Prof.

Prapti Paul
IBS- Gurgaon
• Explain the nature of finance and its interaction with other management
functions

• Review the changing role of the finance manager and his /her position in
the management hierarchy.

• Focus on the Shareholders’ Wealth Maximization (SWM) principle as an

operationally desirable finance decision criterion

• Discuss agency problems arising from the relationship between

shareholders and managers

• Illustrate the organization of finance function

 Production
 Marketing
 Finance
• Real Assets: Can be Tangible or Intangible

• Tangible real assets are physical assets that include plant,

machinery, office, factory, furniture and building.

• Intangible real assets include technical know-how,

technological collaborations, patents and copyrights.

• Financial Assets, also called securities, are financial papers or

instruments such as shares and bonds or debentures.
 Shares represent ownership rights of their holders.
Shareholders are owners of the company. Shares can be of
two types:

 Equity Shares
 Preference Shares

 Loans, Bonds or Debts represent liability of the firm towards

outsiders. Lenders are not owners of the company. These
provide interest tax shield.
• Equity Shares are also known as ordinary shares.
• Do not have fixed rate of dividend.
• There is no legal obligation to pay dividends to equity
shareholders.

• Preference Shares have preference for dividend payment

over ordinary shareholders.
• They get fixed rate of dividends.
• They also have preference of repayment at the time of
liquidation.
 All business activities involve acquisition and
use of funds.
 Finance function makes money available to
meet the costs of production and marketing
operations.
 Financial policies are devised to fit production
and marketing decisions of a firm in practice.
• Finance functions or decisions can be divided
as follows:

 Long-term financial decisions

1. Long-term asset-mix or investment decision or capital budgeting
decisions.(Investment decision)
2. Capital mix or financing decision or capital structure and leverage
decisions. (Financing decision)
3. Profit allocation or dividend decision.(Dividend decision)
 Short-term financial decisions
4 Short-term asset-mix or liquidity decision or working capital
management.( Liquidity decision)
 For effective finance function some routine functions have to
be performed. Some of these are:

• Supervision of receipts and payments and safeguarding of

cash balances
• Custody and safeguarding of securities, insurance policies
and other valuable papers
• Taking care of the mechanical details of new outside
financing
• Record keeping and reporting
 Raising of Funds
 Allocation of Funds
 Profit Planning
 Understanding Capital Markets
•Profit maximization (profit after
tax)
•Maximizing earnings per share
•Wealth maximization
 Maximizing the rupee income of a firm
 Resources are efficiently utilized
 Appropriate measure of firm performance
 Serves interest of society also
• It is Vague
• It Ignores the Timing of Returns
• It Ignores Risk
• Assumes Perfect Competition
• In new business environment Profit
maximization is regarded as
• Unrealistic
• Difficult
• Inappropriate
• Immoral
 Maximizing PAT or EPS does not maximize
the economic welfare of the owners.
 Ignores timing and risk of the expected
benefit.
 Market value is not a function of EPS.
 Maximizing EPS implies that the firm should
make no dividend payment so long as funds
can be invested at positive rate of return—
such a policy may not always work.
 Maximizes the net present value of a course
of action to shareholders.
 Accounts for the timing and risk of the
expected benefits.
 Benefits are measured in terms of cash flows.
 Fundamental objective—maximize the
market value of the firm’s shares.
 SWM requires a valuation model.
 The financial manager must know,
 How much should a particular share be
worth?
 Upon what factor or factors should its value
depend?
 Financial decisions of the firm are guided by
the risk-return trade-off.
 The return and risk relationship: Return
=Risk-free rate+ Risk premium
 Risk free rate is a compensation for time and
risk premium for risk.
Risk and expected return move in tandem; the greater the risk,
the greater the expected return.
• There is a Principal Agent relationship
between managers and shareholders.

• In theory, Managers should act in the best

interests of shareholders.

• In practice, managers may maximise their

own wealth (in the form of high salaries and
perks) at the cost of shareholders.
• Managers may perceive their role as reconciling conflicting objectives of
stakeholders. This stakeholders’ view of managers’ role may compromise
with the objective of SWM.

• Managers may avoid taking high investment and financing risks that may
otherwise be needed to maximize shareholders’ wealth. Such
“satisfying” behaviour of managers will frustrate the objective of SWM as
a normative guide.

• This conflict is known as Agency problem and it results into Agency

costs.
 Agency costs include the less than optimum
share value for shareholders and costs
incurred by them to monitor the actions of
managers and control their behaviour.
• Firms’ primary objective is maximizing the welfare of
owners, but, in operational terms, they focus on the
satisfaction of its customers through the production of
goods and services needed by them.

• Firms state their vision, mission and values in broad terms.

• Wealth maximization is more appropriately a decision

criterion, rather than an objective or a goal.

• Goals or objectives are missions or basic purposes of a firm’s

existence.
• The shareholders’ wealth maximization is the second level
criterion ensuring that the decision meets the minimum
standard of the economic performance.

• In the final decision-making, the judgement of management

plays the crucial role.

• The wealth maximization criterion would simply indicate

whether an action is economically viable or not.
 Reasons for placing the finance functions in the hands of top
management-

 Financial decisions are crucial for the survival of the firm.

 The financial actions determine solvency of the firm.
 Centralisation of the finance function scan result in a number
of economies to the firm.
Organization for finance function Organization for finance function in
a multidivisional company
 The exact organisation structure for financial
management will differ across firms.
 The financial officer may be known as the
financial manager in some organisations,
while in others as the vice-president of
finance or the director of finance or the
financial controller.
 Two officers—the treasurer and the
controller—maybe appointed under
the direct supervision of CFO to assist him or her.

 The treasurer’s function is to raise and manage

company funds while the controller oversees
whether funds are correctly applied.