Financial Management
Core rules
- Financial management deals with planning, raising, investing and distributing funds.
- Objectives: profit maximisation (short-term accounting profit) and wealth maximisation (long-term market value of equity). Wealth maximisation is preferred because it considers risk, time value and shareholder value.
- Three decisions: investment (capital budgeting and fixed assets), financing (debt-equity mix) and dividend (distribution of profit).
- Capital structure is the mix of debt and equity. Factors include cost of debt, risk, control, flexibility, growth plans and tax.
- Fixed capital is for long-term assets; working capital is for current assets. Working capital needs depend on the nature of business, scale, operating cycle, credit terms and seasonality.
Worked example
A firm needs ₹100 crore for a plant. Option A is all equity: low financial risk but high cost and dilution. Option B is 60% equity plus 40% debt: lower cost because interest is tax-deductible but higher financial risk. If sales are stable and debt costs 8% after tax while equity expectation is 14%, debt lowers overall cost, but too much debt raises risk. Reasoning: choose a mix that balances cost and risk, not the lowest tax bill alone.
Traps
Do not equate profit maximisation with wealth maximisation. Capital structure is the debt-equity mix, not the investment decision. Working capital is not cash only; it includes stock and receivables. More debt is not always better because interest must be paid even when sales fall.