Page 13 - DMGT409Basic Financial Management

Basic Financial Management

Notes ?

Did u know? Investment in current assets is popularly termed as “working capital
management”.
2. Financing: After estimation of the amount required and the assets that require purchasing,

comes the next financing decision into the picture. Here, the financial manager is concerned

with make up of the left hand side of the balance sheet. It is related to the fi nancing mix
or capital structure or leverage and he has to determine the proportion of debt and equity.
It should be optimum finance mix, which maximizes shareholders’ wealth. A proper

balance will have to be struck between risk and return. Debt involves fi xed cost (interest),
which may help in increasing the return on equity alongwith an increase in risk.
Raising of funds by issue of equity shares is one permanent source, but the shareholders
expect higher rates of earnings.

3. Dividend Decision: Dividend function relates to dividend policy. Dividend is a part of

profits that are available for distribution, to equity shareholders. Payment of dividends

should be analyzed in relation to the financial decision of a firm. There are two options
available in dealing with the net profits of a firm, viz., distribution of profits as dividends

to the ordinary shareholders’ where, there is no need of retention of earnings or they can
be retained in the firm itself if they require, for financing of any business activity. But

distribution of dividends or retaining should be determined in terms of its impact on the
shareholders’ wealth. The Financial manager should determine optimum dividend policy,
which maximizes market value of the share thereby market value of the fi rm. Considering
the factors affecting the dividend policy is another aspect of dividend policy.
4. Liquidity Decisions: The finance manager should also manage the current assets, to have
liquidity in the business. Investment of funds in current assets reduces the profitability
of the firm. However, at the same time, the finance manager should also look after the
current financial needs of the firm to maintain optimum production. While investing
funds in current assets, he must see that proper balance (trade off) is maintained between
profitability and liquidity.
Every financial decision involves this trade off. At this level the market value of the

company’s shares would be the maximum.

1.5 Risk and Return Trade off

Financial decisions incur different degree of risk. Your decision to invest your money in
government bonds has less risk as interest rate is known and the risk of default is very less. On
the other hand, you would incur more risk if you decide to invest your money in shares, as return
is not certain. However, you can expect a lower return from government bond and higher from
shares. Risk and expected return move in tandem; the greater the risk, the greater the expected
return.
Financial decisions of the firm are guided by the risk-return trade-off. These decisions are

interrelated and jointly affect the market value of its shares by influencing return and risk of the
firm. The relationship between return and risk can be simply expressed as follows:

Return = Risk-free rate + Risk premium
The Figure 1.2 explains the relation between the risk and return.

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