Financial Management : An
Overview
Financial Management : An Overview
1
Question


Why is it that some companies, in some
industries, provide more value to
shareholders?
In answering this question, you might
like to use the information provided
separately on the market capitalization
of some large Indian companies
Financial Management : An Overview
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Concepts of Value

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Gross Profit/ Net Profit
ROA/ ROCE/ RONW
Market value or market capitalization
Market value added
Economic value added
Financial Management : An Overview
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An overview of financial management
Financial Management
Maximization of Share Value
Financial Decisions
Investment DecisionFinancing Decision Dividend Decision Liquidity Decision
Risk
Return
Financial Management : An Overview
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A simple view of a firm
Liabilities

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Debt ( borrowed money )
Equity ( owners’ Funds )
Assets
Investments already made.
These generate cash flows
today
Investments yet to be
made. These future
investments are expected
to create additional value
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The Balance-Sheet Model of A Firm
Total Value of Assets:
Current
Assets
Total Firm Value to Investors:
Current
Liabilities
Long-Term
Debt
Fixed
Assets
Shareholder
s’ Equity
1 Tangible
2 Intangible
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The Balance-Sheet Model of A Firm
The Capital Investment Decision
Current
Liabilities
Current
Assets
Fixed
Assets
1 Tangible
2 Intangible
Long-Term
Debt
What longterm
investment
s should
the firm
engage in?
Financial Management : An Overview
Shareholder
s’ Equity
7
The Balance-Sheet Model of A Firm
The Capital Structure Decision
Current
Liabilities
Current
Assets
Fixed
Assets
How can the
firm raise the
money for the
required
investments?
1 Tangible
Long-Term
Debt
Shareholder
s’ Equity
2 Intangible
Financial Management : An Overview
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The Balance-Sheet Model of A Firm
The Net Working Capital Investment
Current
Decision
Current
Assets
Fixed
Assets
1 Tangible
2 Intangible
Liabilities
Net
Working
Capital
How much
short-term
cash flow
does a
company need
to pay its
bills?
Financial Management : An Overview
Long-Term
Debt
Shareholder
s’ Equity
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Stakeholders and their expectations
• SECURITY
• COMPENSATION
• JOB SATISFACTION
• COMPENSATION
• PRESTIGE
• POWER
• TAXES
• EMPLOYMENT
EMPLOYEES
MINORITY
GROUP
MANAGERS
FIRM
GOVERNMENT
• REGULAR
PAYMENT
• CONTINUITY
OF BUSINESS
• FAIR
• EMPLOYMENT
• NO DISCRIMINATION
COMMUNITY
CREDITORS
SUPPLIERS
CUSTOMERS
• PRODUCT QUALITY
• SERVICE
• VALUE
• EMPLOYMENT
• PRESERVATION OF
THE ENVIRONMENT
SHARE
HOLDERS
• INTEREST
• SECURITY OF
CAPITAL
• DIVIDENDS
• CAPITAL GROWITH
• SAFETY OF INVESTMENT
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Question : Agency Costs

There is a conflict of interest between
shareholders and managers. In theory,
shareholders are expected to exercise
control over managers through the
annual meeting or the board of
directors. In practice, why might these
disciplinary mechanisms not work?
Financial Management : An Overview
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Question

Maximizing firm value, defined as its
market capitalization, has been
suggested as the major goal in
corporate finance. Does this conflict
with a firm’s responsibility to its
customers, to employees and to
society in general?
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Possible answers

Maximizing stock price is not
incompatible with meeting employee
needs/objectives. In particular:


Employees are often stockholders in
many firms
Firms that maximize stock price generally
are firms that have treated employees
well.
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Possible answers

Maximizing stock price does not mean
that customers are not critical to
success. In most businesses, keeping
customers happy is the route to stock
price maximization.
Financial Management : An Overview
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Possible answers
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Maximizing stock price does not imply that a
company has to be a social outlaw.
In fact, companies, such as ONGC and
Hindustan Lever, who are among the most
valuable companies in India today, are also
the companies who have shown a high
degree of sensitivity to the needs of society.
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Building a profitable business is hard work
Maximizing firm value
Managing Investment
Increasing return
Investment in
Fixed assets
Increasing revenues and
ontrolling costs
Quantity
Operating risk
/ Leverage
Working capital
management
Quality
Financial risk
/ Leverage
Financial Management : An Overview
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The DU PONT Formula
Return on Net Worth (RONW) =
Net Profit
To Sales x
Worth
Margin
Sales to
Total Assets
Activity
Financial Management : An Overview
Total Assets
x to Net
Leverage
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Which of these two companies is more risky ?
(Figures in rupees)
Firm A
1 Sales
Firm B
100,000
100,000
2 Variable costs
40,000
60,000
3 Contribution ( 1- 2)
60,000
40,000
4 Less Fixed operating
costs
5 Operating profit ( 3-4)
40,000
20,000
20,000
20,000
6 Less interest on loans
12,000
8,000
8,000
12,000
7 Profit before tax
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Which of these two companies is more risky ?
Leverage measures
8 Operating leverage
( Line 3 / Line 5 )
9 Financial leverage
( Line 5 / Line 7 )
10 Total or combined
leverage ( Line 8 x
Line 9 )
3.0
2.00
2.5
1.67
7.5
3.34
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Risk matrix
High
Financial
leverage
Low
(1) High
financial and
low operating
risk
(2) High
financial and
high
operating risk
(3) Low
financial and
low
operating
risk
(4) High
operating
risk and low
financial risk
Operating leverage
Financial Management : An Overview
High
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