Finance
and Other Related Disciplines
Apart
from economics and accounting, finance also draws-for its day-to-day
decisions-on supportive disciplines such as marketing, production and
quantitative methods. For instance, financial managers should consider the
impact of new product development and promotion plans made in marketing area
since their plans will require capital outlays and have an impact on the
projected cash flows. Similarly, changes in the production process may
necessitate capital expenditures which the financial managers must evaluate and
finance. And, finally, the tools of analysis developed in the quantitative
methods area are helpful in analysing complex financial management problems.
The
marketing, production and quantitative methods are, thus, only indirectly
related to day-today decision making by financial managers and are supportive
in nature while economics and accounting are the primary disciplines on which
the financial manager draws substantially.
The
relationship between financial management and supportive disciplines is
depicted in Fig 1.1.
Financial
Decision Area
Primary
Discipline
1.
Accounting
1. Investment
analysis
Support 2.
Macroeconomics
2~ Working capital
management: 3.
Micro economics
3. Sources and
cost of funds
4. Determination
of capital structure
5.
Dividend policy. '
6. Analysis of
risks and returns Support
Other
Relates Discipline
1.
Marketing
2.
Production
3.
Quantatative method
Resulting in
Shareholders
Wealth Maximisation
SCOPE
OF FINANCIAL MANAGEMENT
The
approach to the scope and functions of financial management is divided, for
purposes of exposition, into two broad categories: (a) The Traditional
Approach, and (b) The Modem Approach.
Traditional
Approach
The
traditional approach to the scope of financial management refers to its
subject-matter, in academic literature in the initial stages of its evolution,
as a separate branch of academic Study. The term 'corporation finance' was used
to describe what is now known in the academic world as 'financial management'.
As the name suggests, the concern of corporation finance was with the financing
of corporate enterprises. In other words, the scope of the finance function was
treated by the traditional approach in the narrow sense of procurement of funds
by corporate enterprise to meet their financing needs. The term 'procurement'
was used in a broad sense so as to include the whole gamut of raising funds
externally. Thus defined, the field of study dealing with finance was treated
as encompassing three interrelated aspects of raising and administering resources
from outside: (i) the institutional arrangement in the form of financial
institutions which comprise the organisation of the capital market; (ii) the
financial instruments through which funds are raised from the capital markets
and the related aspects of practices and the procedural aspects of capital
markets; and (iii) the legal and accounting relationships between a firm and
its sources of funds. The coverage of corporation finance was, therefore,
conceived to describe the rapidly evolving complex of capital market
institutions, instruments and practices. A related aspect was that firms
require funds at certain episodic events such as merger, liquidation,
reorganisation and so on. A detailed description of these major events
constituted the second element of the scope of this field of academic study.
That these were the broad features of the subject-matter of corporation finance
is eloquently reflected in the academic writings around the period during which
the traditional approach dominated academic thinking. 1 Thus, the issues to
which literature on finance addressed itself was how resources could best be
raised from the combination of the available sources.
The
traditional approach to the scope of the finance function evolved during the
1920s and 1930s and dominated academic thinking during' th~ forties and through
the early ftfties. It has now been discarded as it suffers from serious
limitations. The weaknesses of the traditional approach fall into two broad
categories: (i) those relating to the treatment of various topics and the
emphasis attached to them; and (ii) those relating to the basic conceptual and
analytical framework of the definitions and scope of the finance function.
The
first argument against the traditional approach was based on its
emphasis on issues relating to the procurement of funds by corporate
enterprises. This approach was challenged during the period when the approach
dominated the scene itself.2 Further, the traditional treatment of finance was
criticised3 because the finance function was equated with the issues involved
in raising and administering funds, the theme was woven around the viewpoint of
the suppliers of funds such as investors, investment bankers and so on, that,
is the outsiders. It implies that no consideration was given to viewpoint of
those who had to take internal financial decisions. The traditional treatment
was, in other words, the outsider-looking-in approach. The limitation was that
internal decision making (ie. insider-looking-out) was completely ignored.
The second ground of criticism of the
traditional treatment was that the focus was on financing problems of corporate
enterprise. To that extent the scope of financial management was confirmed only
to a segment of the industrial enterprises, as non-corporate organisations lay
outside its scope.
Yet
another basis on which the traditional approach was challenged was that the
treatment was built too closely around episodic events, such as promotion,
incorporation, merger, consolidation, reorganisation and so on. Financial
management was' confirmed to a description of these infrequent happenings in
the life of an enterprise. As a logical corollary, the day-to-day
financial problems of a normal company did not receive much attention.
Finally,
the traditional treatment was found to have a lacuna to the
extent that the focus was on long-term financing. Its natural implication was
that the issues involved in working capital management were not in the purview
of the finance function.
The
limitations of the traditional approach were not entirely based on treatment or
emphasis of different aspects. In other words, its weaknesses were more
fundamental. The conceptual and analytical shortcoming of this approach arose
from the fact that it confirmed financial management to issues involved in
procurement of external funds, it did not consider the important dimension of
allocation of capital. The conceptual framework of the traditional treatment
ignored what Solomon aptly described as the central issues of financial management.
These issues were reflected in the following fundamental questions which a
finance manager should address. Should an enterprise commit capital funds to
certain purposes? Do the expected returns meet financial standards of
performance? How should these standards be set and what is the cost of capital
funds to the enterprises? How does the cost vary with the mixture of financing
methods used? In the absence of the coverage of these crucial aspects, the
traditional approach implied a very narrow scope for financial management. The
modem approach provides a solution to these shortcomings.
Modem
Approach
The
modern approach views the term financial management in a broad sense and
provides a conceptual and analytical framework for financial decision making.
According to it, the finance function covers both acquisition of funds as well
as their allocations. Thus, apart from the issues involved in acquiring
external funds, the main concern of financial management is the efficient and
wise allocation of funds to various uses. Defined in a broad sense, it is
viewed as an integral part of overall management.
The new approach is an analytical way
of viewing the financial problems of a firm. The main contents of this approach
are: What is the total volume of funds an enterprise should commit? What
specific assets should an enterprise acquire? How should the funds required be
financed? Alternatively, the principal contents of the modem approach to
financial management can be said to be: (0 how large should an enterprise be,
and how fast should it grow? (ii) In what form should it hold assets? and (Hi)
what should be the composition of its liabilities?
The
three questions posed above cover between them the major' financial problems of
a firm. In other words, the financial management, according to the new
approach, is concerned with the solution of three major problems relating to
the financial operations of a firm, corresponding to the three questions of
investment, financing and dividend decisions. Thus, financial management in
modern sense of a firm can be broken down into three major decisions as
functions of finance: (D The investment decision, (ii) the financing decision,
and (iii) the dividend policy decision.
Investment
Decision The investment decision relates to the selection of assets
in which funds will be invested by a firm. The assets which can be acquired
fall into two broad groups: (I) long-term assets which yield a return over a
period of time in future, (ii) short-term or current assets, defined as those
assets which in the normal course of business are convertible into cash without
diminution in value, usually within a year. The first of these involving the
first category of assets is popularly known in financial literature as capital
budgeting. The aspect of financial decision making with reference to
current assets or short-term assets is popularly termed as working capital
management.
Capital
Budgeting Capital budgeting
is probably the most crucial financial decision of a firm. It relates to the
selection of an asset or investment proposal or course of action whose benefits
are likely to be available in future over the lifetime of the project. The
long-term assets can be either new or old/existing ones. The first aspect
of the capital budgeting decision relates to the choice of the new asset out of
the alternatives available or the reallocation of capital when an existing
asset fails to justify the funds committed. Whether an asset will be accepted
or not will depend upon the relative benefits and returns associated with it.
The measurement of the worth of the investment proposals is, therefore, a major
element in the capital budgeting exercise. This implies a discussion of the
methods of appraising investment proposals.
The
second element of the capital budgeting decision is the analysis of risk
and uncertainty. Since the benefits from the investment proposals extend into
the future, their accrual is uncertain. They have to be estimated under various
assumptions of the physical volume of sale and the level of prices. An element
of risk in the sense of uncertainty of future' benefits is, thus, involved in
the exercise. The returns from capital budgeting decisions should, therefore,
be evaluated in relation to the risk associated with it.
Finally,
the evaluation of the worth of a long-term project implies a
certain norm or standard against which the benefits are to be judged. The
requisite norm is known by different names such as cut-off rate, hurdle
rate, required rate, minimum rate of return and so on. This standard is
broadly expressed in terms of the cost of capital. The concept and measurement
of the cost of capital is, thus, another major aspect of capital budgeting
decision. In brief, the main elements of capital budgeting decisions are: (I)
the long-term assets and their composition, (ii) the business risk complexion
of the firm, and (Hi) the concept and measurement of the cost of capital.
Working
Capital Management Working capital
management is concerned with the management of current assets. It is an
important and integral part of financial management as short-term survival is a
prerequisite for long-term success. One aspect of working capital management is
the trade-off between profitability and risk (liquidity). There is a conflict
between profitability and liquidity. If a firm does not have adequate working
capital, that is, it does not invest sufficient funds in current assets, it may
become illiquid and consequently may not have the ability to meet its current
obligations and, thus, invite the risk of bankruptcy.. If the current assets
are too large, profitability is adversely affected. The key strategies and
considerations in ensuring a trade-off between profitability and liquidity is
one major dimension of working capital management. In addition, the individual
current assets should be efficiently managed so that neither inadequate nor
unnecessary funds are locked up. Thus, the management of working capital has
two basic ingredients: (1) an overview of working capital management as a
whole, and (2) efficient management of the individual current assets such as
cash, receivables and inventory.
Financing
Decision the second major decision involved in financial management
is the financing decision. The investment decision is broadly concerned with the
asset-mix or the composition of the assets of a firm. The concern of the
financing decision is with the financing-mix or capital structure or leverage.
The term capital structure refers to the proportion of debt
(fixed-interest sources of financing) and equity capital (variable-dividend
securities/source of funds). The financing decision of a firm relates to the
choice of the proportion of these sources to finance the investment
requirements. There are two aspects of the financing decision. First, the
theory of capital
structure which shows the theoretical relationship between the employment of
debt and the return to the shareholders. The use of debt implies a higher
return to the shareholders as also the financial risk. A proper balance between
debt and equity to ensure a trade-off between risk and return to the
shareholders is necessary. A capital structure with a reasonable proportion of
debt and equity capital is called the optimum capital structure. Thus,
one dimension of the financing decision whether there is an optimum capital
structure and in what proportion should funds be raised to maximise the return
to the shareholders? The second aspect of the financing decision is the
determination of to an appropriate capital structure, given the facts of a
particular case. Thus, the financing decision covers two interrelated aspects:
(1) the capital structure theory, and (2) the capital structure decision.
Dividend
Policy Decision The third major decision area of
financial management is the decision relating to the dividend policy. The
dividend decision should be analysed in' relation to the financing decision of
a firm. Two alternatives are available in dealing with the profits of a firm:
(0 they can be distributed to the shareholders in the form of dividends or (i0
they can be retained in the business itself. The decision as to which course
should be followed depends largely on a significant element in the dividend
decision, the dividend-payout ratio, that is, what proportion of net
profits should be paid out to the shareholders. The fmal decision will depend
upon the preference of the shareholders and investment opportunities available
within the firm. The second major aspect of the. dividend decision is the
factors determining dividend policy of a firm in practice. .
To
conclude, the traditional approach to the functions of financial management had
a very narrow perception and was devoid of an integrated conceptual and
analytical framework. It had rightly been discarded in the ac:ldemic
literature. The modem approach to the scope of financial management has
broadened its scope which involves the solution of three major decisions,
namely, investment, fmancing and dividend. These are interrelated and should be
jointly taken so that financial decision making is optimal. The conceptual
framework for optimum financial decisions is the objective of financial
management. In other words, to ensure an optimum decision in respect of these
three areas, they should be related to the objectives of financial management.
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