In the early years of the development of the concepts of Financial Management, it was almost restricted to the issues in raising of funds. However, it is but natural that whatever has been procuredlsecured has to be felt to have been used as efficiently as possible for the betterment of all concerned, if not always for enrichment but also for enthusing one and all to maintain and improve on the business indulgence.
Traditional Approach
In the earlier, or Traditional, approach, the narrow implication as to procurement of funds by corporate bodies for meeting their financing needs was the limited meaning of the term "financial management". Here, procurement referred to the whole range of interactions and activities to raise funds from external sources. That is, what the firm could generate internally by itself was not seriously considered as a component to satisfy the financing needs and policies : Financial institutions which could help in organising for the funds; the financial instruments and the related practices (including legalities involved); and the legal and accounting relationships between the financing agency and the firm being financed - these were the three concerns or subjects of study in the
traditional approach. Such scope was prevalent till even the late 1930s. Whenever mergers, liquidation or reorganisation took place between, or on, firms, these were called episodic events and discussed with circumspection.
Drawbacks
In as much as external sources of finance were at the centrestage, the traditional approach was also called the outsider-looking-in approach. In effect, internal decision-making, i.e, insider-looking-out, was virtually ignored. As times went by, the drawback in this conceptualisation could not be missed. Another drawback in this approach, as already mentioned, lay in focussing attention only on the financing problems of corporate bodies. Non-corporate organisations were not given any attention. Thirdly, only infrequent happenings in the life of an enterprise.viz. episodes of promotion, incorporation, merger, reorganisation, liquidation, etc.alone claimed much emphasis rather than day-to-day situations in the running of the firm. Fourthly, as a restatement of the third, only long-term financing was attended to and working capital management was not given much attention. The committing of capital funds to varied business purposes, evaluation of returns by such commitments, whether such returns would meet the cost of having procured the capital, what sources of capital can be used in an optimal blending for enrichment of the purposes of the firm - such detailed application areas of the corporate mind were hardly engaged upon. These missed issues have been described by Solomon as the central issues of financial management.
Modern Approach
Besides dealing with the acquisition of funds, as the traditional approach does, the modern approach deals also with allocation of funds for the various uses, resulting in efficiency in the use of funds. The issues that are analysed include :
(a) What total volume of funds should be committed intolon the operations of the firm ? This looks into the firm's growth.
(b) What items of assets should be acquired, compatibly with the firm's operations ? This looks into the firm's assets.
HOW shall the needed funds be organised for, i.e. how are the funds financed ?
This looks into the firm's liabilities.
Having thus given attention to investments [by (b)]; financing [by (c)]; and growth by
(a), the shareholders could partake of the growth through the dividends as receivable by them; thus, the three functions of finance, as mentioned in previous Section are the major concerns of the modern approach to financial management.
(c)In the following sections, these functions are discussed in some detail.
Functions of Finance
Investment Decisions
This relates to the acquisition of assets by investing the firm's funds. Long-term assets yield a return over an extended period in the future; and short-term, or current, assets refer to such assets as may be convertible into cash during the normal (note the word - normal) course of the business, generally within a year. As mentioned before, decisions on long-term assets are called as capital budgeting decisions, whereas the latter, i.e. on current assets, are termed as working capital management.
Capital Budgeting Decision
Long-term assets can be either the currently available, or oldlexisting, ones or the ones to be newly acquired. The new one to be acquired is to be decided upon or chosen when either the existing one fails to justify the funds committed to it, or, due to new demand in the lines of business, a new asset has to be chosen out of alternatives available. The benefits or returns available from the employment of the asset in the lines of business as compared to the costs involved in procuring and operating the asset will govern the choice of the asset to be acquired. This is called appraisal of the investment proposal.It should of course be obvious that future benefits are characterised by risk and uncertainty. The return from the capital budgeting decision has therefore to be estimated under a range of relevant assumptions regarding future performances both for operational costs and volumes and unit costs of produces. The return thus estimated is said to be associated with the implied risk, i.e. probabilities in the performances, costs and produces.
For the very purpose of appraisal, it is necessary to stipulate in advance the norms or standards through or against, which the benefits will be judged.Such criteria for judgement are described variously as : cut-off rate, minimum acceptable rate of return, etc. This norm or standard is to be related to the cost of capital.To recapitulate, the composition of the total assets, the business risk
complexion of the firm, and the quantification of the cost of capital as a norm for appraisal -constitute the three core aspects of capital budgeting decisions.
Working Capital Management
To manage the ongoing activities of the firm, i.e. to organise its day-to-day activities, the firm must hold enough, and just enough, current assets, such as cash receivables and inventory. What is enough, and just enough, is dependent on the trade-off between profitability and liquidity. Short-term survival based on liquidity is a pre-requisite for long-term success. Also, profitability, if not assured in the successions of short-runs of business duration, could not be assured in the long-term either. Thus, to manage the working capital or current assets, in its three components of cash, receivables and inventory, is an important and indivisible (or integral) part of financial management. Insufficiency of working capital (i.e. investment in current assets) leads to inability to meet current obligations, i.e. causes illiquidity, or non-readiness for usage. Then business operations grind to a halt, or bankruptcy is likely to occur. If too much is invested in working capital, such assets are not being productively employed, affecting profitability.
Financing Decision
Several types of assets held by the firm constitute its asset-mix. These have to be financed by a proper mix of the financing sources, called also capital structure or leverage. Debt, as a source of finance, cames, or is liable to be compensated on a recurring basis by a fixed interest, thereby being called as a fixed-interest source of financing. Equity capital, on the other hand, would be compensated
periodically for its being locked up in the business through dividends, which are most often quite variable. By financing decision of a firm is meant the choice of the proportion between the fixed-return capital, or debt, and variable-return capital, or the equity of the owners (or shareholders). In other words, the choice of the Debt-to-Equity ratio (indicated as DIE) is a major financing decision to ensure a trade-off between risk and return to the shareholders. It is demonstrable that use of debt implies a higher return to the shareholders; but, at the same time, it also implies financial risk. A capital structure with a reasonable DIE ratio can be identified as an optimal capital structure. Theoretical study on the proportion between debt and equity, i.e. capital structure, and any decision on the choice of the financing-mix based on such theoretical study, are the two aspects of Financing Decision.
Dividend Policy Decision
The dividend decision has to be taken integrally with the financing decision of the firm. The firm may handle the divisible profit of any period of business in one of two ways : it may distribute it to the shareholders as dividend, or it may retain it in the business, in part at least. Thus, dividend or retention, or better still, the dividend payout ratio, i.e. what proportion of the net (divisible) profits may be paid out to the shareholders - is referred to as the dividend policy decision. Not only the preference of the shareholders but also the investment opportunities available within the firm, both influence this decision. Besides these two aspects, what has been the firm's practice in the (recent) past too plays a role in this decision-making.
Objectives of Financial Management
Whereas the traditional approach to financial management was on the lines of outsider-looking-in type of approach, the modem approach has emphasised, and is based,on internal decision-making, i.e. this latter is insider-looking-out approach, as said before.Such an objective of the modem approach concerns itself with devising methods of operating the internal investment and financing of a firm. The methods therefor, within the modem approach, fall under a further classification of one of two approaches, viz.
(a) Profit maximisation approach, and
(b) Wealth maximisation approach.
Either of the objectives (better describable as "goals"), viz. to maximise either profit or wealth, is a "decision criterion" for the three decisions discussed . In other words, such a set of mutually related business decisions on Investment, Financing and Dividend distribution is sought as to maximise the decision objective, viz. either profit or wealth.Whether or not such mutually related decisions are actually followed by business organisations is immaterial; it is only to emphasise that such a set of decisions can be sought andcan be implemented if so chosenlelected by the organisation. Technically, one says that a normative framework of decisions is developed to achieve the'goal of maximising profit, or, wealth. It is not a prescriptive framework, i.e. firms may not practice such set of decisions.
Profit Maximisation Approach
Profit maximisation, as a goal, calls for such a set of investment, financing and dividend policy decisions as would maximise the profits.Herein, profit may refer to one of two possibilities of interpretation. Firstly, it may refer to the share (amount of money) of the national income which is paid to the owners of business, viz. the holders (and suppliers) of equity capital. Secondly, it may be taken to be akin to profitability, signifying economic efficiency. In this interpretation, the output, i.e. the value created by the employment of the resources, exceeds the input, i.e. total value of the input resources. The second interpretation is what is generally meant in the context of financial management as a discipline of study or practice. Only such projects, assets and decisions are taken as would be profitable, rejecting those that would not be profitable. [Projects are synonymous with Investments.]Whenever fairness in private enterprise is questioned by societal or political,ambience, profit maximisation, as a goal, stands doubted or misapprehended.Furthermore, real-world situations complicate the applicability of the concept of profit maximisation.
Shortcomings
Whereas maximising profit, per se, would not be affected by the timing of the realisation of the benefit, real world situations would appreciate if a good part of the profits is realised at as early a timing as possible, i.e. the time value of money is not explicitly considered in the approach through profit maximisation.More than the timing of the benefits, the risk aspect of the sequential instances of benefit realisation implies a more serious shortcoming in this approach. Risk refers to the variability of the quantum of the benefit. A projected benefit of, say, Rs. 1,000, may, in fact, be realised at anything between, say, Rs. 600 and Rs. 1,200, in one instance (or project); and, in another instance, the variation may perhaps be only between, say, Rs. 900 and Rs. 1,050. The former benefit quantum is said to be of an inferior quality relative to the latter benefit quantum.
In another type of variance of benefits, one may consider a sequence of four successive years where benefits in one case (project) were, Rs. 800, Rs. 900,Rs. 1,000 and Rs. 1,000, respectively; and in another case these were Rs. 500,Rs. 900, Rs. 1,600, and Rs. 700. Obviously, the latter stream of benefits would be described as of inferior quality compared to the former one, though the sum in each case is Rs. 3,700.
Besides these two aspects, viz. shortcbming based on timing and quality of benefits, there may be impreciseness in4he connotation of the profit, if it is not specified as : long-term or short-term; pre-tax or post-tax; relative to total capital employed or to equity capital, only; and so on.Even when profit is defined as earnings per share (EPS), the former two shortcomings hold. Moreover, EPS may, when read with the dividend policy, affect the market price of the stock.
Wealth Maximisation
Net Present Worth or Value (NPW, or NPV) discussed in earlier units is the same as wealth as used herein.How this can be computed by applying the concept of time value of money to cash flow streams has also been dealt with in detail in earlier units. When defining the quantum of individual cash flow magnitudes, each item can be moderated for its quality characteristics also through techniques of certainty equivalents, expected value, etc.
Market price per share is dependent on such computations on the earnings on the equity capital and, accordingly, is an outcome of wealth maximisation approach.However, one may say that wealth maximisation is but an extension of profit maximisation in real-world situations of uncertain and multiperiod cash flows. If the time period is short and uncertainty is rather negligible, wealth maximisation is indistinguishable from profit maximisation as a business objective.To recapitulate, it may be stated that wealth maximisation, or maximising market price per share takes into account present and prospective (future) earnings per share, the timing of the respective earnings, the total duration of the earnings, the risk of those earnings (defined as the financial risk), the dividend policy of the firm, and othei factors that may bear on the market price of the stock.Though wealth maximisation is a better criterion than profit maximisation in judging the performance of a firm, yet maximising shareholder wealth should not be at the cost of social responsibility. Social responsibility extends over consumer protection, payment of fair wages, maintaining good labour relations, environmental awareness and sensitivity, etc.
Traditional Approach
In the earlier, or Traditional, approach, the narrow implication as to procurement of funds by corporate bodies for meeting their financing needs was the limited meaning of the term "financial management". Here, procurement referred to the whole range of interactions and activities to raise funds from external sources. That is, what the firm could generate internally by itself was not seriously considered as a component to satisfy the financing needs and policies : Financial institutions which could help in organising for the funds; the financial instruments and the related practices (including legalities involved); and the legal and accounting relationships between the financing agency and the firm being financed - these were the three concerns or subjects of study in the
traditional approach. Such scope was prevalent till even the late 1930s. Whenever mergers, liquidation or reorganisation took place between, or on, firms, these were called episodic events and discussed with circumspection.
Drawbacks
In as much as external sources of finance were at the centrestage, the traditional approach was also called the outsider-looking-in approach. In effect, internal decision-making, i.e, insider-looking-out, was virtually ignored. As times went by, the drawback in this conceptualisation could not be missed. Another drawback in this approach, as already mentioned, lay in focussing attention only on the financing problems of corporate bodies. Non-corporate organisations were not given any attention. Thirdly, only infrequent happenings in the life of an enterprise.viz. episodes of promotion, incorporation, merger, reorganisation, liquidation, etc.alone claimed much emphasis rather than day-to-day situations in the running of the firm. Fourthly, as a restatement of the third, only long-term financing was attended to and working capital management was not given much attention. The committing of capital funds to varied business purposes, evaluation of returns by such commitments, whether such returns would meet the cost of having procured the capital, what sources of capital can be used in an optimal blending for enrichment of the purposes of the firm - such detailed application areas of the corporate mind were hardly engaged upon. These missed issues have been described by Solomon as the central issues of financial management.
Modern Approach
Besides dealing with the acquisition of funds, as the traditional approach does, the modern approach deals also with allocation of funds for the various uses, resulting in efficiency in the use of funds. The issues that are analysed include :
(a) What total volume of funds should be committed intolon the operations of the firm ? This looks into the firm's growth.
(b) What items of assets should be acquired, compatibly with the firm's operations ? This looks into the firm's assets.
HOW shall the needed funds be organised for, i.e. how are the funds financed ?
This looks into the firm's liabilities.
Having thus given attention to investments [by (b)]; financing [by (c)]; and growth by
(a), the shareholders could partake of the growth through the dividends as receivable by them; thus, the three functions of finance, as mentioned in previous Section are the major concerns of the modern approach to financial management.
(c)In the following sections, these functions are discussed in some detail.
Functions of Finance
Investment Decisions
This relates to the acquisition of assets by investing the firm's funds. Long-term assets yield a return over an extended period in the future; and short-term, or current, assets refer to such assets as may be convertible into cash during the normal (note the word - normal) course of the business, generally within a year. As mentioned before, decisions on long-term assets are called as capital budgeting decisions, whereas the latter, i.e. on current assets, are termed as working capital management.
Capital Budgeting Decision
Long-term assets can be either the currently available, or oldlexisting, ones or the ones to be newly acquired. The new one to be acquired is to be decided upon or chosen when either the existing one fails to justify the funds committed to it, or, due to new demand in the lines of business, a new asset has to be chosen out of alternatives available. The benefits or returns available from the employment of the asset in the lines of business as compared to the costs involved in procuring and operating the asset will govern the choice of the asset to be acquired. This is called appraisal of the investment proposal.It should of course be obvious that future benefits are characterised by risk and uncertainty. The return from the capital budgeting decision has therefore to be estimated under a range of relevant assumptions regarding future performances both for operational costs and volumes and unit costs of produces. The return thus estimated is said to be associated with the implied risk, i.e. probabilities in the performances, costs and produces.
For the very purpose of appraisal, it is necessary to stipulate in advance the norms or standards through or against, which the benefits will be judged.Such criteria for judgement are described variously as : cut-off rate, minimum acceptable rate of return, etc. This norm or standard is to be related to the cost of capital.To recapitulate, the composition of the total assets, the business risk
complexion of the firm, and the quantification of the cost of capital as a norm for appraisal -constitute the three core aspects of capital budgeting decisions.
Working Capital Management
To manage the ongoing activities of the firm, i.e. to organise its day-to-day activities, the firm must hold enough, and just enough, current assets, such as cash receivables and inventory. What is enough, and just enough, is dependent on the trade-off between profitability and liquidity. Short-term survival based on liquidity is a pre-requisite for long-term success. Also, profitability, if not assured in the successions of short-runs of business duration, could not be assured in the long-term either. Thus, to manage the working capital or current assets, in its three components of cash, receivables and inventory, is an important and indivisible (or integral) part of financial management. Insufficiency of working capital (i.e. investment in current assets) leads to inability to meet current obligations, i.e. causes illiquidity, or non-readiness for usage. Then business operations grind to a halt, or bankruptcy is likely to occur. If too much is invested in working capital, such assets are not being productively employed, affecting profitability.
Financing Decision
Several types of assets held by the firm constitute its asset-mix. These have to be financed by a proper mix of the financing sources, called also capital structure or leverage. Debt, as a source of finance, cames, or is liable to be compensated on a recurring basis by a fixed interest, thereby being called as a fixed-interest source of financing. Equity capital, on the other hand, would be compensated
periodically for its being locked up in the business through dividends, which are most often quite variable. By financing decision of a firm is meant the choice of the proportion between the fixed-return capital, or debt, and variable-return capital, or the equity of the owners (or shareholders). In other words, the choice of the Debt-to-Equity ratio (indicated as DIE) is a major financing decision to ensure a trade-off between risk and return to the shareholders. It is demonstrable that use of debt implies a higher return to the shareholders; but, at the same time, it also implies financial risk. A capital structure with a reasonable DIE ratio can be identified as an optimal capital structure. Theoretical study on the proportion between debt and equity, i.e. capital structure, and any decision on the choice of the financing-mix based on such theoretical study, are the two aspects of Financing Decision.
Dividend Policy Decision
The dividend decision has to be taken integrally with the financing decision of the firm. The firm may handle the divisible profit of any period of business in one of two ways : it may distribute it to the shareholders as dividend, or it may retain it in the business, in part at least. Thus, dividend or retention, or better still, the dividend payout ratio, i.e. what proportion of the net (divisible) profits may be paid out to the shareholders - is referred to as the dividend policy decision. Not only the preference of the shareholders but also the investment opportunities available within the firm, both influence this decision. Besides these two aspects, what has been the firm's practice in the (recent) past too plays a role in this decision-making.
Objectives of Financial Management
Whereas the traditional approach to financial management was on the lines of outsider-looking-in type of approach, the modem approach has emphasised, and is based,on internal decision-making, i.e. this latter is insider-looking-out approach, as said before.Such an objective of the modem approach concerns itself with devising methods of operating the internal investment and financing of a firm. The methods therefor, within the modem approach, fall under a further classification of one of two approaches, viz.
(a) Profit maximisation approach, and
(b) Wealth maximisation approach.
Either of the objectives (better describable as "goals"), viz. to maximise either profit or wealth, is a "decision criterion" for the three decisions discussed . In other words, such a set of mutually related business decisions on Investment, Financing and Dividend distribution is sought as to maximise the decision objective, viz. either profit or wealth.Whether or not such mutually related decisions are actually followed by business organisations is immaterial; it is only to emphasise that such a set of decisions can be sought andcan be implemented if so chosenlelected by the organisation. Technically, one says that a normative framework of decisions is developed to achieve the'goal of maximising profit, or, wealth. It is not a prescriptive framework, i.e. firms may not practice such set of decisions.
Profit Maximisation Approach
Profit maximisation, as a goal, calls for such a set of investment, financing and dividend policy decisions as would maximise the profits.Herein, profit may refer to one of two possibilities of interpretation. Firstly, it may refer to the share (amount of money) of the national income which is paid to the owners of business, viz. the holders (and suppliers) of equity capital. Secondly, it may be taken to be akin to profitability, signifying economic efficiency. In this interpretation, the output, i.e. the value created by the employment of the resources, exceeds the input, i.e. total value of the input resources. The second interpretation is what is generally meant in the context of financial management as a discipline of study or practice. Only such projects, assets and decisions are taken as would be profitable, rejecting those that would not be profitable. [Projects are synonymous with Investments.]Whenever fairness in private enterprise is questioned by societal or political,ambience, profit maximisation, as a goal, stands doubted or misapprehended.Furthermore, real-world situations complicate the applicability of the concept of profit maximisation.
Shortcomings
Whereas maximising profit, per se, would not be affected by the timing of the realisation of the benefit, real world situations would appreciate if a good part of the profits is realised at as early a timing as possible, i.e. the time value of money is not explicitly considered in the approach through profit maximisation.More than the timing of the benefits, the risk aspect of the sequential instances of benefit realisation implies a more serious shortcoming in this approach. Risk refers to the variability of the quantum of the benefit. A projected benefit of, say, Rs. 1,000, may, in fact, be realised at anything between, say, Rs. 600 and Rs. 1,200, in one instance (or project); and, in another instance, the variation may perhaps be only between, say, Rs. 900 and Rs. 1,050. The former benefit quantum is said to be of an inferior quality relative to the latter benefit quantum.
In another type of variance of benefits, one may consider a sequence of four successive years where benefits in one case (project) were, Rs. 800, Rs. 900,Rs. 1,000 and Rs. 1,000, respectively; and in another case these were Rs. 500,Rs. 900, Rs. 1,600, and Rs. 700. Obviously, the latter stream of benefits would be described as of inferior quality compared to the former one, though the sum in each case is Rs. 3,700.
Besides these two aspects, viz. shortcbming based on timing and quality of benefits, there may be impreciseness in4he connotation of the profit, if it is not specified as : long-term or short-term; pre-tax or post-tax; relative to total capital employed or to equity capital, only; and so on.Even when profit is defined as earnings per share (EPS), the former two shortcomings hold. Moreover, EPS may, when read with the dividend policy, affect the market price of the stock.
Wealth Maximisation
Net Present Worth or Value (NPW, or NPV) discussed in earlier units is the same as wealth as used herein.How this can be computed by applying the concept of time value of money to cash flow streams has also been dealt with in detail in earlier units. When defining the quantum of individual cash flow magnitudes, each item can be moderated for its quality characteristics also through techniques of certainty equivalents, expected value, etc.
Market price per share is dependent on such computations on the earnings on the equity capital and, accordingly, is an outcome of wealth maximisation approach.However, one may say that wealth maximisation is but an extension of profit maximisation in real-world situations of uncertain and multiperiod cash flows. If the time period is short and uncertainty is rather negligible, wealth maximisation is indistinguishable from profit maximisation as a business objective.To recapitulate, it may be stated that wealth maximisation, or maximising market price per share takes into account present and prospective (future) earnings per share, the timing of the respective earnings, the total duration of the earnings, the risk of those earnings (defined as the financial risk), the dividend policy of the firm, and othei factors that may bear on the market price of the stock.Though wealth maximisation is a better criterion than profit maximisation in judging the performance of a firm, yet maximising shareholder wealth should not be at the cost of social responsibility. Social responsibility extends over consumer protection, payment of fair wages, maintaining good labour relations, environmental awareness and sensitivity, etc.
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