M.com. semester - ii (cbcs) corporate finance most important questions

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M.COM. SEMESTER - II (CBCS)

CORPORATE FINANCE

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Unit-1 NATURE AND SCOPE OF FINANCIAL MANAGEMENT

 

Q.1. Define the scope of financial management

ANS:

According to James Van Horne,

“Financial management connotes responsibility for obtaining and effectively utilizing funds necessary for the efficient operation of an enterprise.”

 

All decisions that have monetary benefits come under the purview of financial management. There are basically, two approaches for understanding the scope of financial management: one is traditional approach and the second one is the modern approach.

1. Traditional approach:

Traditional approach views the scope of finance function in a narrow sense of arrangement of funds by business firm to meet their financing needs. Hence, the following three inter-related aspects of raising and administering financial resources were covered:

a) Arrangement of finance from institution;

b) Raising funds in the capital market through financial instruments including the procedural aspects;

c) Legal and accounting aspects involved for raising finance for the firm. The traditional approach was criticized for the reasons:

a) It emphasis only the issues relating to procurement of funds and ignored the issues related to internal financial decisions.

b) It focused only on the problems related to corporate entities ignoring the non-corporate bodies. The scope of financial management was confined only to a particular segment of business enterprises.

c) It laid more emphasis on the onetime events (episode) such as promotion, incorporation, reorganization, etc., taking place in the corporate life of the concern/ignoring the day-to-day financial problems of the concern.

d) The focus was more on long term financing. Working capital management was considered to be outside the purview of finance function According to Solomon, the traditional approach has ignored the central issues of financial management which comprise the following:

i) Should the enterprise commit capital funds to certain purpose?

ii) Do the expected returns meet financial standards of performance?

iii) How should these standards be set and what is the cost of capital funds to   enterprise?

iv) How does the cost vary with the mixture of financing methods used? Therefore, the traditional approach while ignoring the above crucial aspects implied a very narrow scope for financial management. These defects were taken care by the Modern approach.

2. Modern Approach: The traditional approach focused on sources of funds and was too often largely concerned with specific procedural details. Experts pointed out the following two defects of traditional approach:

i) It does not recognize the relationship between financing mix and the cost of capital and fails to solve the problems relating to optimum combination of finance, and

ii) It also fails to deal with the problems relating to the valuation of the firm and the cost of capital.

The modern approach aims at formulating rational policies for the optimal use procurement and allocation of funds; unlike the traditional approach which has focused only on the sources of funds and their procedural details. The modern approach apart for covering the acquisition of external funds; includes the efficient and wise allocation of funds for various uses. Emphasis has shifted from a detailed analysis, of operating procedures in the acquisition, custody and disbursement of funds to the formulation of rational decisions on the optimal use and allocation of funds. Financial decision making has become fully integrated in more advanced companies with top management policy formulation via capital budgeting, loan range planning, evaluation of alternate uses of funds, and establishment of measurable standards of performance in financial terms.

In the words of Solomon, a financial manager should know the following:

i) How large should an enterprise be and how fast should it grow?

ii) In what form should it hold its assets?

iii) What should be the composition of its liabilities?

Thus, the modern approach views the term financial management in a broad sense and provides a conceptual and analytical framework for financial decision making. Therefore, financial management, in the modern sense of the term, can be related to three major decision making areas. They are as follows:

1. Investment Decision i.e. Where to invest funds and in what amounts?

2. Financing Decisions i. e .Where to raise funds from and in what amount?

3. Dividend Decisions i. e how much of profits should be paid by way of dividends and how much should be retained in the business?

All the above three decisions contribute towards the goal of wealth maximization.

1. Investment Decisions:

Investment decisions involve identifying the asset or projects in which the firms limited resources should be invested. It involves the major task of measuring the prospective profitability of investment in assets of the company or in new projects. The decisions relating to acquisition of fixed assets investment are known as capital budgeting decisions and the decisions relating to current assets investment are known as working capital management decisions. Capital budgeting decisions relate to selection of an asset or investment proposal or course of action which have hot long term implications on the cash flows and profitability of such investment. It helps in judging whether it is financial feasible to commit funds in future. An important aspect of working capital, the profitability would be adversely affected, whereas with too inadequate working capital, it would be unable to meet its financial commitment on time and thereby invite the risk of insolvency. The investment in the fixed assets of the company determines the production capacity of the company. The production should be sufficient to demand in the market. Production should not fall short or be too excessive in relation to the demand for the product in the market. Further, the fixed assets must be productive enough to ensure the returns expected from such investment. This should be supported by sufficient investment in the working capital assets. The working capital assets should be adequate enough to maintain sufficient liquidity to augment the sales level. Investment decisions yield returns in future. Future performance is subject to uncertainty and risk. Therefore, investment decisions require careful analysis before substantial amounts are committed in fixed assets. The investment decisions having long term implications and affects the cash inflows in the years to come. Hence any wrong decision taken in the initial year, would adversely affect the future profitability and growth. Hence appropriate techniques need to be adopted for proper evaluation of investment decisions.

2. Financing Decisions:

Financing decisions involve deciding on the most cost effective method of financing the chosen investments. Financing decisions relate to the financing pattern of the firm. It involves in deciding as to when, where and how to acquire the funds to meet the firm’s investment needs. Different sources of finance have different advantages with different degree of risks. Hence it becomes imperative to decide as to how much finance is to be raised and from which sources. The prime objective of financing decisions is to keep the cost of finance at the minimum with maximum utilization of funds. Primarily, there are two main sources of finance: one is the owned funds and second is the borrowed funds. Owned funds are the shareholder’s monies on which dividend are paid. Dividend payment depends upon the profitability of the company and is not binding. There is no commitment involved in the shareholders funds. On the other hand, borrowed funds involve fixed commitments; their repayments are secured by a charge created on the assets and interest payments are obligatory irrespective of the profits or losses of the company. Hence, it increases the financial risk of the company. The borrowed funds are relatively cheaper, but entail a certain degree of risk, therefore, due prudence must be exercised while determining the mix of owned and borrowed funds.

3. Dividend Decision:

Dividend Decisions involve the decisions as regards what amount of profits earned should be distributed by way of dividends and what amount should be retained in the business. Dividend policy is to be decided having regard to it’s implicate on the shareholder wealth in the firm. The aim is to decide an optimum dividend policy which would maximize the market price of shares. This is a crucial decision as it determines the reputation of the management of the company and therefore, the market value of the shares. If the management decides to retain profits, it should be able to generate adequate returns (by investing such retained profits), which should be much more that what the, shareholders could have got had they received the dividends and invested the amount elsewhere. If the management is not able to generate adequate returns on reinvestment of retained profits, then it should prefer to pay dividends rather than retaining the profits. Therefore, the two important factors which affect the dividend decisions are: firstly, the investment opportunities available to the firms and secondly, the opportunity rate of return of the shareholders. The topic has been dealt in more details in the subsequent chapters of this book.


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