Function of Financial Management
Orenburg branch
The Essay:
Financial Management:
Function
of Financial Management.
2 st year studies
Supervisor: O.N.Safonova
December-2011
Orenburg
Introduction………………………………………………
Part 1. Financial Management terms.……………………………………5
1.1 Financial Management objectives………………………………..6
Part 2. Functions of Financial Management……………………………...7
2.1. The investment decision……………………………………9
2.2 The financing decision………………………………….....13
2.3. The dividend decision……………………………………..14
Conclusion……………………………………………………
References……………………………………………………
Appendix №1 CD-RW
Appendix №2
Report
Introduction.
Ever since 1494 when a monk of Italian origin, Lucas Pacioli wrote the
first book on modern accounting, financial management has grown to become
the key to corporate growth. Financial management can be simply termed
as efficient management of finances of a business/organization in order
to achieve financial objectives
The key objectives of a financial management are to generate wealth
for the business and its shareholders, to provide a return of investment
and to generate cash flow. There are two main aspects of financial management,
namely, the procurement of funds and the effective use of those funds.
On the procurement of funds, one may note here that funds may be procured
from different sources and funds procured from different sources have
different characteristics in terms of cost, risk and control in financial-management-speak.
Funds issued through equity participation, that is, the financier acquires
some stake in the company, are least risky as the money used to buy
equity can only be repaid upon the liquidation of the company. But in
terms of cost, these funds are pricey compared to others mainly because
the dividend expectations are normally higher than the prevailing interest
rates.
In
principle, financial management comprises of risk, cost and control.
For a proper balancing of risk and control, the cost of funds should
be at the minimum.
Sound financial management is essential in all types of organizations,
whether they are profit motivated, public or state owned bodies or those
that are altruistic in nature.
Financial management ultimately will involve making of some financial
decisions, and there are three types of such financial management decisions;
long term investment decisions, long-term financing decisions and working
capital management decisions. The third type of financial management
decision, unlike the first two, is short term in nature. the decision
in this segment involve managing cash, inventories and short term financing.
All financial management decisions should form part of overall strategy
and not be seen as separate. The investment decision of financial
management involves the managers deciding on the kind and nature of
assets that they want to hold. So, inevitably this will involve selling,
buying, reducing or holding of various assets. Managing those aforementioned
activities is called capital budgeting. The process of decision making
on investments will involve one of the cardinal principles of financial
management, which is that a firm should hold only those assets which
yield a return not less than a prescribed minimum
Long
term financing decision, as the name suggests, involve deciding the
mode of procurement of funds to finance the necessary long term investments.
The corporate “graveyard” is littered with companies that went burst
not because their products had no market or that the workers were lazy,
but because the decision makers did not adhere to the principles of
good financial management. If, carried out competently, financial management
increases the output from the factors of production, especially capital.
Good financial management is especially essential for start-ups which
need it for their survival. It is also important to an organization
even if the profits are not in any way the motivation. Most of non-profit
organizations have scant respect for good financial management, but
even such bodies, and indeed everyone should be encouraged, if only
for a wider utilitarian objective.
1.
Financial Management terms.
Finance is the application of economic principles and concepts to business
decision-making and problem solving. The field of finance can be
considered to comprise three broad categories: financial management,
investments, and financial institutions:
Financial management.
Sometimes called corporate finance or business finance, this area of finance is concerned primarily with financial decision-making within a business entity. Financial management decisions include maintaining cash balances, extending credit, acquiring other firms, borrowing from banks, and issuing stocks and bonds.
Investments.
This area of finance focuses on the behavior of financial markets and the pricing of securities. An investment manager’s tasks, for example, may include valuing common stocks, selecting securities for a pension fund, or measuring a portfolio’s performance.
Financial institutions.
This area of finance deals with
banks and other firms that specialize in bringing the suppliers
of funds together with the users of funds. For example, a manager
of a bank may make decisions regarding granting loans, managing cash
balances, setting interest rates on loans, and dealing with government regulations.
No matter the particular category of finance, business situations that call for the application of the theories and tools of finance generally involve either investing (using funds) or financing (raising funds). Managers who work in any of these three areas rely on the same basic knowledge of finance. In this book, we introduce you to this common body of knowledge and show how it is used in financial decision-making. Though the emphasis of this book is financial management, the basic principles and tools also apply to the areas of investments and financial institutions. In this introductory chapter, we’ll consider the
types of decisions financial
managers make, the role of financial analysis, the forms of business
ownership, and the objective of managers decisions. Finally, we will
describe the relationship between owners and managers.
1.1
Financial Management objectives.
The financial management is generally concerned with procurement, allocation and control of financial resources of a concern.
The objectives can be-
- To ensure regular and adequate supply of funds to the concern.
- To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders.
- To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost.
- To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved.
- To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.
2.
Functions of Financial Management
Estimation of capital requirements: A finance manager has to make estimation
with regards to capital requirements of the company. This will depend
upon expected costs and profits and future programmes and policies of
a concern. Estimations have to be made in an adequate manner which increases
earning capacity of enterprise.
Determination of capital composition: Once the estimation have been
made, the capital structure have to be decided. This involves short-
term and long- term debt equity analysis. This will depend upon the
proportion of equity capital a company is possessing and additional
funds which have to be raised from outside parties.
Choice of sources of funds: For additional funds to be procured, a company has many choices like-
Issue of shares and debentures
Loans to be taken from banks and financial institutions
Public deposits to be drawn like in form of bonds.
Choice of
factor will depend on relative merits and demerits of each source and
period of financing.
Investment
of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is
possible.
Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done in two ways:
Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.
Retained
profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.
Management
of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages
and salaries, payment of electricity and water bills, payment to creditors,
meeting current liabilities, maintainance of enough stock, purchase
of raw materials, etc.
Financial
controls: The finance manager has not only to plan, procure and utilize
the funds but he also has to exercise control over finances. This can
be done through many techniques like ratio analysis, financial forecasting,
cost and profit control, etc.
Financial management encompasses many different types of decisions.
We can classify these decisions into three groups: investment decisions, financing decisions, and decisions that involve both investing and financing.
Investment decisions are concerned with the use of funds the buying,
holding, or selling of all types of assets: Should we buy a new die
stamping machine? Should we introduce a new product line? Sell the old
production facility? Buy an existing company? Build a warehouse? Keep
our cash in the bank?
Financing decisions are concerned with the acquisition of funds to be used for investing and financing day-to-day operations. Should managers use the money raised through the firms’ revenues? Should they seek money from outside of the business? A company’s operations and investment can be financed from outside the business by incurring debts, such as though bank loans and the sale of bonds, or by selling ownership interests. Because each method of financing obligates the business in different ways, financing decisions are very important.
Many business decisions simultaneously involve both investing and financing.
For example, a company may wish to acquire another firm an investment
decision. However, the success of the acquisition may depend on how
it is financed: by borrowing cash to meet the purchase price, by selling
additional shares of stock, or by exchanging existing shares of stock.
If managers decide to borrow money, the borrowed funds must be repaid
within a specified period of time. Creditors (those lending the money)
generally do not share in the control of profits of the borrowing firm.
If, on the other hand, managers decide to raise funds by selling ownership
interests, these funds never have to be paid back. However, such a sale
dilutes the control of (and profits accruing to) the current owners.
Whether a financial decision involves investing, financing, or both,
it also will be concerned with two specific factors: expected return and
risk. And throughout your study of finance, you will be concerned with
these factors. Expected
return is the difference between potential benefits
and potential costs. Risk
is the degree of uncertainty associated with
these expected returns.
Financial management is concerned with the acquisition, financing, and
management of assets with some overall goal in mind. Thus the decision
function of financial management can be broken down into three major
areas: the investment, financing, and dividend decisions
2.1. The investment decision
Management must allocate limited resources between competing opportunities
(projects) in a process known as capital budgeting. Making this investment,
or capital allocation, decision requires estimating the value of each
opportunity or project, which is a function of the size, timing and
predictability of future cash flows.
In general, each project's value will be estimated using a discounted
cash flow (DCF) valuation, and the opportunity with the highest value,
as measured by the resultant net present value (NPV) will be selected
This requires estimating the size and timing of all of the incremental
cash flows resulting from the project. Such future cash flows are then
discounted to determine their present value. These present values are
then summed, and this sum net of the initial investment outlay is the
NPV.
The NPV is greatly affected by the discount rate. Thus, identifying
the proper discount rate – often termed, the project "hurdle
rate" – is critical to making an appropriate decision. The hurdle
rate is the minimum acceptable return on an investment—i.e. the project
appropriate discount rate. The hurdle rate should reflect the riskiness
of the investment, typically measured by volatility of cash flows, and
must take into account the project-relevant financing mix. Managers
use models such as the CAPM or the APT to estimate a discount rate appropriate
for a particular project, and use the weighted average cost of capital
(WACC) to reflect the financing mix selected. (A common error in choosing
a discount rate for a project is to apply a WACC that applies to the
entire firm. Such an approach may not be appropriate where the risk
of a particular project differs markedly from that of the firm's existing
portfolio of assets.)
In conjunction with NPV, there are several other measures used as (secondary)
selection criteria in corporate finance. These are visible from the
DCF and include discounted payback period, IRR, Modified IRR, equivalent
annuity, capital efficiency, and ROI. Alternatives (complements) to
NPV include MVA / EVA (Joel Stern, Stern Stewart & Co) and APV (Stewart
Myers). See list of valuation topics.
In many cases, for example R&D projects, a project may open (or
close) various paths of action to the company, but this reality will
not (typically) be captured in a strict NPV approach. Management will
therefore (sometimes) employ tools which place an explicit value on
these options. So, whereas in a DCF valuation the most likely or average
or scenario specific cash flows are discounted, here the “flexible
and staged nature” of the investment is modelled, and hence "all"
potential payoffs are considered. The difference between the two valuations
is the "value of flexibility" inherent in the project.
The two most common tools are Decision Tree Analysis (DTA) and Real
options analysis (ROA);they may often be used interchangeably:
DTA values flexibility by incorporating possible events (or states)
and consequent management decisions. (For example, a company would build
a factory given that demand for its product exceeded a certain level
during the pilot-phase, and outsource production otherwise. In turn,
given further demand, it would similarly expand the factory, and maintain
it otherwise. In a DCF model, by contrast, there is no "branching"
– each scenario must be modelled separately.) In the decision tree,
each management decision in response to an "event" generates
a "branch" or "path" which the company could follow;
the probabilities of each event are determined or specified by management.
Once the tree is constructed: (1) "all" possible events and
their resultant paths are visible to management; (2) given this “knowledge”
of the events that could follow, and assuming rational decision making,
management chooses the actions corresponding to the highest value path
probability weighted; (3) this path is then taken as representative
of project value. See Decision theory: Choice under uncertainty.
ROA is usually used when the value of a project is contingent on the
value of some other asset or underlying variable. (For example, the
viability of a mining project is contingent on the price of gold; if
the price is too low, management will abandon the mining rights, if
sufficiently high, management will develop the ore body. Again, a DCF
valuation would capture only one of these outcomes.) Here: (1) using
financial option theory as a framework, the decision to be taken is
identified as corresponding to either a call option or a put option;
(2) an appropriate valuation technique is then employed – usually
a variant on the Binomial options model or a bespoke simulation model,
while Black Scholes type formulae are used less often; see Contingent
claim valuation. The "true" value of the project is then
the NPV of the "most likely" scenario plus the option value.
(Real options in corporate finance were first discussed by Stewart Myers
in 1977; viewing corporate strategy as a series of options was originally
per Timothy Luehrman, in the late 1990s.)
Given the uncertainty inherent
in project forecasting and valuation, analysts will wish to assess the
sensitivity of project NPV to the various inputs (i.e. assumptions)
to the DCF model. In a typical sensitivity analysis the analyst will
vary one key factor while holding all other inputs constant, ceteris
paribus. The sensitivity of NPV to a change in that factor is then observed,
and is calculated as a "slope": ΔNPV / Δfactor. For example,
the analyst will determine NPV at various growth rates in annual revenue
as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....),
and then determine the sensitivity using this formula. Often, several
variables may be of interest, and their various combinations produce
a "value-surface",[11] (or even a "value-space"),
where NPV is then a function of several variables. See also Stress testing.
Using a related technique, analysts also run scenario based forecasts
of NPV. Here, a scenario comprises a particular outcome for economy-wide,
"global" factors (demand for the product, exchange rates,
commodity prices, etc...) as well as for company-specific factors (unit
costs, etc...). As an example, the analyst may specify various revenue
growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely
Case" and 25% for "Best Case"), where all key inputs
are adjusted so as to be consistent with the growth assumptions, and
calculate the NPV for each. Note that for scenario based analysis, the
various combinations of inputs must be internally consistent (see discussion
at Financial modeling), whereas for the sensitivity approach these need
not be so. An application of this methodology is to determine an "unbiased"
NPV, where management determines a (subjective) probability for each
scenario – the NPV for the project is then the probability-weighted
average of the various scenarios.
A further advancement is to construct stochastic or probabilistic financial
models – as opposed to the traditional static and deterministic models
as above. For this purpose, the most common method is to use Monte Carlo
simulation to analyze the project’s NPV. This method was introduced
to finance by David B. Hertz in 1964, although it has only recently
become common: today analysts are even able to run simulations in spreadsheet
based DCF models, typically using an add-in, such as Risk or Crystal
Ball. Here, the cash flow components that are (heavily) impacted by
uncertainty are simulated, mathematically reflecting their "random
characteristics". In contrast to the scenario approach above, the
simulation produces several thousand random but possible outcomes, or
"trials"; see Monte Carlo Simulation versus “What If”
Scenarios. The output is then a histogram of project NPV, and the average
NPV of the potential investment – as well as its volatility and other
sensitivities – is then observed. This histogram provides information
not visible from the static DCF: for example, it allows for an estimate
of the probability that a project has a net present value greater than
zero (or any other value).
Continuing the above example: instead of assigning three discrete values
to revenue growth, and to the other relevant variables, the analyst
would assign an appropriate probability distribution to each variable
(commonly triangular or beta), and, where possible, specify the observed
or supposed correlation between the variables. These distributions would
then be "sampled" repeatedly – incorporating this correlation
– so as to generate several thousand random but possible scenarios,
with corresponding valuations, which are then used to generate the NPV
histogram. The resultant statistics (average NPV and standard deviation
of NPV) will be a more accurate mirror of the project's "randomness"
than the variance observed under the scenario based approach. These
are often used as estimates of the underlying "spot price"
and volatility for the real option valuation as above; see Real options
valuation: Valuation inputs. A more robust Monte Carlo model would include
the possible occurrence of risk events (e.g., a credit crunch) that
drive variations in one or more of the DCF model inputs.
2.2. The financing decision
Achieving the goals of corporate finance requires that any corporate
investment be financed appropriately. The sources of financing are,
generically, capital self-generated by the firm as well as debt and
equity financing sourced form outside investors. As above, since both
hurdle rate and cash flows (and hence the riskiness of the firm) will
be affected, the financing mix will impact the valuation of the firm
as well as long-term financial management decisions. There are two interrelated
decisions here:
Management must identify the "optimal mix" of financing—the
capital structure that results in maximum value. Financing a project
through debt results in a liability or obligation that must be serviced,
thus entailing cash flow implications independent of the project's degree
of success. Equity financing is less risky with respect to cash flow
commitments, but results in a dilution of share ownership, control and
earnings. The cost of equity is also typically higher than the cost
of debt (see CAPM and WACC), and so equity financing may result in an
increased hurdle rate which may offset any reduction in cash flow risk.
Management must attempt to match the long-term financing mix to the
assets being financed as closely as possible, in terms of both timing
and cash flows. Managing any potential asset liability mismatch or duration
gap entails matching the assets and liabilities according to maturity
pattern ("Cashflow matching") or duration ("immunization");
managing this relationship in the short-term is a major function of
working capital management, as discussed below. Other techniques, such
as securitization, or hedging using interest rate- or credit derivatives,
are also common. See Asset liability management; Treasury management;
Credit risk; Interest rate risk.
One of the main theories of how firms make their financing decisions
is the Pecking Order Theory, which suggests that firms avoid external
financing while they have internal financing available and avoid new
equity financing while they can engage in new debt financing at reasonably
low interest rates. Another major theory is the Trade-Off Theory in
which firms are assumed to trade-off the tax benefits of debt with the
bankruptcy costs of debt when making their decisions. An emerging area
in finance theory is right-financing whereby investment banks and corporations
can enhance investment return and company value over time by determining
the right investment objectives, policy framework, institutional structure,
source of financing (debt or equity) and expenditure framework within
a given economy and under given market conditions. One last theory about
this decision is the Market timing hypothesis which states that firms
look for the cheaper type of financing regardless of their current levels
of internal resources, debt and equity.
- The dividend decision
Whether to issue dividends, and what amount, is calculated mainly on
the basis of the company's unappropriated profit and its earning prospects
for the coming year. The amount is also often calculated based on expected
free cash flows i.e. cash remaining after all business expenses, and
capital investment needs have been met.
If there are no NPV positive opportunities, i.e. projects where returns
exceed the hurdle rate, then – finance theory suggests – management
must return excess cash to investors as dividends. This is the general
case, however there are exceptions. For example, shareholders of a "Growth
stock", expect that the company will, almost by definition, retain
earnings so as to fund growth internally. In other cases, even though
an opportunity is currently NPV negative, management may consider “investment
flexibility” / potential payoffs and decide to retain cash flows;
see above and Real options.
Management must also decide on the form of the dividend distribution,
generally as cash dividends or via a share buyback. Various factors
may be taken into consideration: where shareholders must pay tax on
dividends, firms may elect to retain earnings or to perform a stock
buyback, in both cases increasing the value of shares outstanding. Alternatively,
some companies will pay "dividends" from stock rather than
in cash; see Corporate action. Today, it is generally accepted that
dividend policy is value neutral – i.e. the value of the firm would
be the same, whether it issued cash dividends or repurchased its stock
(see Modigliani-Miller theorem).
Conclusion.
■ Finance comprises three areas: financial management, investments, and
financial institutions. These three areas are linked together through a
common body of knowledge that includes the theories and tools of
finance.
■ The decision-making of financial managers can be broken down into
two broad classes: investment decisions and financing decisions. Investment
decisions are those decisions that involve the use of the firm’s
funds. Financing decisions are those decisions that involve the acquisition
of the firm’s funds.
■ Financial managers assess the potential risks and rewards associated
with investment and financing decisions through the application of
financial analysis.
Investment decision, Financial decision, Dividend decision.
These three components of the
financial functions interact among themselves in order to attain the
objectives of financial management, namely wealth maximisation. This
is also known as Value Maximisation or Net Present Worth Maximisation.
It is almost universally accepted as an appropriate operational decision
criterion for FM decisions as it removes the technical limitations,
which characterizes the PM criterion
References
1. BAKER, KH, Powell, GE (2005) Understanding Financial Management: How to Blackwell Publishing, Boston.
2. Drucker, P., «The Practice of Management», Harper, New York, 1954;
3. Odiorne, G.S., «Management
by Objectives: a system of Managerial Leadership», Pitman Publishing,1995
4. URLhttp: / / www.financialmanagement.org / financial-management.html
5. URLhttp: / / www.economywatch.com / finance / financial-management.html
6. URLhttp: / / en.wikipedia.org / wiki / Corporate_finance
http://university-essays.
7. http://university-essays.
8. http://www.
9. http://www.shvoong.com/
10. http://etiqu.ru/
Appendix 1
Financial management is concerned with the acquisition, financing, and management of assets with some overall goal in mind. Thus the decision function of financial management can be broken down into three major areas: the investment, financing, and dividend decisions.
lnvestment Decision
The investment decision is the most important of the firm's three major decisions when it comes to value creation. It begins with a determination of the total amount of assets needed to be held by the firm. Picture the firm's balance sheet in your mind for a moment. Imagine liabilities and owners' equity being listed on the right side of the balance sheet and its assets on the left. The financial manager needs to determine the dollar amount that appears above the double lines on the ieft-hand side of the balance sheet - that is, the size of the firm. Even when this number is known, the composition of the assets must still be decided. For example, how much of the firm's total assets should be devoted to cash or to inventory? Also, the flip side of investment - disinvestment - must not be ignored. Assets that can no longer be economically justified may need to be reduced, eliminated, or replaced.
Financing Decision
The second major decision of the firm is the financing decision. Here the financial manager is concerned with the makeup of the right-hand side of the balance sheet. If you look at the mix of financing for firms across industries, you will see marked differences. Some firms have relatively large amounts of debt, whereas others are almost debt free. Does the type of financing employed make a difference? If so, why? And, in some sense, can a certain mix offinancing be thought ofas best?
In addition, dividend policy must be viewed as an integral part of the firm's financing decision. The dividend-payout ratio determines the amount of earnings that can be retained in the firm. Retaining a greater amount of current earnings in the firm means that fewer dollars will be available for current dividend payments. The value of the dividends paid to stockholders must therefore be balanced against the opportunity cost of retained earnings lost as a means of equity financing.
Once the mix of financing has
been decided, the financial manager must still determine how best to
physically acquire the needed funds. The mechanics of getting a short-term
loan, entering into a long-term lease arrangement, or negotiating a
sale of bonds or stock must be understood.
The dividend decision
Whether to issue dividends,
and what amount, is calculated mainly on the basis of the company's
unappropriated profit and its earning prospects for the coming year.
The amount is also often calculated based on expected free cash flows
i.e. cash remaining after all business expenses, and capital investment
needs have been met.
- Function of the Respiratory System
- Functions and kinds of money
- Functions Of Ibms And Msf Essay Research
- Functions of Management
- Functions Of Memory Essay Research Paper THE
- Functions of Money
- Fundamentals of International Trade
- Fullerenes Essay Research Paper Overall View of
- Full Stop Why Apes Look Like People
- Functionalism Essay Research Paper Functionalism is the
- Functional Styles
- Functional Styles
- Functional Styles of the English Language
- Functional Training Essay Research Paper Most fitness
