Introduction to Financial Management:


Nov 10, 2013 (4 years and 7 months ago)


Introduction to Financial Management:

From the humble beginnings of a sole trader where all the risk and rewards of a venture
was endured and enjoyed by an individual man today organizes commercial activity
where a large number of people invest their savi
ngs to buy a small part of a large
business. These shareholders today form the suppliers of money needed to establish and
operate businesses. In the last thirty years firms that were operating in their home markets
have gone abroad in search of new markets
. This book is about what do finance managers
of firms do, have been doing and need to do to preserve and enhance the value of the
firms. If you are an entrepreneur then this book will give you the philosophy to manage
finance in your business, apart from
the theory of finance this book seeks to apply those
theories in real life settings using extensively spreadsheets .

The decisions a chief financial officer of say a Tata Motors needs to take or an individual
needs to take when he is starting out might di
ffer in scale and complexity but the
fundamental thought process is the same, consequently the principals explained here in is
equally applicable to a large multinational corporation as it is to a small enterprise just
starting out.

There are three import
ant decisions a manager is to make when it comes to financial


What Projects To Take and what not to take


How to Fund the projects undertaken .


How much Dividends to pay and how much to reinvest.

The decisions taken by the finance manager mus
t lead to enhancing the value of the firm
or in case of private businesses that are not listed, increase the net worth of the firm.

the firm is listed and the stock trades actively then the goal of the firm can be narrowed
down to maximizing stock price
. However for such a narrowed objective to be successful
there must be goal congruence between stock holders and managers since in most modern
day firms the ownership is separated from management; managers are likely to put their
interests ahead of the sto
ckholders thus creating Agency Cost .

Firms need to have a objective since they need to make decisions during tough times and
just like a light house guides a ship towards land the objective function helps study the
ship when it is encountering financial

distress or staring at bankruptcy.

Maximizing stock price as the sole aim is quite dangerous.

Moreover for maximization of stock price to be the sole objective the managers must not
rip off the bond holders, ie violate the trust of the bond holders an
d put their loan in risk.
Managers are likely to accept risky projects in the quest of higher expected returns much
to the dismay of bond holders , managers are likely to indulge in sale and lease back of
assets that weakens the hold bond holders have over

the assets in a case of default. In the
late eighties RJR Nabisco undertook an exercise where they borrowed money to buy back
all their outstanding shares to b
ecome a privately held firm from an publicly listed firm.
The new borrowings they made for this
purpose left the old bond holders interest exposed
since by virtue of the new borrowing the credit rating of RJR ( the sanguine indicator of a
bond holders comfort) dropped and increased the risk of default. This once incidence did
more damage to the confi
dence of the bond holders that all of the bad news of the Regan
years of inflation and the years of oil shock before it. Bond holders started to make the
firms sign a covenant where the dos and don’ts were listed for the managers to follow.

Further in th
eir quest of enhancing stock price managers have put the long term interest
of the firm at stake for short term spike in stock prices. The case of Enron is all too well
known. Enron’s fall from grace was due to a combination of creative accounting, audito
sleeping at the wheel, connivance of the investment banking community with the bosses
at Enron and greed . Enron’s disgraced CFO Andy Fastow created off balance sheet
partnerships to hide Enron’s debt. These partnerships were formed by using Enron’s
ck as collateral. When the debts came up for payment the partnerships which generate
no real cash of their own needed to be bailed out by Enron. They went bankrupt taking
down with them the savings of millions of hard working people.

In spite of the thor
n surrounding the issue of stock price maximization it is still a very
wise way to manage the finance of the firm the most expensive stock to own today is the
stock of Berkshire Heathway

the investment conglomerate. At the time of the writing the
stock was

trading at $102000/
. The firm owned by Warren Buffet has been very
successful in increasing the wealth of its shareholders. One of the things that they do right
is “The Managers never gain when the shareholders don’t gain”. Most firms line up the
of the top management while the ordinary stock holders are experiencing a capital
loss due to the drop is the stock price (hit a dart at any Indian firm quoted in the Business
Standard after sticking it to a dart board) the dart board experiment of Indian
firms will
reveal that this is true for most of them.

The principals laid down in this book are not only applicable for large firms but also
equally applicable to small businesses and to private firms.

Invest in Projects on which the returns expected ar
e higher than the required rate of

Returns means the cash flows generated. The time value of cash flows matter.

Rate of return or Hurdle rate needs to be higher for riskier projects and must
reflect the mix of debt and equity used.

Select a fina
ncing mix of debt and equity that

the cost of capital.
Choice of



the assets being financed

must match for maturity and currency

If there are no projects that earn the hurdle rate, return the cash back to the
shareholders. The choice

of method of returning cash will depend on shareholder


the Value of the Firm

What do we need a goal to manage the finances of a firm? We need a goal to focus our
effort. Just like the Indian cricket team steps out on to

the field to win and all the
decisions preceding the game and on the pitch are made with that goal in mind , in
finance too we need a goal that is not too ambiguous, a goal that holds up to close
scrutiny and that wont send us down the wrong path.
ons made when there are
conflicting goals to be achieved can cause wastage of resource at best and bankruptcy at
worst. Choosing a wrong objective can be disastrous. Imagine a Airline that sets out to
make all Indian’s fly ,prices tickets below cost to lur
e more and more Indian’s to fly.
Each ticket sold means that the firm is bleeding, the bleeding has to stop after sometime,
but the firm is not able to increase the tickets because of competitors’ backlash and the
fear of the customers going to stop flying

with them, result is a bail out. Another firm
buys this firm and the stock price

draining investor confidence in such future

What not focus on maximizing Accounting Profits?

Another oft used objective is to maximize profit. Profit can
mean many things to many
people , if there are two managers both aim to maximize profits of their division, both
will avoid new investment in plant and equipment since the depreciation charge on old
assets will be smaller than brand new assets. This is how

textile mills in Mumbai failed to
invest in technology and died out. Poor assets produce inferior products, inferior products
erode market share and reduce cash flows to a trickle.

Nike faced problems from customers when word got out that their sub contr
actors were
using under aged children in sweat shops in the far east to cut costs in effort to boost
profits, good corporate behavior is rewarded by increasing stock price, and the penalty
for bad corporate behavior is often severe and brutal with the stoc
k prices dropping off
never to recover. In their quest to report a profit on thei
r Indian Subsidiary Union Carbid

routine maintenance by a month resulting a poisonous gas leak that killed
about fourteen thousand Indians. Maximizing profits as an
d objective makes for short
sightedness decisions often with long term disastrous consequences.

Maximizing Profits can be achieved by treating revenue expenses as capital expenses.
Minimizing profits can be achieved by doing exactly the reverse. As the j
oke goes when
asked what is 2 plus 2 a young Chartered Accountant replied 5 for the shareholders and 3
for the Income Tax Department. In many cases the financial statements are not just
window dressed but they are white washed!

Lastly why do we focus of M
aximizing Shareholder Value is because most of the times
the top management is forced to resign in the wake of sustained drop in stock prices. The
stock price serves as a barometer of management efficiency like it or not. It is because in
markets we trust.

Market is the only man made institution apart from democracy that has
an internal self correcting mechanism, ie when something goes wrong ( over or
undervaluation ) things set themselves right without external influence. Any other
institution does not hav
e this mechanism and thus the mistakes might never be corrected.
Of course it is true that markets might delay recognizing the mistake and might take a
long time to correct the mistakes, but eventually they do. We have eighty years of market
data to that e

How About other Objectives?

Still many firms choose more sophisticated but wrong objectives. Growth is one such
objective. Firm’s with strong cash flow diversify into businesses they have no core
competence to be in. They venture out into industry

that has no synergy with their
existing operations and burn the surplus cash earn’t from their core business. The guff
they give to the shareholders is that they intend to diversify the cash flows and reduce the
risk. Well here is a more inexpensive way t
o diversify risk, “Don’t diversify risks at the
firm level which the stock holders can diversify at their level” Eg: If a cash rich Brewery
wants to div
ersify from the sprits business
, rather than messing around starting an airlines
business can distribute

the cash to the shareholders, if the shareholders want they will use
the cash to buy the stock of airline firm or a software firm.

Lets Maximize Market Share?

Again if the firm can maximize market share by making an surplus then good, but most
firms cu
t prices to get market share. Typically in the automobile sector in the United
States the manufacturers cut the prices in December to encourage buying, this is just to
clock sales and get bragging rights to claim the largest car seller . Bragging rights do

increase value, operating margins do.

What about social good?

Corporate Finance has been accused of promoting greed, The advocates of corporate
social responsibility have spruced venom on maximizing shareholder value. Nothing can
be more diabolical
in intent.

Maximizing shareholder value necessarily means that the firm treats all the stake holders
, the customers, the employees, the environment and the public at large with fairness and
as per the law of the land. Firms that have focused on

shareholder value have
provided high quality sustainable jobs to millions of people, contributed trillions of
rupees to the government tax revenues and provided avenues for pension funds to invest
for the future retirement costs to be incurred by indivi
Firm’s that have deviated
from this goal have had their existence truncated.

Corporate Social Responsibility does not mean that the CEO will dip into the coffers of
the firm to do charity, it means because he is the CEO he earns well , he must be
hearted to part with his personal wealth, like Bill Gates and Warren Buffet. The Firm’s
money is not the personal piggy bank of the CEO to do as he pleases with it, every dime
belongs to the shareholders and must be solely devoted to only one pursuit

to maximize
their value.

To conclude we can say that all decisions must stand up to a strict scrutiny “Will this
decision maximize the value of the firm?” if the answer is a yes then the management
must go all out to achieve it, if the answer is no and
even if it is the pet project of the loan
shareholder who holds 90% of shares outstanding it must not be proceeded with.

Who is to


The mechanism evolved to get the management to put in pl
ace those policies and practice

to enhance sh
areholder value is the Annual General Meeting and the Board of Directors.
Disgruntled stock holders can attend the AGM and ask tough questions to the
management and vote against any resolution that is against the shareholder’s interest.
However in reality
most small stock holders do not attend meetings since the cost of
attending the meeting often is more than their investment in the firm. The large stock
holders do not take up any issues with the management but choose to sell the stock of the
firm if they
do not like the management’s style of operating. Thus the incumbent
management starts of with a clear advantage since the stockholders whose interest is
trying to be protected is in the first place indifferent.