AGENCY PROBLEM---Management versus Stockholders

Management serves as an agent to the stockholders (owner)

Stockholders delegate authority to management to act on their
behalf and are expected to act in their best interest
 Management’s objectives may differ from those of stockholders
In many large corporations, where ownership is largely diversified,
the situation arises where management may act in their own best
interests rather than in the best interests of the stockholders
Management may attempt to amass income, power and prestige
Appropriate incentives such as stock options, bonuses and
perquisites, should be given to managers to ensure they act in the
best interest of the stockholders

1/22/2018 1
 ROLE/FUNCTIONS OF FINANCE MANAGER
Finance manager is one of the important role players in the field of finance
function. He must have entire knowledge in the area of accounting, finance,
economics and management. His position is highly critical and analytical to
solve various problems related to finance.
1.Forecasting Financial Requirements He should estimate, how much
finances required to acquire fixed assets and forecast the amount needed to
meet the working capital requirements in future
2. Acquiring Necessary Capital After deciding the financial requirement, the
finance manager should concentrate how the finance is mobilized and
where it will be available
3.Investment Decision The finance manager must carefully select best
investment alternatives and consider the reasonable and stable return from
the investment. He must be well versed in the field of capital budgeting
techniques to determine the effective utilization of investment

1/22/2018 2
 ROLE/FUNCTIONS OF FINANCE MANAGER Contd.

4. Cash Management Proper cash management is not only essential for

effective utilization of cash but it also helps to meet the short-term
liquidity position of the concern
5. Interrelation with Other Departments Finance manager deals with
various functional departments such as marketing, production, personnel,
research & development, etc. Finance manager should have sound
knowledge not only in finance related area but has to be well versed in
other areas too. He must maintain a good relationship with all the
functional departments of the business organization

1/22/2018 3
 IMPORTANCE OF FINANCIAL MANAGEMENT
Financial Planning Long-term profit planning aimed at generating greater
return on assets, growth in market share, and at solving foreseeable
problems
Acquisition of Funds Financial management involves the acquisition of
required finance to the business concern. Acquiring needed funds play a
major part of the financial management, which involve possible source of
finance at minimum cost
Proper Use of Funds Proper use and allocation of funds leads to improve
the operational efficiency of the business concern. When the finance
manager uses the funds properly, they can reduce the cost of capital and
increase the value of the firm.
Financial Decision Financial decision will affect the entire business
operations of the concern because there is a direct relationship with
various department functions such as marketing, production personnel, etc

1/22/2018 4
 IMPORTANCE OF FINANCIAL MGMT. Contd.
Improve Profitability Financial management helps to improve the
profitability position of the concern through effectiveness utilization of
funds with the help of strong financial control devices such as budgetary
control, ratio analysis and cost volume profit analysis
Increase the Value of the Firm Ultimate aim of any business concern is to
achieve maximum profit. Higher profitability leads to the maximization of
the wealth of investors as well as the nation
Promoting Savings Savings are possible only when the business concern
earns higher profitability and maximizing wealth. Effective financial
management helps to promoting and mobilizing individual and corporate
savings. Nowadays

financial management is also popularly known as business finance or

corporate finance. The business concern or corporate sectors cannot
function without the importance of the financial management.

1/22/2018 5
 Areas of financial Mgmt.
1. Financial Management and Economics Economic concepts like micro
and macroeconomics are directly applied with the financial management
approaches. Financial management also uses the economic equations like
money value discount factor, economic order quantity etc.

2. Financial Management and Accounting Accounting records include the

financial information of the business concern. Hence, we can easily
understand the relationship between the financial management and
accounting. In the old periods, both financial management and accounting
are treated as a same discipline and then it has been merged as
Management Accounting because this part is very much helpful to finance
manager to take decisions. But nowadays financial management and
accounting discipline are separate and interrelated.

1/22/2018 6
 Areas of financial Mgmt. Contd.
3. Financial Management and Mathematics Economic order quantity,
discount factor, time value of money, present value of money, cost of capital,
capital structure theories, dividend theories, ratio analysis and working
capital analysis are used as mathematical and statistical tools and techniques
in the field of financial management
4. Financial Management and Production Management Profit of the
concern depends upon the production performance. Production
performance needs finance, because production department requires raw
material, machinery, wages, operating expenses etc. These expenditures are
decided and estimated by the financial department and the finance manager
allocates the appropriate finance to production department.

1/22/2018 7
 Areas of financial Mgmt. Contd.
5. Financial Management and Marketing Produced goods are sold in
the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements. The
financial manager or finance department is responsible to allocate the
adequate finance to the marketing department
6.Financial Management and Human Resource Financial
management is also related with human resource department, which
provides manpower to all the functional areas of the management.
Financial manager should carefully evaluate the requirement of
manpower to each department and allocate the finance to the human
resource department as wages, salary, remuneration, commission,
bonus, pension and other monetary benefits

1/22/2018 8
SOURCES AND FORMS OF
FINANCING
 THE NEED FOR FUNDS

No business can live without funds. Throughout the

life of a business, money is needed continuously.
Firms raise money mainly to meet the following three
types of need:
1. To start a business as initial expenditure
2. To fund continuous business activities
3. To expand the business
 SOURCES OF FUNDS

Sources of Funds

Internal Sources External Sources

Short term:
Long-term: Overdraft
Profit Depreciation Sales of assets Share Capital Leasing
Loan Capital Credit card…
THE MONEY AND CAPITAL MARKETS
Two types of external markets for
funds:
1. Money market
 Short-term debt securities: maturity of less than 1
year
 T-bills, commercial paper, bankers’ acceptances,
and short-term certificates of deposit
2. Capital market (focus of this chapter)
 Intermediate-term securities: maturity of
more than 1 but less than 10 years
 Long-term securities: maturity of 10 or more
years
 Equity securities: preferred and common stock
have longest time horizon since they are issued
for life of corporation
 BUSINESS FINANCE: EXTERNAL

Long Term
 Shares
 Ordinary Shares
 Preference Shares

 New share issues

 Rights Issue

 Bonus or Scrip Issue

 Loans
 Debentures
 Bank loans (mortgage)

 Merchant or Investment Banks

 Grants by Government i.e. research and development

agreements
 Ordinary Shares

Contributed by the owners of the company

 This capital forms the backbone of the
financial structure of the company
 It is the risk capital of the company
 No fixed rate of dividend is attached
 New share issues

Methods

An initial public offering (IPO) or stock market launch is a

type of public offering where shares of stock in a company
are sold to the general public, on a securities exchange,
for the first time. Through this process, a private
company transforms into a public company

Placing: Shares are issued at a fixed price to a number of

institutional investors, such as insurance companies,
pension fund etc
 Rights Issues

Sale of shares for cash to existing owners in

proportion to their existing holdings;
Law requires shares which are to be issued for
cash to be offered first to existing shareholders (pre-
emptive rights)
Control and ownership is not diluted
cheaper than other methods
prevents greater competition
Bonus/script issue

 involves issuing new shares to existing

shareholders in proportion to their existing
shareholdings
However the shareholders do not have
to pay for the new shares issued
INTERMEDIATE- AND LONG-TERM DEBT
Term loans
 Paid off over some number of years
 Usually negotiated with commercial bank or some
other financial institution
 Fully amortized (principal and interest are paid off
in installments over life of loan)
INTERMEDIATE- AND LONG-TERM DEBT
Debentures
 Intermediate to long term debt agreements issued by
governments, corporations, and other organizations
 Issued in units of Rs.1,000 principal value per debenture
 Two “promises” to:
 Repay Rs.1,000 principal value at maturity
 Pay stated interest rate (coupon rate) when due
 Most bonds pay interest semiannually at a rate equal to
one-half of the annual coupon rate
 LEASE FINANCING

 Business has the use of the asset and incurs an

obligation either to pay off loan or meet monthly
lease payment.
 At the end of lease term, residual value of asset
belongs to lessee.
 Leasing is a form of debt financing.
 LEASE FINANCING

Capital leases meet any one of these four

conditions:
1. Title is transferred to lessee at end of lease
term.
2. Lease contains bargain purchase option (an
option to buy asset at very low price).
3. Term of lease is greater than or equal to
75% of estimated economic life of asset.
4. Present value of minimum lease payment is
greater than or equal to 90% of fair value of
leased property.
 PREFERRED STOCK
Two important preferences over common
stock:
1. Payment of dividends
2. Stockholders’ claims on assets of business in event
of bankruptcy
 PREFERRED STOCK
Preferred stock combines some of the characteristics of
bonds and some of the characteristics of common stock

 Fixed in amount
 Holders do not participate in growth of corporate
earnings, but rather collect only dividends promised
in indenture
 Payments must be voted on and approved by board
of directors of corporation
 Issues are cumulative (missed dividends accumulate
as arrearages and must be paid off before dividends
on common stock can be paid)
 COMMON STOCK
 Each share of common stock has one vote in
electing members of corporation’s board of
directors.
 Board is responsible to stockholders.
 Board selects president.
 President reports to board.
 If one person is a majority stockholder, he/she
may serve as both president and chairman.
In large, publicly held corporations, no
single individual or small group holds
enough shares to exercise voting control of
corporation.
 COMMON STOCK
Common stock serves as corporation’s
equity cushion
 Money paid to corporation for common
stock does not have to be repaid.
 Board declares when dividends are paid.
 Dividends do not accumulate as
arrearages.
 Stockholders cannot legally claim any
specified dividend level.
 As corporation prospers, board votes
to increase dividend along with
increased growth in earnings.
 As dividends increase, value of stock
increases.
 External short-term sources of loans
Major Main
Types Characteristics
Bank This is a short term financing from banks.
overdraft The amount to be overdrawn depends on the needs of the business at the
time and its credit standing.
Interest is calculated from the time the account is overdrawn..
Bank This is a loan which requires a rigid agreement between the borrower and
loan the bank. The amount borrowed must be repaid over a certain period or in
regular installments.
Sometimes, banks change persistent overdrafts into loans, so borrowers
must repay at regular intervals.
Leasing Leasing allows businesses to buy plant, machinery or equipment without
paying large sums of money immediately.
The leasing company or bank hires or buys the equipment and for the use of
the hire company for a certain period of time. If the user can never owns the
equipment, it is an operating lease, while if it is given the choice to own the
equipment at the expiry time, it is a finance lease.
Lease payments are made by the hire company yearly or monthly, etc.
 Commercial Paper (CP)

CPs are short term, unsecured, usance promissory notes issued by large
corporations. The rate of interest will depend on overall short term money
market rates as well as credit standing of the issuer company. Individual
investors can invest in commercial paper. These are issued at discounts to the
face value and extent of discount will determine the yield on the paper. Banks
are not permitted to co-accept or underwrite Cps issued by companies. The
CPs are regulated by Reserve Bank of India and companies can issue Cps to
meet their short term requirement of funds, subject to norms laid by RBI from
time to time. A company is eligible to issue CP only if its tangible net worth is
more than Rs. 4 crores and if it has a sanctioned working capital limit from a
bank or a financial institution. The minimum credit rating required for Cps is P-2
of CRISIL or its equivalent of other credit rating agencies. The period is 15
days to less than a year and the domination is Rs. 5 lacs and its multiples.
TREASURY BILL (TB)
 FACTORS AFFECTING THE CHOICE OF FUNDS
 Costs of the fund
Costs in terms of interest payments and other expenses: Long term and
short term.
 Use or purpose of funds
For example, the building of a new plant is usually financed by mortgage or
share capital, while the purchase of raw materials by trade credit or bank
overdraft.
 Status and size of the business
For a large firm, there are more sources of finance and often with lower
interest rates.
 Financial situations of a firm
For example, a business in poor financial situation is forced to pay high
interest rate for loans. And the bank often requires security or collaterals
for their financing.
 FACTORS CONTINUED

 Gearing condition (ratio) of the firm

 Gearing is the relationship between the loan capital and share
capital of a business. High geared companies have a larger share
of loan capital to share capital. Low geared ones have a small
amount of loan capital.
 Impact over a firm:
High gearing may mean ‘no loss of ownership’ but high risk of
liquidity since interest rates may change and loans must be
repaid in time. Low gearing may mean some loss of ownership
but no burden of loans and interest payments.