Evolution of Finance Function

Finance Function Evolution.

Financial management has emerged as a distinct field of study, only in the early part of this century, as a result of consolidation movement and formation of large enterprises. Its evolution may be divided into three phases (some what arbitrary) viz.,

1. The Traditional phase,
2. The Transitional phase and
3. The Modern phase.

The Traditional Phase: 

This phase lasted for about four decades. Its finest expression was shown in the scholarly work of Arthur S. Dewing, in his book titled “the Financial Policy of Corporation in 1920s. In this phase the focus of financial management was on four selected aspects.

It treats the entire subject of finance from the outsider’s point of view (investment banks, lenders, other) rather than the financial decision-maker’s viewpoint in the firm.

It places much importance on corporation finance and too little on the financing problems of non-corporate enterprises.

The sequence of treatment was on certain episodic events like formation, issuance of capital, major expansion, merger,

It placed heavy emphasis on long-term financing, institutions, instruments, procedures used in capital markets and legal aspects of financial events. That is it lacks emphasis on the problems of working capital management.

It was criticized throughout the period of its dominance, but the criticism is based on matters of treatment and emphasis. Traditional phase was only outsiders looking approach, due to its over emphasis on episodic events and lack of importance to day-to-day problems.

The Transition Phase: 

It began around the early 1940s and continued through the early 1950s. The nature of financial management in this phase is almost similar to that of earlier phase but more emphasis was given to the day-to-day (working capital) problems faced by the finance managers.

Capital budgeting techniques were developed in this phase only. Much more details of this phase are given in the book titled “Essays on Business Finance”.

The Modern Phase:

It begun in the mid 1950s. It has showed commendable development with a combination of ideas from economic and statistics that has lead financial management to be more analytical and quantitative.

The main issue of this phase was rational matching of funds to their uses, which leads to the maximization of shareholders wealth.

This phase witnessed significant developments. The areas of advancements are: capital structure. The study says the cost of capital and capital structure are independent in nature.

Dividend policy, suggests that there is the effect of dividend policy on the value of the firm. This phase has also seen one of the first applications of linear programming. For estimation of opportunity cost of funds, multiple rates of return-gives way to calculate multiple rates of a project.

Investment decisions under conditions of uncertainty, gives formulas for determination of expected cash inflows and variance of net present value of projects and gives how probabilistic information helps the firm to optimize investment decisions involving risk.

Portfolio analysism gives the idea for allocation a fixed sum of money among the available investment securities.

Capital Asset Pricing Model (CAPM), suggests that some of the risks in investments can be neutralized by holding diversified portfolio of securities.

Arbitrage Pricing Model (APM), argued that the expected return must be related to risk in such a way that no single investor could create unlimited wealth through arbitrage.

CAPM is still widely used in the real world, but APM is slowly gaining momentum. Agency theory emphasizes the role of financial contracts in creating and controlling agency problems.

Option Pricing Theory (OPT), applied Martingale pricing principle to the pricing of real estates. Cash management of models (working capital management) by Baumol Model, Miller and Orglers. Baumol models helps to determine optimum cash conversion size Miller model reorder point and upper control points and Orglers model helps to determine optimal cash management strategy by adoption of linear programming application.

Further, new means of raising finance with the introduction of new capital market instruments, such as Pads, Fads, PSBs and Capps, etc. Financial engineering that involves the design, development and implementation of innovative financial instruments and formulation of creative optional solutions to problems in finance.

While the above developed areas of finance are remarkable, but understanding the international dimension of corporate finance was little, which is not sufficient in the globalized era.