Financial management: concept, functions and sources of finance
Financial management plans the raising and use of funds through investment, financing, dividend and liquidity decisions, with shareholder wealth maximisation as the goal.
Traditional versus modern approach
Profit versus wealth maximisation
| Basis | Profit maximisation | Wealth maximisation |
|---|---|---|
| Meaning | Maximise accounting profit or EPS | Maximise the market value of shares (NPV) |
| Time value of money | Ignored | Considered: cash flows are discounted |
| Risk | Ignored | Considered: higher risk, higher discount rate |
| Measure | Vague: short or long term, before or after tax? | Precise: cash flows |
| Status | Traditional, narrow | Accepted modern goal |
Finance decisions
| Decision | Question it answers | Tools |
|---|---|---|
| Investment | Where should long-term funds go? | Capital budgeting: NPV, IRR, payback |
| Financing | How should funds be raised: what debt-equity mix? | Capital structure, cost of capital, leverage |
| Dividend | How much profit to pay out and how much to retain? | Payout ratio, dividend models |
| Liquidity | How much to hold in current assets? | Working capital management |
Sources of finance
| Term | Sources |
|---|---|
| Long-term | Equity shares, preference shares, debentures and bonds, term loans, retained earnings, venture capital |
| Medium-term | Term loans, leasing, hire purchase, public deposits |
| Short-term | Trade credit, bank overdraft and cash credit, commercial paper, bill discounting, factoring, customer advances |
| International | ADRs and GDRs, external commercial borrowings, foreign currency convertible bonds, masala bonds (rupee bonds issued abroad) |
Ways of issuing shares (Companies Act 2013)
- IPO: a company's first public issue. FPO: a later public issue by a listed company.
- Rights issue (s.62): offered to existing shareholders in proportion to their holding; they may renounce the right.
- Bonus issue (s.63): free shares made out of reserves; no fresh cash comes in.
- Private placement (s.42): an offer to a select group, not to the public.
- Sweat equity (s.54): shares to employees or directors for know-how or value added.
- Preference shares must be redeemable; irredeemable preference shares cannot be issued (s.55).
Theoretical ex-rights price
A company offers 1 new share for every 4 held at ₹80. The market price before the issue (cum-rights) is ₹100.
- Value of 4 old shares = 4 × 100 = ₹400; add 1 new share at ₹80, giving ₹480 for 5 shares
- Ex-rights price = 480 ÷ 5 = ₹96
- Value of a right per existing share = 100 − 96 = ₹4
- Check: value of a right = (cum-rights price − issue price) ÷ (N + 1) = (100 − 80) ÷ 5 = ₹4
Ex-rights price ₹96; each right is worth ₹4.
NET asks you to pick the better objective (wealth over profit) with reasons, match decisions with examples, and classify sources by term, ownership or instrument.
Typical MCQ: “Why is wealth maximisation preferred to profit maximisation?” It counts the timing and risk of cash flows. Trap: thinking it ignores profit; it values profits as discounted cash flows.
Typical MCQ: “Does a bonus issue raise new capital?” No. It only turns reserves into share capital. A rights issue does bring in cash.
I-F-D-L: Invest, Finance, Distribute, stay Liquid. Wealth beats profit because it counts time and risk.