INTRODUCTION Business concern needs finance to meet their requirements in the economic world. Any kind of business activity depends on the finance. Hence, it is called as lifeblood of business organization. Whether the business concerns are big or small, they need finance to fulfil their business activities. In the modern world, all the activities are concerned with the economic activities and very particular to earning profit through any venture or activities. The entire business activities are directly related with making profit. (According to the economics concept of factors of production, rent given to landlord, wage given to labour, interest given to capital and profit given to shareholders or proprietors), a business concern needs finance to meet all the requirements. Hence finance may be called as capital, investment, fund etc., but each term is having different meanings and unique characters. Increasing the profit is the main aim of any kind of economic activity. MEANING OF FINANCE Finance may be defined as the art and science of managing money. It includes financial service and financial instruments. Finance also is referred as the provision of money at the time when it is needed. Finance function is the procurement of funds and their effective utilization in business concerns. The concept of finance includes capital, funds, money, and amount. But each word is having unique meaning. Studying and understanding the concept of finance become an important part of the business concern. DEFINITION OF FINANCE According to Khan and Jain, Finance is the art and science of managing money. According to Oxford dictionary, the word finance connotes management of money. Websters Ninth New Collegiate Dictionary defines finance as the Science on study of the management of funds and the management of fund as the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities. DEFINITION OF BUSINESS FINANCE According to the Wheeler, Business finance is that business activity which concerns with the acquisition and conversation of capital funds in meeting financial needs and overall objectives of a business enterprise. OVERVIEW OF FINANCIAL MANAGEMENT
2 | ANJUMAN PG CENTRE DHARWAD
According to the Guthumann and Dougall, Business finance can broadly be defined as the activity concerned with planning, raising, controlling, administering of the funds used in the business. In the words of Parhter and Wert, Business finance deals primarily with raising, administering and disbursing funds by privately owned business units operating in non- financial fields of industry. Corporate finance is concerned with budgeting, financial forecasting, cash management, credit administration, investment analysis and fund procurement of the business concern and the business concern needs to adopt modern technology and application suitable to the global environment. According to the Encyclopedia of Social Sciences, Corporation finance deals with the financial problems of corporate enterprises. These problems include the financial aspects of the promotion of new enterprises and their administration during early development, the accounting problems connected with the distinction between capital and income, the administrative questions created by growth and expansion, and finally, the financial adjustments required for the bolstering up or rehabilitation of a corporation which has come into financial difficulties. TYPES OF FINANCE Finance is one of the important and integral part of business concerns, hence, it plays a major role in every part of the business activities. It is used in all the area of the activities under the different names. Finance can be classified into two major parts: Private Finance, which includes the Individual, Firms, Business or Corporate Financial activities to meet the requirements. Public Finance which concerns with revenue and disbursement of Government such as Central Government, State Government and Semi- Government Financial matters. FINANCIAL MANAGEMENT The present age is the age of industrialization. Large industries are being established in every country. It is very necessary to arrange finance for building, plant and working capital, etc. for the established of these industries. OVERVIEW OF FINANCIAL MANAGEMENT
3 | ANJUMAN PG CENTRE DHARWAD
How much of capital will be required, from what sources this much of finance will be collected and how will it be invested, is the matter of financial management. Financial management is that managerial activity which is concerned with the planning and controlling of the firms financial resources. It was a branch of economics till 1890, and as a separate discipline, it is of recent origin. Still, it has no unique body of knowledge of its own, and draws heavily on economics for its theoretical concepts even today. In general financial management is the effective & efficient utilization of financial resources. It means creating balance among financial planning, procurement of funds, profit administration & sources of funds. Definitions of Financial Management: According to Solomon, Financial management is concerned with the efficient use of an important economic resource, namely, capital funds. According to J. L. Massie, Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operation. According to Weston & Brigham, Financial management is an area of financial decision making harmonizing individual motives & enterprise goals. According to Howard & Upton, Financial management is the application of the planning & control functions of the finance function. According to J. F. Bradley, Financial management is the area of business management devoted to the judicious use of capital & careful selection of sources of capital in order to enable a spending unit to move in the direction of reaching its goals. Thus, Financial Management is mainly concerned with the effective funds management in the business. In simple words, Financial Management as practiced by business firms can be called as Corporation Finance or Business Finance. Main features of financial management: On the basis of the above definitions, the following are the main characteristics of the financial management- Analytical Thinking-Under financial management financial problems are analyzed and considered. Study of trend of actual figures is made and ratio analysis is done. OVERVIEW OF FINANCIAL MANAGEMENT
4 | ANJUMAN PG CENTRE DHARWAD
Continuous Process-previously financial management was required rarely but now the financial manager remains busy throughout the year. Basis of Managerial Decisions- All managerial decisions relating to finance are taken after considering the report prepared by the finance manager.The financial management is the base of managerial decisions. Maintaining Balance between Risk and Profitability-Larger the risk in the business larger is the expectation of profits. Financial management maintains balance between the risk and profitability. Coordination between Process- There is always a coordination between various processes of the business. Centralized Nature- Financial management is of a centralized nature. Other activities can be decentralized but there is only one department for financial management. Scope of financial management Financing Decision The Financing decision is the most important of the rms nancing decision. Here the nancial manager is concerned with the makeup of the right-hand side of the balance sheet. If you look at the mix of nancing for rms across industries, you will see marked differences. Some rms have relatively large amounts of debt, whereas others are almost debt free. Does the type of nancing employed make a difference? If so, why? And, in some sense, can a certain mix of nancing be thought of as best? In addition, dividend policy must be viewed as an integral part of the rms nancing decision. The dividend-pay-out ratio determines the amount of earnings that can be retained in the rm. Retaining a greater amount of current earnings in the rm means that fewer dollars will be available for current dividend payments. The value of the dividends paid to stockholders must therefore be balanced against the opportunity cost of retained earnings lost as a means of equity nancing. Once the mix of nancing has been decided, the nancial manager must still determine how best to physically acquire the needed funds. The mechanics of getting a short-term loan, entering into a long-term lease arrangement, or negotiating a sale of bonds or stock must be understood. Investment Decision/ The second major decision of the rm is the investment decisions when it comes to value creation. It begins with a determination of the total amount of assets needed to be held by the rm. Picture the rms balance sheet in your mind for a moment. Imagine liabilities and owners equity being listed on the right side of the balance sheet and its assets on the left. The nancial manager needs to determine the dollar amount that appears above the OVERVIEW OF FINANCIAL MANAGEMENT
5 | ANJUMAN PG CENTRE DHARWAD
double lines on the left-hand side of the balance sheet that is, the size of the rm. Even when this number is known, the composition of the assets must still be decided. For example, how much of the rms total assets should be devoted to cash or to inventory? Also, the ip side of investment disinvestment must not be ignored. Assets that can no longer be economically justied may need to be reduced, eliminated, or replaced. Asset Management Decision/ Capital Budgeting The third important decision of the rm is the asset management decision. Once assets have been acquired and appropriate nancing provided, these assets must still be managed efciently. The nancial manager is charged with varying degrees of operating responsibility over existing assets. These responsibilities require that the nancial manager be more concerned with the management of current assets than with that of xed assets. A large share of the responsibility for the management of xed assets would reside with the operating managers who employ these assets. Efcient nancial management requires the existence of some objective or goal, because judgment as to whether or not a nancial decision is efcient must be made in light of some standard. Although various objectives are possible, we assume in this book that the goal of the rm is to maximize the wealth of the rms present owners. OBJECTIVES OF FINANCIAL MANAGEMENT
Effective procurement and efficient use of finance lead to proper utilization of the finance by the business concern. It is the essential part of the financial manager. Hence, the financial manager must determine the basic objectives of the financial management. Objectives of Financial Management may be broadly divided into two parts such as: 1. Profit maximization 2. Wealth maximization. 3. Economic value added 4. Market value added
Profit Maximization Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization consists of the following important features. 1. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization. OVERVIEW OF FINANCIAL MANAGEMENT
6 | ANJUMAN PG CENTRE DHARWAD
2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern. 4. Profit maximization objectives help to reduce the risk of the business. Favourable Arguments for Profit Maximization The following important points are in support of the profit maximization objectives of the business concern: (i) Main aim is earning profit. (ii) Profit is the parameter of the business operation. (iii) Profit reduces risk of the business concern. (iv) Profit is the main source of finance. (v) Profitability meets the social needs also. Unfavourable Arguments for Profit Maximization the following important points are against the objectives of profit maximization: (i) Profit maximization leads to exploiting workers and consumers. (ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc. (iii) Profit maximization objectives leads to inequalities among the stake holders such as customers, suppliers, public shareholders, etc. Profit maximization objective consists of certain drawback also: (i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern. (ii) It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period. (iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern.
Wealth Maximization Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those who are involved in the business concern. Wealth maximization is also known as value maximization or net present worth maximization. This objective is an universally accepted concept in the field of business.
Favourable Arguments for Wealth Maximization OVERVIEW OF FINANCIAL MANAGEMENT
7 | ANJUMAN PG CENTRE DHARWAD
(i) Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders. (ii) Wealth maximization considers the comparison of the value to cost associated with the business concern. Total value detected from the total cost incurred for the business operation. It provides extract value of the business concern. (iii) Wealth maximization considers both time and risk of the business concern. (iv) Wealth maximization provides efficient allocation of resources. (v) It ensures the economic interest of the society. Unfavourable Arguments for Wealth Maximization (i) Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities. (ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization. (iii) Wealth maximization creates ownership-management controversy. (iv) Management alone enjoy certain benefits. (v) The ultimate aim of the wealth maximization objectives is to maximize the profit. (vi) Wealth maximization can be activated only with the help of the profitable position of the business concern. Economic value added
The goal of the financial management is to maximise the shareholders value. The shareholders wealth is measured by the returns they receive o their investments. Returns are in two parts, first are in the form of dividend and the second in the form of capital appreciation reflected in market value of the shares, of which market value is the dominant part. The market value of share is influenced by number of factors, many of which may not be fully influenced by the management of firm, however, one factor, which influence on the market value is the expectation of the shareholders regarding return on their investment. The share prices influenced by the extent to which the management is able to meet the expectation of the shareholders. Various measures like return on capital employed, return on equity, earnings per share, etc.
The excess of returns over cost of capital simply termed as the Economic Value Added (EVA). EVA measures whether operating profit is sufficient enough to cover cost of capital. Shareholders must earn sufficient return for the risk they have taken in investing their money in companys capital. The return generated by the company for the shareholders has to be more than OVERVIEW OF FINANCIAL MANAGEMENT
8 | ANJUMAN PG CENTRE DHARWAD
the cost of capital to justify the risk taken by the shareholders. If the companys EVA is negative, the firm is destroying the wealth of shareholders even though it may be reporting positive and growing EPS or return on capital employed. EVA is just a way of measuring an operations real profitability. EVA can be calculated as follows:
Where, NOPAT=Net operating profit after tax TCE= Total Capital Employed WACC= Weighted Average cost of capital
Market Value Added
A term closely related to EVA is Market Value Added (MVA). It is the market value of capital employed in the firm less the book value of capital employed. MVA is calculated by summing up the paid value of equity and preference capital, retained earnings, long term and short term debt and subtracting this sum from market value of equity and debt. MVA is cumulative measure of corporate performance. It measures how a companys stock has added to or taken out of investors pocket books over its life and compares it with the capital those same investors put into the firm. EVA drives MVA. Continuous improvements in EVA year after year will lead to increase in MVA. Functions of Financial Management Functions of financial management can be broadly divided into two groups. 1. Executive functions of financial management, and 2. Routine functions of financial management. This division of functions of financial management is depicted below.
Executive Functions of Financial Management OVERVIEW OF FINANCIAL MANAGEMENT
9 | ANJUMAN PG CENTRE DHARWAD
The executive functions of financial management are depicted & listed below.
Eight executive functions of financial management (FM) are:- 1. Estimating capital requirements : The company must estimate its capital requirements (needs) very carefully. This must be done at the promotion stage. The company must estimate its fixed capital needs and working capital need. If not, the company will become over- capitalized or under-capitalized. 2. Determining capital structure : Capital structure is the ratio between owned capital and borrowed capital. There must be a balance between owned capital and borrowed capital. If the company has too much owned capital, then the shareholders will get fewer dividends. Whereas, if the company has too much of borrowed capital, it has to pay a lot of interest. It also has to repay the borrowed capital after some time. So the finance managers must prepare a balanced capital structure. 3. Estimating cash flow : Cash flow refers to the cash which comes in and the cash which goes out of the business. The cash comes in mostly from sales. The cash goes out for business expenses. So, the finance manager must estimate the future sales of the business. This is called Sales forecasting. He also has to estimate the future business expenses. 4. Investment Decisions : The business gets cash, mainly from sales. It also gets cash from other sources. It gets long-term cash from equity shares, debentures, term loans from financial institutions, etc. It gets short-term loans from banks, fixed deposits, dealer deposits, etc. The OVERVIEW OF FINANCIAL MANAGEMENT
10 | ANJUMAN PG CENTRE DHARWAD
finance manager must invest the cash properly. Long-term cash must be used for purchasing fixed assets. Short-term cash must be used as a working capital. 5. Allocation of surplus : Surplus means profits earned by the company. When the company has a surplus, it has three options, viz., 1. It can pay dividend to shareholders. 2. It can save the surplus. That is, it can have retained earnings. 3. It can give bonus to the employees. 6. Deciding Additional finance : Sometimes, a company needs additional finance for modernisation, expansion, diversification, etc. The finance manager has to decide on following questions. 1. When the additional finance will be needed? 2. For how long will this finance be needed? 3. From which sources to collect this finance? 4. How to repay this finance? Additional finance can be collected from shares, debentures, loans from financial institutions, fixed deposits from public, etc. 7. Negotiating for additional finance : The finance manager has to negotiate for additional finance. That is, he has to speak to many bank managers. He has to persuade and convince them to give loans to his company. There are two types of loans, viz., short-term loans and long- term loans. It is easy to get short-term loans from banks. However, it is very difficult to get long-term loans. 8. Checking the financial performance : The finance manager has to check the financial performance of the company. This is a very important finance function. It must be done regularly. This will improve the financial performance of the company. Investors will invest their money in the company only if the financial performance is good. The finance manager must compare the financial performance of the company with the established standards. He must find ways for improving the financial performance of the company. Routine Functions of Financial Management The routine functions are also called as incidental functions. Routine functions are clerical functions. They help to perform the Executive functions of financial management. The routine functions of financial management are briefly listed below. OVERVIEW OF FINANCIAL MANAGEMENT
11 | ANJUMAN PG CENTRE DHARWAD
Six routine functions of financial management (FM) are:- 1. Supervision of cash receipts and payments. 2. Safeguarding of cash balances. 3. Safeguarding of securities, insurance policies and other valuable papers. 4. Taking proper care of mechanical details of financing. 5. Record keeping and reporting. 6. Credit Management.
Risk-return trade off Financial decisions of the firm are guided by risk return trade off. These decisions are interrelated and jointly affect the market value of its shares by influencing return and the risk of the firm. The relationship between risk and return can be simply expressed as below Return = risk free rate+ risk premium OVERVIEW OF FINANCIAL MANAGEMENT
12 | ANJUMAN PG CENTRE DHARWAD
Risk free rate is the rate obtainable from a default risk free government security. An investor assuming risk from his/her investment requires a risk premium above the risk free rate. Risk free rate is compensation for the time and risk premium for the risk involved in the investment. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. A proper balance between return and the risk should be maintained to maximise the market value of the firms shares. Such balance is called risk-return trade off. The financial manager, in a bid to maximise shareholders wealth should strive to maximise the return in relation to the given risk; He/She should seek actions that avoid unnecessary risks. To ensure maximum return, funds flowing in and out of the organisation should be constantly monitored to assure that they are safeguarded and properly utilised. The financial reportimg systems must be designed to provide timely and accurate picture of the firms activities
FINANCIAL MANAGEMENT AND ITS RELATIONSHIP WITH OTHER DISCIPLINES Finance and Economics Finance is a branch of economics. Economics deals with supply and demand, costs and profits, production and consumption and so on. The relevance of economics to financial management can be described in two broad areas of economics i.e., micro economics and macroeconomics. Micro economics deals with the economic decisions of individuals and firms. It concerns itself with the determination of optimal operating strategies of a business firm. These strategies include profit maximization strategies, product pricing strategies, strategies for valuation of firm and assets etc. The basic principle of micro economics that applies in financial management is OVERVIEW OF FINANCIAL MANAGEMENT
13 | ANJUMAN PG CENTRE DHARWAD
marginal analysis. Most of the financial decisions should be made taken into account the marginal revenue and marginal cost. So, every financial manager must be familiar with the basic concepts of micro economics. Macroeconomics deals with the aggregates of the economy in which the firm operates. Macroeconomics is concerned with the institutional structure of the banking system, money and capital markets, monetary, credit and fiscal policies etc. So, the financial manager must be aware of the broad economic environment and their impact on the decision making areas of the business firm
Finance and Accounting Accounting and finance are closely related. Accounting is an important input in financial decision making process. Accounting is concerned with recording of business transactions. It generates information relating to business transactions and reporting them to the concerned parties. The end product of accounting is financial statements namely profit and loss account, balance sheet and the statements of changes in financial position. The information contained in these statements assists the financial managers in evaluating the past performance and future direction of the firm (decisions) in meeting certain obligations like payment of taxes and so on. Thus, accounting and finance are closely related.
Finance and Production Finance and production are also functionally related. Any changes in production process may necessitate additional funds which the financial managers must evaluate and finance. Thus, the production processes, capacity of the firm are closely related to finance.
Finance and Marketing Marketing and finance are functionally related. New product development, sales promotion plans, new channels of distribution, advertising campaign etc. in the area of marketing will require additional funds and have an impact on the expected cash flows of the business firm. Thus, the financial manager must be familiar with the basic concept of ideas of marketing.
Finance and Quantitative Methods Financial management and Quantitative methods are closely related such as linear programming, probability, discounting techniques, present value OVERVIEW OF FINANCIAL MANAGEMENT
14 | ANJUMAN PG CENTRE DHARWAD
techniques etc. are useful in analyzing complex financial management problems. Thus, the financial manager should be familiar with the tools of quantitative methods. In other way, the quantitative methods are indirectly related to the day-to-day decision making by financial managers.
Finance and Costing Cost efficiency is a major strategic advantage to a firm, and will greatly contribute towards its competitiveness, sustainability and profitability. A finance manager has to understand, plan and manage cost, through appropriate tools and techniques including Budgeting and Activity Based Costing.
Finance and Law A sound knowledge of legal environment, corporate laws, business laws, Import Export guidelines, international laws, trade and patent laws, commercial contracts, etc. are again important for a finance executive in a globalized business scenario. For example the guidelines of Securities and Exchange Board of India [SEBI] for raising money from the capital markets. Similarly, now many Indian corporate are sourcing from international capital markets and get their shares listed in the international exchanges. This calls for sound knowledge of Securities Exchange Commission guidelines, dealing in the listing requirements of various international stock exchanges operating in different countries.
Finance and Taxation A sound knowledge in taxation, both direct and indirect, is expected of a finance manager, as all financial decisions are likely to have tax implications. Tax planning is an important function of a finance manager. Some of the major business decisions are based on the economics of taxation. A finance manager should be able to assess the tax benefits before committing funds. Present value of the tax shield is the yardstick always applied by a finance manager in investment decisions.
Finance and Treasury Management Treasury has become an important function and discipline, not only in banks, but in every organization. Every finance manager should be well grounded in treasury operations, which is considered as a profit center. It deals with optimal management of cash flows, judiciously investing surplus cash in the most appropriate investment avenues, anticipating and meeting emerging OVERVIEW OF FINANCIAL MANAGEMENT
15 | ANJUMAN PG CENTRE DHARWAD
cash requirements and maximizing the overall returns, it helps in judicial asset liability management. It also includes, wherever necessary, managing the price and exchange rate risk through derivative instruments. In banks, it includes design of new financial products from existing products.
Finance and Banking Banking has completely undergone a change in todays context. The type of financial assistance provided to corporate has become very customized and innovative. During the early and late 80s, commercial banks mainly used to provide working capital loans based on certain norms and development financial institutions like ICICI, IDBI, and IFCI used to provide long term loans for project finance. But, in todays context, these distinctions no longer exist. Moreover, the concept of development financial institutions also does not exist any longer. The same bank provides both long term and short term finance, besides a number of innovative corporate and retail banking products, which enable corporate to choose between them and reduce their cost of borrowings. It is imperative for every finance manager to be up-to date on the changes in services & products offered by banking sector including several foreign players in the field. Thanks to Governments liberalized investment norms in this sector.
Finance and Insurance Evaluating and determining the commercial insurance requirements, choice of products and insurers, analyzing their applicability to the needs and cost effectiveness, techniques, ensuring appropriate and optimum coverage, claims handling, etc. fall within the ambit of a finance managers scope of work & responsibilities.
International Finance Capital markets have become globally integrated. Indian companies raise equity and debt funds from international markets, in the form of Global Depository Receipts (GDRs), American Depository Receipts (ADRs) or External Commercial Borrowings (ECBs) and a number of hybrid instruments like the convertible bonds, participatory notes etc., Access to international markets, both debt and equity, has enabled Indian companies to lower the cost of capital. For example, Tata Motors raised debt as less than 1% from the international capital markets recently by issuing convertible bonds. Finance managers are expected to have a thorough knowledge on international OVERVIEW OF FINANCIAL MANAGEMENT
16 | ANJUMAN PG CENTRE DHARWAD
sources of finance, merger implications with foreign companies, Leveraged Buy Outs (LBOs), acquisitions abroad and international transfer pricing. The implications of exchange rate movements on new project viability have to be factored in the project cost and projected profitability and cash flow estimates. This is an essential aspect of finance managers expertise. Similarly, protecting the value of foreign exchange earned, through instruments like derivatives, is vital for a finance manager as the volatility in exchange rate movements can erode in no time, all the profits earned over a period of time.
Finance and Information Technology Information technology is the order of the day and is now driving all businesses. It is all pervading. A finance manager needs to know how to integrate finance and costing with operations through software packages including ERP. The finance manager takes an active part in assessment of various available options, identifying the right one and in the implementation of such packages to suit the requirement.
Agency Theory Weve seen that the nancial manager in a corporation acts in the best interests of the stock- holders by taking actions that increase the value of the rms stock. However, weve also seen that in large corporations ownership can be spread over a huge number of stockholders. This dispersion of ownership arguably means that management effectively controls the rm. In this case, will management necessarily act in the best interests of the stockholders? Put another way, might not management pursue its own goals at the stockholders expense? We briey consider some of the arguments below. Agency Relationships The relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interest. For example, you might hire someone (an agent) to sell a car that you own while you are away at school. In all such relationships, there is a possibility of conict of interest between the principal and the agent. Such a conict is called an agency problem. Suppose you hire someone to sell your car and you agree to pay her a at fee when she sells the car. The agents incentive in this case is to make OVERVIEW OF FINANCIAL MANAGEMENT
17 | ANJUMAN PG CENTRE DHARWAD
the sale, not necessarily to get you the best price. If you paid a commission of, say, 10 percent of the sales price instead of a at fee, then this problem might not exist. This example illustrates that the way an agent is compensated is one factor that affects agency problems. Management Goals To see how management and stockholder interests might differ, imagine that a corporation is considering a new investment. The new investment is expected to favourably impact the stock price, but it is also a relatively risky venture. The owners of the rm will wish to take the investment (because the share value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost. It is sometimes argued that, left to themselves, managers would tend to maximize the amount of resources over which they have control, or, more generally, business power or wealth.Thisgoalcouldleadtoanoveremphasisonbusinesssizeorgrowth.Forexam ple,cases where management is accused of overpaying to buy another company just to increase the size of the business or to demonstrate corporate power are not uncommon. Obviously, if overpayment does take place, such a purchase does not benet the owners of the purchasing company. Our discussion indicates that management may tend to overemphasize organizational survival to protect job security. Also, management may dislike outside interference, so independence and corporate self-sufciency may be important goals. Do Managers Act in the Stockholders Interests? Whether managers will, in fact, act in the best interests of stockholders depends on two factors. First, how closely are management goals aligned with stockholder goals? This question relates to the way managers are compensated. Second, can management be replaced if they do not pursue stockholder goals? This issue relates to control of the rm. There are a number of reasons to think that, even in the largest rms, management has a signicant incentive to act in the interests of stockholders. Managerial Compensation Management will frequently have a signicant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to nancial performance OVERVIEW OF FINANCIAL MANAGEMENT
18 | ANJUMAN PG CENTRE DHARWAD
in general and oftentimes to share value in particular. For example, managers are frequently given the option to buy stock at a xed price. The more the stock is worth, the more valuable is this option. The second incentive managers have relates to job prospects. Better performers within the rm will tend to get promoted. More generally, those managers who are successful in pursuing stock- holder goals will be in greater demand in the labour market and thus command higher salaries. In fact, managers who are successful in pursuing Stockholder goals can reap enormous rewards. For example, Rueben Mark, CEO of consumer products maker Colgate-Palmolive, receivedabout$148millionin2004alone, which is less than MelGibson($210million),but way more than Beyonc Knowles ($21 million). For the ve-year period ending 2004, Larry Ellison of software giant Oracle was one of the top earners, receiving over $835 million. Control of the Firm Control of the rm ultimately rests with stockholders. They elect the board of directors, who, in turn, hires and res management. The mechanism by which unhappy stockholders can act to replace existing management is called a proxy ght. A proxy is the authority to vote someone elses stock. A proxy ght develops when a group solicits proxies in order to replace the existing board, and thereby replace existing management. Another way that management can be replaced is by takeover. Those rms that are poorly managed are more attractive as acquisitions than well-managed rms because a greater prot potential exists. Thus, avoiding a takeover by another rm gives management another incentive to act in the stockholders interests. Information on executive compensation, along with a ton of other information, can be easily found on the Web for almost any public company. Our nearby Work the Web box shows you how to get started. Sometimes its hard to tell if a companys management is really acting in the shareholders best interests. Consider the 2005 merger of software giants Oracle and PeopleSoft. PeopleSoft repeatedly rejected offers by Oracle to purchase the company. In November 2004, the board rejected a best and nal offer, even after 61 per cent of PeopleSofts shareholders voted in favour of it. So was the board really acting in shareholders best interests? At rst, it may not have looked like it, but Oracle then increased its offer price by $2 per share, which the board accepted. So, by holding out, PeopleSofts management got a much better price for its shareholders. Conclusion The available theory and evidence are consistent with the view that stock- holders control the rm and that stockholder wealth maximization is the relevant goal of the corporation. Even so, there will undoubtedly be OVERVIEW OF FINANCIAL MANAGEMENT
19 | ANJUMAN PG CENTRE DHARWAD
times when management goals are pursued at the expense of the stockholders, at least temporarily.