internet. They provide the place to international companies and investors to deal in shares and bonds of
different countries.

After invention of computer and Internet and revolution of financial market in 2010, almost all financial
markets are converted in international capital markets. We can give the example of Hong Kong, Singapore
and New York world trade centre. International capital market was started with dealing of foreign exchange.
After globalization of financial sector, companies have to take certificate for dealing in international market.
Suppose, Indian company wants to sell shares in France, for this, Indian company should take certificate
named global depository receipt (GDR).

International capital market's daily turnover has crossed $ 5 trillion. International capital market is very
helpful for reducing the risk of small company because in international market, you can buy different
countries companies shares, debentures and mutual funds. Different countries have different business
environment, so if any country is facing loss and due to financial crisis, your investment in that country may
suffer losses but you can fulfill this loss from other country's investment. So, overall risk will be reduced by
this technique.

Suppose, a company wants to invest his money, then it is good option, that A company must invest it in
international market. He can invest with following way and make his best portfolio:

a) A company can buy 10000 shares of USA Company.

+
b) A company can buy 10000 shares of Indian company.
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c) A company can buy 10000 bonds of UK Company.
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d) A company can also invest in the mutual funds of Pakistan or USA or Canada.

4. Discuss the feature of optimum capital structure.

The salient features of an optimal capital structure are described below:

(i) Maximum Return:
The financial structure of a company should be guided by clear- cut objective. Its objective can be
maximisation of the wealth of the shareholders or maximisation of return to the shareholders.

(ii) Less Risky:

The capital structure should represent a balance between different types of ownership and debt securities.
This is essential to reduce risk on the use of debt capital.

(iii) Safety:
A sound capital structure should ensure safety of investment. It should be so determined that fluctuations in
the earnings of the company do not have heavy strain on its financial structure.

(iv) Flexibility:
A sound capital structure should facilitate expansion and contraction of funds. The company should be able
to procure more capital in times of need and should be able to pay all its debts when it does not require
funds.

(v) Economy:
The capital structure should ensure the minimum costs of capital which in turn would increase its ability to
generate more wealth for the company.

(vi) Capacity:
The financial structure of a company should be d3mamic. It should be revised periodically depending upon
the changes in the business conditions. If it has surplus funds, the company should have the capacity to
repay its debt and reduce interest obligations.

(vii) Control:
The capital structure of a company should not dilute the control of equity shareholders of the company. That
is why, convertible debentures should be issued with great caution.
5. Distinguish between shares and debentures.

Comparison Chart
BASIS FOR
SHARES DEBENTURES
COMPARISON

Meaning The shares are the owned funds of the The debentures are the borrowed funds
company. of the company.

What is it? Shares represent the capital of the Debentures represent the debt of the
company. company.

Holder The holder of shares is known as The holder of debentures is known as

shareholder. debenture holder.

Status of Holders Owners Creditors

Form of Return Shareholders get the dividend. Debenture holders get the interest.

Payment of return Dividend can be paid to shareholders Interest can be paid to debenture holders
only out of profits. even if there is no profit.

Allowable Dividend is an appropriation of profit Interest is a business expense and so it is

deduction and so it is not allowed as deduction. allowed as deduction from profit.

Security for No Yes

payment

Voting Rights The holders of shares have voting rights. The holders of debentures do not have
any voting rights.

Conversion Shares can never be converted into Debentures can be converted into shares.
debentures.

Repayment in the Shares are repaid after the payment of all Debentures get priority over shares, and
event of winding up the liabilities. so they are repaid before shares.

Quantum Dividend on shares is an appropriation of Interest on debentures is a charge against

profit. profit.

Trust Deed No trust deed is executed in case of When the debentures are issued to the
shares. public, trust deed must be executed.
9. Describe the various objectives of financial management.

The main objectives of financial management are:-

1. Profit maximization : The main objective of financial management is profit maximization. The
finance manager tries to earn maximum profits for the company in the short-term and the long-term. He
cannot guarantee profits in the long term because of business uncertainties. However, a company can earn
maximum profits even in the long-term, if:-
i. The Finance manager takes proper financial decisions.
ii. He uses the finance of the company properly.
2. Wealth maximization : Wealth maximization (shareholders' value maximization) is also a main
objective of financial management. Wealth maximization means to earn maximum wealth for the
shareholders. So, the finance manager tries to give a maximum dividend to the shareholders. He also tries to
increase the market value of the shares. The market value of the shares is directly related to the performance
of the company. Better the performance, higher is the market value of shares and vice-versa. So, the finance
manager must try to maximise shareholder's value.
3. Proper estimation of total financial requirements : Proper estimation of total financial requirements is
a very important objective of financial management. The finance manager must estimate the total financial
requirements of the company. He must find out how much finance is required to start and run the company.
He must find out the fixed capital and working capital requirements of the company. His estimation must be
correct. If not, there will be shortage or surplus of finance. Estimating the financial requirements is a very
difficult job. The finance manager must consider many factors, such as the type of technology used by
company, number of employees employed, scale of operations, legal requirements, etc.
4. Proper mobilisation : Mobilisation (collection) of finance is an important objective of financial
management. After estimating the financial requirements, the finance manager must decide about the
sources of finance. He can collect finance from many sources such as shares, debentures, bank loans, etc.
There must be a proper balance between owned finance and borrowed finance. The company must borrow
money at a low rate of interest.
5. Proper utilisation of finance : Proper utilisation of finance is an important objective of financial
management. The finance manager must make optimum utilisation of finance. He must use the finance
profitable. He must not waste the finance of the company. He must not invest the company's finance in
unprofitable projects. He must not block the company's finance in inventories. He must have a short credit
period.
6. Maintaining proper cash flow : Maintaining proper cash flow is a short-term objective of financial
management. The company must have a proper cash flow to pay the day-to-day expenses such as purchase
of raw materials, payment of wages and salaries, rent, electricity bills, etc. If the company has a good cash
flow, it can take advantage of many opportunities such as getting cash discounts on purchases, large-scale
purchasing, giving credit to customers, etc. A healthy cash flow improves the chances of survival and
success of the company.
7. Survival of company : Survival is the most important objective of financial management. The
company must survive in this competitive business world. The finance manager must be very careful while
making financial decisions. One wrong decision can make the company sick, and it will close down.
8. Creating reserves : One of the objectives of financial management is to create reserves. The company
must not distribute the full profit as a dividend to the shareholders. It must keep a part of it profit as reserves.
Reserves can be used for future growth and expansion. It can also be used to face contingencies in the
future.
9. Proper coordination : Financial management must try to have proper coordination between the
finance department and other departments of the company.
10. Create goodwill : Financial management must try to create goodwill for the company. It must
improve the image and reputation of the company. Goodwill helps the company to survive in the short-term
and succeed in the long-term. It also helps the company during bad times.
11. Increase efficiency : Financial management also tries to increase the efficiency of all the departments
of the company. Proper distribution of finance to all the departments will increase the efficiency of the entire
company.
12. Financial discipline : Financial management also tries to create a financial discipline. Financial
discipline means:-
i. To invest finance only in productive areas. This will bring high returns (profits) to the company.
ii. To avoid wastage and misuse of finance.
13. Reduce cost of capital : Financial management tries to reduce the cost of capital. That is, it tries to
borrow money at a low rate of interest. The finance manager must plan the capital structure in such a way
that the cost of capital it minimised.
14. Reduce operating risks : Financial management also tries to reduce the operating risks. There are
many risks and uncertainties in a business. The finance manager must take steps to reduce these risks. He
must avoid high-risk projects. He must also take proper insurance.
15. Prepare capital structure : Financial management also prepares the capital structure. It decides the
ratio between owned finance and borrowed finance. It brings a proper balance between the different sources
of. capital. This balance is necessary for liquidity, economy, flexibility and stability.

10. What is meant by preferance shares ? Discuss its types.

Following are the major types of preference shares:

1. Cumulative Preference Shares

When unpaid dividends on preference shares are treated as arrears and are carried forward to subsequent
years, then such preference shares are known as cumulative preference shares. It means unpaid dividend on
such shares is accumulated till it is paid off in full.
2. Non-cumulative Preference Shares
Non-cumulative preference shares are those type of preference shares, which have right to get fixed rate of
dividend out of the profits of current year only. They do not carry the right to receive arrears of dividend. If
a company fails to pay dividend in a particular year then that need not to be paid out of future profits.

3. Redeemable Preference Shares

Those preference shares, which can be redeemed or repaid after the expiry of a fixed period or after giving
the prescribed notice as desired by the company, are known as redeemable preference shares. Terms of
redemption are announced at the time of issue of such shares.

4. Non-redeemable Preference Shares

Those preference shares, which can not be redeemed during the life time of the company, are known as non-
redeemable preference shares. The amount of such shares is paid at the time of liquidation of the company.

5. Participating Preference Shares

Those preference shares, which have right to participate in any surplus profit of the company after paying
the equity shareholders, in addition to the fixed rate of their dividend, are called participating preference
shares.
6. Non-participating Preference Shares
Preference shares, which have no right to participate on the surplus profit or in any surplus on liquidation of
the company, are called non-participating preference shares.

7. Convertible Preference Shares

Those preference shares, which can be converted into equity shares at the option of the holders after a fixed
period according to the terms and conditions of their issue, are known as convertiblepreference shares.

8. Non-convertible Preference Shares

Preference shares, which are not convertible into equity shares, are called non-convertible preference shares.

11. Explain the MM approach to capital structure.

Modigliani Millar approach, popularly known as the MM approach is similar to the Net operating
income approach. The MM approach favors the Net operating income approach and agrees with the fact that
the cost of capital is independent of the degree of leverage and at any mix of debt-equity proportions. The
significance of this MM approach is that it provides operational or behavioral justification for constant cost
of capital at any degree of leverage. Whereas, the net operating income approach does not provide
operational justification for independence of the company's cost of capital.

Basic Propositions of MM approach:

1. At any degree of leverage, the company's overall cost of capital (ko) and the Value of the firm (V)
remains constant. This means that it is independent of the capital structure. The total value can be
obtained by capitalizing the operating earnings stream that is expected in future, discounted at an
appropriate discount rate suitable for the risk undertaken.
2. The cost of capital (ke) equals the capitalization rate of a pure equity stream and a premium for
financial risk. This is equal to the difference between the pure equity capitalization rate and ki times
the debt-equity ratio.
3. The minimum cut-off rate for the purpose of capital investments is fully independent of the way in
which a project is financed.

Assumptions of MM approach:

1. Capital markets are perfect.

2. All investors have the same expectation of the company's net operating income for the purpose of
evaluating the value of the firm.
3. Within similar operating environments, the business risk is equal among all firms.
4. 100% dividend payout ratio.
5. An assumption of "no taxes" was there earlier, which has been removed.

Arbitrage process

Arbitrage process is the operational justification for the Modigliani-Miller hypothesis. Arbitrage is the
process of purchasing a security in a market where the price is low and selling it in a market where the price
is higher. This results in restoration of equilibrium in the market price of a security asset. This process is a
balancing operation which implies that a security cannot sell at different prices. The MM hypothesis states
that the total value of homogeneous firms that differ only in leverage will not be different due to the
arbitrage operation. Generally, investors will buy the shares of the firm that's price is lower and sell the
shares of the firm that's price is higher. This process or this behavior of the investors will have the effect of
increasing the price of the shares that is being purchased and decreasing the price of the shares that is being
sold. This process will continue till the market prices of these two firms become equal or identical. Thus the
arbitrage process drives the value of two homogeneous companies to equality that differs only in leverage.

Limitations of MM hypothesis:

1. Investors would find the personal leverage inconvenient.

2. The risk perception of corporate and personal leverage may be different.
3. Arbitrage process cannot be smooth due the institutional restrictions.
4. Arbitrage process would also be affected by the transaction costs.
5. The corporate leverage and personal leverage are not perfect substitutes.
6. Corporate taxes do exist. However, the assumption of "no taxes" has been removed later.

12. Discuss the factors determining the cost of capital.

Cost of capital is an important concept in financial management. Various financing and investing decisions
depend upon the cost of capital of a firm. There are several factors that make cost of capital of a firm high or
low.

Some of the important factors are discussed below:

1. Demand and Supply of Capital:

Demand and supply of capital affects the cost of capital. If the demand for funds in the economy increases,
lenders will automatically increase the required rate of return and vice-versa. Supply of funds has an inverse
relation to cost of capital: If supply of fund increases then the cost of capital decreases; and if the supply of
funds decreases, the cost of capital increases.

2. Market Condition:

The market condition of the product produced by the project for which a fund is required is an important
factor for determining the cost of capital. Funds required for risky projects increases the cost of capital, as
lenders demand a higher rate to compensate their risk. On the other hand, if the market condition of the
products produced by the project is such that it will have a high and secured return, then the risk will be
lower and obviously the cost of capital will be less.

3. Unsystematic Risk:

Unsystematic risk is of two types: Business risk and financial risk. Business risk arises due to investment
decisions of the company. Financing risk arises due to financing decisions, i.e. proportion of debt and equity
in the capital structure. Business risk and financing risk affect the overall cost of capital of a firm. A firm's
total unsystematic risk is the sum of business and financing risks. The cost of capital is directly proportional
to the total unsystematic risk of the firm.

4. Volume of Financing:

Volume of financing also affects the cost of capital. High volume of capital also increases the overall cost of
capital due to issue related costs and the greater risks involved. The liquidity risk associated with high
volume of capital also increases cost of capital. If the firm uses lower volume of capital then the suppliers of
the fund remain more assured of their fund and the cost of capital reduces.