Financial Management
Financial management deals with planning, raising, investing and monitoring funds to maximise owners' wealth. The exam tests objectives, the three financial decisions, capital structure and working capital.
Objectives
- Profit maximisation ignores timing, risk and the cost of capital.
- Wealth maximisation (maximising market value of equity) is better because it considers time value, risk and shareholder return.
Three decisions
- Investment decision: long-term (capital budgeting) and short-term (working capital). Criteria include cash flows, rate of return and risk.
- Financing decision: debt–equity mix, i.e., capital structure. Debt is cheaper due to tax deductibility but raises financial risk.
- Dividend decision: distribute profits or retain them for growth.
Capital structure factors
Cash flow position, interest coverage ratio, debt-service coverage, tax rate, cost of debt, floatation costs, risk, flexibility, control and regulatory requirements.
Working capital factors
Nature of business, scale of operations, business cycle, seasonal factors, credit allowed and received, operating cycle and growth prospects.
Worked example
A firm needs ₹50 lakh for a machine. Option A: equity, no fixed interest but dilutes control. Option B: 60% debt at 10%. Expected return on the machine is 14%. Debt is cheaper after tax, but the firm's cash flow is seasonal, so the interest coverage ratio would be low. The finance manager chooses a mix of 40% debt and 60% equity to balance cost and risk.
Traps
Do not say profit maximisation and wealth maximisation are identical. Finance is not only about borrowing. Dividend policy is not the same as financing policy. High debt is not always good because interest must be paid even in a loss.