Introduction to Financial Management 1 Block - 1 Notes Unit 1: Introduction to Financial Management Structure: 1.1 Introduction 1.2 Concepts of Financial Management 1.3 Need for Financial Management 1.4 Importance of Financial Management 1.5 Objectives of Financial Management 1.6 Who is a Finance Manager? 1.7 Function of Corporate Financial Manager 1.8 Role of a Finance Manager 1.9 Financial Management Decision 1.10 Scope of Financial Management 1.11 Approaches of Financial Management 1.12 A’s of Financial Management 1.13 Methods or Tools of Financial Management 1.14 Challenges of Financial Manager in Global Scenario 1.15 Interface of Financial Management with other Functional Areas 1.16 Summary 1.17 Check Your Progress 1.18 Questions and Exercises 1.19 Key Terms 1.20 Check Your Progress: Answers 1.21 Case Study 1.22 Further Readings 1.23 Bibliography Objectives After studying this unit, you should be able to understand: Concepts of Financial Management Need and Importance of Financial Management Objectives of Financial Management Function of Corporate Financial Manager Role of a Finance Manager Financial Management Decision Scope of Financial Management Methods or Tools of Financial Management Challenges of Financial Manager in Global Scenario Amity Directorate of Distance and Online Education 2 Financial Management Notes 1.1 Introduction Every business enterprise whether small, medium or big needs finance to carry out its operations and accomplish its targets. Finance is the study of how investors allocate their financial resources over time under conditions of certainty and uncertainty. It is judicious way of managing funds. Earlier the concept of finance focussed on raising funds by the enterprise. Now the domain of finance has expanded. It focuses not only on raising of funds by the business enterprise but also its optimum usage An enterprise need finance to meet its requirements in the economic world. For smooth functioning of a business activity, proper flow of fund is required of time to ensure maximum profit. So it is necessary to understand the need of finance, which plays a vital role in business. In the modern economy all the business operations are taking new shape as per the changing demands in the business world. It further becomes essential for finance managers, academicians, practicing managers and all people who are connected to the finance world to understand the wider aspects of financial management. All the business operations are concerned with maximizing profits. A finance manager should be able to integrate with other departments for improving the efficiency of business process by proper utilization of finance. To do integrate the financial manager has to consider the other functional activities like marketing, production, human resources, research and development, technology etc., which requires adequate finance to achieve functional goals and in turn the overall goals of an organization. All type of organizations whether small, medium or large scale corporation requires finance for the above said functions without which the smooth functioning of business cannot be accomplished. In short, finance plays a key role in the business. The term financial management can be defined as the management of the flow of funds in a firm and it deals with financial decision making. The financial Management as practiced by corporate firms can be called as corporate finance or business finance. Finance function has become so important that it has given birth to financial management as a separate subject. Financial management refers to that part of the management activity which is concerned with planning and controlling of the firm’s financial resources. It encompasses the procurement of funds in the most economic and prudent manner and employment of these funds in the most optimum way to maximize the return to the owner. The financial management has got a place of prime relevance as a functional area because raising of funds and their best utilization is a key to the success of any business organisation. All business decisions have financial implications and therefore financial management is inevitably related to almost every aspect of business operations. Meaning of Finance The term finance is derived from the Latin word ‘finis’ which means end/finish. Finance can also be interpreted in many ways such as fund, money, investment, capital, amount etc. Finance act as a medium for business which involves the acquisition and usage of funds in various departments such as production department, purchase department, research and development etc. Finance is the life blood of business. Finance is provision of money at the time when it is required. Finance is an art and science of managing money. Finance is the set of activities dealing with the management of funds. More specifically, it is the decision of collection and use of funds. Amity Directorate of Distance and Online Education Introduction to Financial Management 3 Finance also refers to the science that describes the management, creation and Notes study of money, banking, credit, investments, assets and liabilities. Finance consists of financial systems, which include public, private and government bodies and the study of finance and financial instruments, which can relate to countless assets and liabilities. For instance, when a manager has to buy machineries for a production process, he requires fund in order to procure it for further process. Fund is also required in human resource department for providing training to their employees. In a nut shell it can be stated that every department needs finance for their business operations. Hence, Finance has been rightly termed as universal lubricant which keeps the enterprise dynamic. Definitions of Finance According to Paul G Hasings, “Finance is the management of the monetary affairs of a company.” Financing is the process of organising the flow of funds so that a business firm can carry out its objectives in the most efficient manner and meet its obligations as they fall due. - Kenneth Midgley and Ronald Burns According to Simon Andrade, “Finance is the area of economic activity in which money is the basis of various embodiments, whether stock market investments, real estate, industrial, construction, agricultural development and so on”. According to Bodie and Merton, “Finance is the study of how scarce resources are allocated over time”. According to Ivan Thompson, “The term finance comes from the Latin word “finis” which means end or finish. It is a term whose implications affect both individuals and business, organizations and states what it has to do with obtaining and using money or money management”. According to O. Ferrel C. and Geoffrey Hirt, “The term finance refers to “all activities related to obtaining money and its effective use”. According to Henry Ford, “Finance or money is an arm or leg which one can either use it or lose it”. Webster’s 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”. Nature of Finance 1. Finance management is one of the important education which has been realized word wide. Now a day’s people are undergoing through various specialization courses of financial management. 2. The nature of financial management is never a separate entity. Even as an operational manager or functional manager one has to take responsibility of financial management. 3. Finance is a foundation of economic activities. The person who manages finance is called as financial manager. Important role of financial manager is to control finance and implement the plans. Amity Directorate of Distance and Online Education 4 Financial Management Notes 4. Nature of financial management is multi-disciplinary. Financial management depends upon various other factors like: accounting, banking, inflation, economy etc. for the better utilization of finances. 5. Approach of financial management is not limited to business functions but it is a backbone of commerce, economic and industry. 1.2 Concepts of Financial Management As stated earlier finance plays a key role in business, hence it is imperative to understand financial management. It is an integral part of overall management which has close relationship with economics, accounting and other areas of management. It covers the broader area of decision making at all levels of management. Financial management is the managerial activity which is related to planning, organizing, and controlling the firm’s financial resources and it is an essential part of the management. As it is integrated with other departments, proper management should be at place for smooth operations of business. Financial Management is basically the application of general management principles to the areas of financial decision-making related to investment, dividend, working capital etc., with a view to maximize the wealth of the company and also shareholders. In simple financial management deals with financial planning, acquisition of funds, use and allocation of funds and financial controls. Definitions of Financial Management According to S.C. Kuchal “Financial Management deals with procurement of funds and their effective utilization in the business”. According to Soloman, “Financial Management is concerned with the efficient use of an important economic resource viz., Capital Funds” Financial management is an area of financial decision making, harmonizing individual motives and enterprise goals. - Weston and Brigham Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations. - Joseph and Massie According to J. F. Bradlery “Financial management is the area of business management devoted to a judicious use of capital and a careful selection of sources of capital in order to enable a business firm to move in the direction of reaching its goals”. Financial management is an application of general managerial principles to the area of financial decision-making. - Howard and Upton 1.3 Need for Financial Management Financial management system enables to accomplish important big picture and daily financial objectives. The following needs are as- 1. Book keeping Bookkeeping is the process of tracking your company's daily financial activities, such as sales and expenditures, and periodically compiling this information into reports, such as profit and loss statements and balance sheets. Bookkeeping is important because it Amity Directorate of Distance and Online Education Introduction to Financial Management 5 gives you feedback about whether you are making ends meet. It also helps you to identify Notes areas that need adjustment. 2. Financing Business financing can be a valuable tool that helps your business grow and enables you to make ends meet during slow periods. However, business financing must be carefully managed to ensure that you make smart choices about credit options and make payments on schedule to avoid costly finance charges. 3. Cash Flow Financial management ensures that the company is able to meet day-to-day expenses, having enough product on hand to meet customer demand, having enough money in the bank to pay the staff on time and having enough capital ready when your business has the opportunity to grow. Cash flow management involves keeping accurate tabs on regular expenses and income, being resourceful enough to have alternative sources of funding available in case of emergencies and having good enough judgment to determine when to take advantage of these emergency funding options. 4. Budgeting Budgeting is the area of financial management that involves planning for typical expenses. It is the process of deciding the best time to make a particular purchase based on the amount of money the business is currently earning and the expectations about how much it will earn in the future. Budgeting is important because it enables the business to approach financial decisions with sound information and sufficient resources. 1.4 Importance of Financial Management Financial management is important mainly because it helps to make decisions towards the maximization of value of the firm. The importance of financial management to a firm is as follows: 1. It helps setting clear goals: Simplicity of the goal is important for any firm. Financial management defines the goal of the firm in clear terms. Setting goal helps to judge whether the decisions taken are in the best interest of the shareholders or not. Financial management also direct the efforts of all functional areas of business towards achieving the goal and facilitates among the functional areas of the firm. 2. It helps efficient utilization of resources: Firms use fixed as well as current assets which involve huge investment. Acquiring and holding assets that do not earn minimum return do not add value to the shareholders. Moreover, wrong decision regarding the purchase and disposal of fixed assets can cause threat to the survival of the firm. The application of financial management techniques helps to answer the questions like which asset to buy, when to buy and whether to replace the existing asset with new one or not. The firm also requires current assets for its operation. Therefore, maintaining proper balance of these assets and financing them from proper sources is a challenge to a firm. Financial management helps to decide what level of current assets is to be maintained in a firm and how to finance them so that these assets are utilized efficiently. 3. It helps deciding sources of financing: Firms collect long-term funds mainly for purchasing permanent assets. The sources of long term finance may be equity shares, preference shares, bond, term loan etc. The firm needs to decide the appropriate mix of these sources and amount of long-term funds; otherwise Amity Directorate of Distance and Online Education 6 Financial Management Notes the firm will have to bear higher cost and expose to higher risk. Financial management (capital structure theories) guides in selecting these sources of financing. 4. It helps making dividend decision: Dividend is the return to the shareholders. The firm is not legally obliged to pay dividend to the shareholders. However, how much to pay out of the earning is a vital issue. Financial management helps a firm to decide how much to pay as dividend and how much to retain in the firm. It also suggests answering questions such as when and in what form such as cash dividend or stock dividend should the dividend be paid. 1.5 Objectives of Financial Management The financial goals can be classified into two categories: 1. Specific objectives 2. General objectives 1. Specific Objectives Profit Maximization Profit maximization refers to the process where in companies focus on maximizing their profit or getting the best possible profit in the particular kind of business. Under profit maximisation companies experience the best output and price levels in order to maximize its return. In simple Profit maximization implies maximizing the Rupee income of the firm. Profit is a yardstick for measuring the efficiency of a business which is associated with economic activity. The survival of the firm depends upon its ability to earn profits which can act as a guard against risk. The profits which are accumulated in business can help business overcome the unforeseen situations like market fluctuations, changes in price, competition, sudden change in government policies etc. Thus, profit maximization achieved by an organization is regarded as a primary measure of success. Hence, it is rightly said, No business can survive without earning profit. Profit is the only means through which an efficiency of business enterprise can be measured. Features of Profit Maximisation Profit maximization consists of the following important features: 1. Profit maximization is called as cashing per share maximization. It leads to maximization of the business operation for profit maximization. 2. Ultimate aim of the business concern is earning profit; hence, it considers all the possible ways to increase the profitability of the concern. 3. Profit is the parameter of measuring the efficiency of the business concern. Thus, it shows the entire position of the business concern. 4. Profit maximization objectives help to reduce the risk of the business. 5. Profit maximization leads to exploitation of workers and consumers. 6. Profit maximization creates immoral practices such as corrupt practices, unfair trade practices, etc. 7. Profit maximization objectives leads to inequalities among the stake holders such as customers, suppliers, public shareholders, etc. 8. Profit maximisation is the parameter of the business operation. Amity Directorate of Distance and Online Education Introduction to Financial Management 7 9. Profit maximisation reduces risk of the business concern. Notes 10. Profitability meets the social needs. Advantages of Profit Maximisation 1. Profit maximization leads to maximizing the business operation. 2. It considers all the possible ways to increase the profitability of the concern. 3. Profit is the parameter of measuring the efficiency of the business concern. Thus, it shows the status of the business concern. 4. It is a technique which is mainly focused on efficient utilization of capital resources to maximize profit. 5. Profit maximization objectives help to reduce the risk of business. 5. It will be easy to determine the link between financial decisions and profits. 6. The company can adjust influential factors such as production costs, sale prices, and output levels as a way of reaching its profit goal. 7. It attracts the investors to invest their savings in securities. 8. Profit maximization can be achieved in a short-period. 9. Profit indicates the efficient use of funds for different requirements. 10. Profit maximization will give way to the business for expansion and diversification of a company. Disadvantages of Profit Maximisation 1. Profit is not defined precisely or correctly under profit maximisation objective. 2. It creates some unnecessary opinion regarding earning habits of the business concern. 3. 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. 4. It leads to certain differences between the actual cash inflow and net present cash flow during a particular period. 5. 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. 6. Profit maximization leads to exploitation of workers and consumers. 7. Profit maximization creates immoral practices such as corrupt practice, unfair trade practices, etc. 8. Profit maximization objectives leads to inequalities among the stake holders such as customers, suppliers, public shareholders, etc. 9. Profit maximization is a good thing for a company, but can be a bad thing for consumers if the company starts to use cheaper products or decides to increase prices. 10. Profit maximisation can lead to management anxiety and frustration. Arguments in favour of Profit Maximization 1. Profit is the test of economic efficiency: It is a measuring rod by which the economic performance of the company can be judged. 2. Efficient allocation of fund: Profit leads to efficient allocation of resources as resources tend to be directed to uses, which in terms of profitability are the most desirable. Amity Directorate of Distance and Online Education 8 Financial Management Notes 3. Social welfare: It ensures maximum social welfare i.e., maximum dividend to shareholders, timely payments to creditors, more and more wages and other benefits to employees, better quality at lesser rate to consumers, more employment opportunities and maximization of capital to the entrepreneur. 4. Internal resources for expansion: It will consume a lot of time to raise equity funds in a primary market. Retained profits can be used for expansion and modernization. 5. Reduction in risk and uncertainty: After availing huge profits the company develops risk bearing capacity. The gross present value of a course of action is found by discounting and low capitalizing is a benefit at a rate which reflects their timing and uncertainty. A financial action which has positive net present value creates wealth and therefore it is desirable. The negative present value should be rejected. 6. More competitive: More and more profits enhance the competitive spirit thus, under such conditions firms having more and more profits are considered to be more dependable and can survive in any environment. 7. Desire for controls: More and more profits are desirable and imperative for the management to make optimum use of available financial resources for continued survival. 8. Increase in confidence: Profit maximization increases the confidence of management in expansion and diversification programme’s of a company. 9. Attraction of Investors: Profit maximization attracts the investors to invest their savings in securities. 10. Survival: Profit helps the business to survive under unfavorable conditions like recession, sever competition etc. Arguments against Profit Maximization 1. It is argued that profit maximization assumes perfect competition, and in the face of imperfect modern markets, it cannot be a legitimate objective of the firm. 2. It is also argued that profit maximization, as a business objective, developed in the early 19th century for single entrepreneurship. The only aim of single owner was to enhance his individual wealth. But the modern business environment is characterized by limited liability and a difference between management and ownership. Share holders and lenders today finance the firm but it is controlled and directed by professional management. In the new business environment, profit maximization is regarded as unrealistic, difficult, inappropriate and immoral. 3. It is also feared that profit maximization behaviour in a market economy may tend to produce goods and services that are wasteful and unnecessary from the society’s point of view. 4. Firms producing same goods and services differ substantially in terms of technology, costs and capital. In view of such conditions, it is difficult to have a truly competitive price system, and thus, it is doubtful if the profit maximizing behaviour will lead to the optimum social welfare. 5. Profit cannot be ascertained well in advance to express the probability of return as future is uncertain. It is not possible to maximize something that is unknown. Moreover the term profit is vague and not clearly expressed. 6. The executive or the decision maker may not have enough confidence in the estimates of future returns so that he does not attempt further to maximize. Amity Directorate of Distance and Online Education Introduction to Financial Management 9 It is argued that a firm’s goal cannot be, to maximize profits but to attain a Notes certain level or certain share of the market or certain level of sales. 7. The criterion of profit maximization ignores the time value factors. It considers the total benefits or profits into account while considering a project whereas the length of time in earning that profit is not considered at all. 8. Profit maximization encourages corrupt practices to increase the profits. 9. Profit maximization does not consider the element of risks and it attracts cut- throat competition. 10. Profit maximization may exploit workers and customers and a huge profit invites problems from worker, they demand high salary and fringe benefits. Shareholders Wealth Maximisation Wealth maximisation is a process that increases the current net value of business or shareholder capital gains, with the objective of bringing in the highest possible return. The wealth maximization strategy generally involves making sound financial investment decisions which takes into consideration any risk factors that would compromise or outweigh the anticipated benefits. It refers to maximization of the net present value of a course of action for increasing shareholders wealth. The concept of ‘wealth maximization’ refers to the gradual growth of the value of assets of the firm in terms of benefits it can offer. The wealth maximization attained by an organization is reflected by the market value of shares. It is the method of creating wealth in an organization. Wealth maximization given importance on net present value of a business. Mathematically NPV can be equated as equal to the gross present value of the benefits minus the amount invested to receive such benefits. Net Present Value (NPV) can be derived by using the following formula: CI CI2 CI3 CI2 C0 NPV = 1 + + +........+ - 1+r 1+r 1+r 1+r 1+r 1 2 3 2 0 n CIi C0 NPV = - 1+r 1+r i 0 i1 = Sum of present value of cash inflow – cash outflows Where, CI = Cash inflows, r = Rate of return (discount rate) n = Numbers of years, Co = Cash outflows Further, the wealth of an organization should be maximized by keeping in mind the various factors like avoiding high level of risk in business, paying regular dividends to the shareholders which increases the goodwill of the company and maintaining the stable growth in sales, along with social responsibility of business and coping up with restrictions imposed by government body. Amity Directorate of Distance and Online Education 10 Financial Management Notes Maximization wealth of shareholders i.e. maximization of value of share (market value of share) is the aim of wealth maximization. It is a long run goal and indicates wealth for growth, survival of overall interest of the business. Wealth i.e. economic value i.e. presents value of future cash flows generated by a decision, discounted at opportunity rate of discount repressing the amount of risk. Economic value gives importance on cash flow rather than profit i.e. the value of the firm – market price of the company’s stock. Market value of the share at long run takes into account • Present and prospective future earning per share. • Timing and risk of these earning. • Dividend policy of the firm and retain earning policy. • Risk and return mix of the firm which related to inflation, cost of living etc. • Technical factors machinery, manpower, technology, mass physiology, goodwill, name fame. • The wealth maximization structurally related to investment decision, financial decision and dividend decision. • The market price of share= EPS x capitalization rate. • EPS = profit afire tax / No. of equity share. • Capitalization rate = How much profit return by firm in % • Shareholder’s current wealth = No of share held x current price of stock. Features of Wealth Maximization 1. Protection of interest of shareholders: Shareholders interest is protected by increased market value of their holdings in the firm. 2. Security to financial lenders: It provides security to short term and long term financial lenders, who supply funds to the business enterprise. Short term lenders are interested in the firm’s liquidity position, whereas long term lenders enjoy priority over shareholder at the time of return of funds besides getting fixed rate of interest. 3. Protection of interest of the employees: Employees contribution is a primary consideration in raising the wealth of an enterprise. Their productivity and efficiency ultimately leads to fulfilling company’s objective of wealth maximization. 4. Survival of Management: Management is a representative body of shareholders. When shareholders interest is protected, they may not wish to change the management and hence it can survive for a longer period of time. 5. Interest of society: When all the available productive resources are put to optimum and efficient use, economic interest of the society is served. Advantages of Wealth Maximization i) Wealth maximization is a clear term. Here, the present value of cash flow is taken into consideration. The net effect of investment and benefits can be measured clearly. ii) It considers the concept of time value of money. The present values of cash inflows and outflows help the management to achieve the overall objectives of a company. iii) The concept of wealth maximization is universally accepted, because, it takes care of interests of financial institution, owners, employees and society at large. iv) Wealth maximization guides the management in framing consistent strong dividend policy, in order to earn maximum returns to the equity holders. Amity Directorate of Distance and Online Education Introduction to Financial Management 11 v) The concept of wealth maximization considers the impact of risk factor. While Notes calculating the ‘Net Present Value’ at a particular discount rate, adjustment is made to cover the risk that is associated with the investments. Disadvantage of Wealth Maximization 1. Absence of and efficient capital market. 2. It is a prescriptive idea. 3. It is not socially desirable. 4. Ignores other stakeholders. 5. Creates conflict between managerial interest and owners interest. Favourable Arguments for Wealth Maximization (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 is total value deducted 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. (vi) The concept of wealth maximization is universally accepted, because it takes care of interest of financial institutions, owners, employees and society at large. (vii) Wealth Maximization guide the management in framing consistent strong dividend policy to reach maximum returns to the equity holders. Unfavourable Arguments for Wealth Maximization (i) Wealth maximization is nothing but profit maximization, it is the indirect name of the profit maximization. Because the ultimate aim of the wealth maximization objectives is to maximize the profit. (ii) Wealth maximization creates ownership-management controversy. (iii) Management alone enjoys certain benefits. (iv) Wealth maximization can be activated only with the help of profitable position of the business concern. (v) There is some controversy as to whether the objective is to maximize the stockholders wealth or the wealth of the firm, which includes other financial claimholders such as debenture holders, preference shareholders etc. 2. General Objectives The general objective of the business considers the following: 1. Balance assets structure: A proper balance between the fixed and current assets is an important factor for efficient management of funds. This is one of the objectives of financial management where the size of current asset must permit the company to exploit the investments on fixed assets. The subject of financial management must have a goal of maintaining balanced asset structure of company. The sizes of fixed assets are to be decided scientifically. The size of current assets must permit the company to exploit the investment on fixed assets. Therefore balanced asset structure has to be maintained. Amity Directorate of Distance and Online Education 12 Financial Management Notes 2. Liquidity: Liquidity refers to available cash and it is an indication of positive growth of a company. It is an important factor for meeting the short and long term obligations of a firm. The liquidity objective of a company will exploit the long-term vision of the company. If a firm is liquid it is an indication of positive growth. Hence company should maintain liquidity. 3. Proper planning of funds: Proper planning of funds includes acquisition and allocation of funds in the best possible manner i.e. minimum cost of acquisition of funds but maximum returns through wise decisions. The concept of wealth or profit maximization is achieved only when a company reduces its overall cost with judicious planning about requirement of funds and application of funds and also with proper blend of different sources in the capital structure. 4. Efficiency: Efficiency and effectiveness are very much necessary in controlling the flow of funds. The efficiency level should continuously increase for the betterment of organisation. 5. Financial discipline: There shouldn’t be any bulk handling of funds, misuse etc. Proper discipline should be practiced in matters relating to finance, its flow and control. This can be done through various techniques such as budgeting, fund flow statements etc. In recent scenario country has witnessed different types of scandals, financial indiscipline, window dressing etc. Hence it has become an obligatory responsibility of a company to have financial discipline through various financial management techniques to uplift the dignity of the company and also it is moral responsibility of corporate. Distinguish between Profit Maximization and Wealth Maximization Profit Maximization Wealth Maximization 1. Profit cannot be ascertained well in 1. There is no vagueness in wealth advance to express the probability of maximization goal. It represents the return. The term profit has no clear value of benefits minus the cost of meaning. investment. 2. The executive or the decision maker 2. It is argued that a firm’s goal cannot may not have enough confidence in the be, to maximize profits but to attain estimates of future returns so he does a certain level or share of the market not attempt to maximize further. or certain level of sales. 3. The risk variations and related 3. Inwealth maximization, it is capitalization rate is not considered in considered that there should be the concept of profit maximization. balance between expected return and risk. 4. The goal of profit maximization is 4. The goal of wealth maximization is considered as narrow outlook. considered as broad outlook. 5. It ignores the interests of the 5. Its objective is to enhance the community. shareholders wealth. 6. The criterion of profit maximization 6. Wealth maximization concept fully ignores the time value factor for the considers the time value factor of profits of a project. cash inflows. Amity Directorate of Distance and Online Education Introduction to Financial Management 13 1.6 Who is a Finance Manager? Notes Finance Manger is a person who heads the department of finance. He performs important activities in connection with each of the general functions of management. His focus is on profitability of the firm. Finance manager is a person who manages the activities pertaining to financial activities and accountable for an organization .His primary focus is on profitability. Every business, irrespective of its size should have a financial manager who has to make decisions on the allocation and use of money to various departments. i.e., finance manger should anticipate financial needs; acquire financial resources and allocate funds to various departments of the business. Since finance is an integral part of top management activity, his decision plays a major role in overall development of the business. 1.7 Function of Corporate Financial Manager The following are the important functions of finance manager: 1. Estimation of the financial requirements: The requirement of finance in a business is perpetual and it is required in all stages of business cycle from initial stage to decline stage. Finance manager plans the required funds to meet capital expenditure and revenue expenditure i.e., Financial Manager should anticipate and estimate the total financial requirements of the firm i.e., preparing sound financial plan (Financial forecasting and Planning). 2. Selection of the right sources of funds: After estimating the funds required for business, the finance manager has to select the right source of funds at the right time at right cost i.e., balancing the own capital (equity) and borrowed capital (debt) for the best advantage of the firm. 3. Allocation of funds: After mobilizing the total funds required for a firm, financial manager has to distribute the funds to capital and revenue expenditure. The evaluation of different proposals should be made before making a final decision on investment. Each investment should yield maximum benefits resulting in wealth maximization of the firm. Therefore Financial Manger has to allocate the available funds in the profitable avenues i.e. judicious fund allocation. 4. Analysis and interpretation of financial performance: It is the other task of finance manger which should not be ignored. He has to monitor the performance of each portfolio that can be measured in terms of profitability and returns on investment. Ratio analysis and comparison of actual with standards, aid financial manager to have maximum control over the entire operations of the business i.e. continuous financial appraisal activity. 5. Working capital management: Working capital refers to short term investments in business such as cash receivables, inventories etc. It can be said that working capital management is the nervous system of finance. Therefore, Finance manger has to administrate the activities of working capital management 6. Profit planning and control: Profit is the purpose of any business. It acts as a tool for evaluating the performance of financial management. It is determined in terms of volume of revenue generated and expenditure incurred in the business. Profit maximization is considered as an important objective of a business .Profit planning and control directly impacts the declaration of dividend, creation of surpluses, taxation, etc. Break-evenanalysis and cost-volume profit Amity Directorate of Distance and Online Education 14 Financial Management Notes analysis are the tools required in profit planning and control. Hence, Finance Manger has focus on profit planning and control. 7. Fair returns to the investors: Returns are the profits available to investors. Equity share holders generally expect fair amount of profit and capital appreciation for their investment. It is also an economic obligation on the part of the organization to protect the interest of shareholders. This can be a motivating factor for investors in to invest in securities. Hence, a business firm must guarantee regular income to the shareholders. 10. Maintaining liquidity: Another important task of financial manager is to maintain liquidity, because liquidity of a firm increases the borrowing capacity of the firm. 1.8 Role of a Finance Manager Financial activities of a firm are vital part of an organization and it is complex. In order to take care of these activities a finance manager performs requisite financial activities. A finance manager is a person who is responsible for all the important financial functions of an organization. The decisions taken by finance manager will affect the profitability, growth and goodwill of the firm. Following are the main functions of a finance manager: 1. Raising of Funds In order to meet the obligation of the business, it is important to have enough cash and liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a finance manager to decide the ratio between debt and equity. It is important to maintain a trade-off between equity and debt. 2. Allocation of Funds Once the funds are raised through different channels, the next important function is to allocate the funds. The funds should be allocated in such a manner that they are optimally used. In order to allocate funds in the best possible manner, the following points must be considered. a) The size of the firm and its growth capability. b) Status of assets whether they are long term or short term. c) Mode by which the funds are raised. These financial decisions directly and indirectly influence other managerial activities. Hence formation of a good assets mix and proper allocation of funds is one of the most important activities. 3. Profit Planning Profit earning is one of the prime functions of any business organization. Profit earning is important for survival and sustenance of any organization. Profit planning refers to proper usage of the profit generated by the firm. Profit arises due to many factors such as pricing, industry competition, state of the economy, mechanism of demand and supply, cost and output. A healthy mix of variable and fixed factors of production can lead to an increase in the profitability of the firm. Fixed costs are incurred by the use of fixed factors of production such as land and machinery. In order to maintain a tandem it is important to continuously value the depreciation cost and fixed cost of production. An opportunity cost must be calculated in order to replace those factors of production which has gone through Amity Directorate of Distance and Online Education Introduction to Financial Management 15 wear and tear. If this is not noted then these fixed cost can cause huge fluctuations in Notes profit. 4. Understanding Capital Markets Shares of a company are traded on stock exchange and there is a continuous sale and purchase of securities. Hence a clear understanding of capital market is an important function of a finance manager. When securities are traded on stock market there involves a huge amount of risk. Therefore a finance manger understands and calculates the risk involved in this trading of shares and debentures. It is on the discretion of a finance manager to decide about how to distribute the profits. Many investors do not like the firm to distribute the profits amongst share holders as dividend instead invest in the business itself to enhance growth. The practices of a financial manager directly impact the operation in capital market. As financial activities of a firm is a vital part of an organization, financial manager has to be careful in decision making pertaining to financial activities as it will impact the profitability of an organization and goodwill. 1.9 Financial Management Decision Financial decisions refer to the decisions concerning financial matters of a business concern. There are many kinds of financial management decisions that the firm makes in pursuit of maximizing shareholder’s wealth, viz, kind of assets to be acquired, pattern of capitalization, distribution of firm’s income. Major Financial Decision Financial decision can be divided into following catagories: Fig: Types of Financial Decision 1. Investment Decisions Investment decisions is referred to the activities of deciding the pattern of investments. It covers both short term as well as long term investment, nothing but fixed assets and the current assets. Long term investment decision is about the allocation of capital to investment projects whose benefits accrue in the long run, where as short term investment decision is about allocation of funds as among cash and receivables and inventory etc. The funds invested in assets should also yield maximum return to the business concern. Amity Directorate of Distance and Online Education 16 Financial Management Notes Hence, it is a risky decision where finance manager has to take maximum care in selecting the areas of investment. As the future is uncertain the returns expected must cover both risk as well as the uncertainties. The selection of proposal can be evaluated by using certain techniques such as costing technique, capital budgeting, CVP analysis etc., before making a final decision on the investment avenues. Investment decisions pertain to the determination of total amount of assets to be held in the firm. It is the most important decision since funds involve cost and are available in a limited quantity. Its proper utilization is necessary to achieve the goal of wealth maximization. Investment decisions can be classified into two categories: (i) Long term investment decisions (ii) Short term investment decisions (i) Long term investment decisions The long term investment decisions is referred to as the capital budgeting decisions. Capital budgeting is the process of making investment decisions in capital expenditure. These are expenditure, the benefit of which is expected to be received over a long period of time. The finance manager has to assess the profitability of various projects before committing funds. The investment proposal should be evaluated in terms of profitability, cost involved and risk associated with the project. (ii) Short term investment decisions They are also called as working capital decisions. It is related to allocation of funds towards current assets. Short term decisions ensure sound liquidity position. 2. Financing Decisions It is another important decision where a business concern has to take maximum care in financing different proposals. The profitability of the business depends upon the appropriate blend of finance with debt and equity. The instruments that are to be selected must aim at maximizing returns to the investors and to protect the interest to the creditors. Decision with regard to the combination of the capital structure is vital. The finance manager must decide the mode of raising the funds to meet the firm’s investment requirement. He has to select such sources which will minimize the cost of capital and maximize the profitability. The debt equity ratio should be fixed in such a way that it helps in maximizing profitability of the concern. Raising of more debt will involve fixed interest. It may help in increasing the return on equity but will also enhance risk. Therefore a finance manager has to strike a balance between debt and equity The finance manager should have an alternative of mobilizing the funds through: (i) Equity. (ii) Equity plus debt. (iii) Equity plus preference share. (iv) Equity plus preference share plus debt. Each opportunity must be evaluated with its benefits. If a company opts only for equity it loses its tax benefits. If it opts for both debt and equity proper balance must be maintained between the two. For instance, a finance manager would like to have more debt and less equity. This may bring in more dividends to shareholders and results in increase price of the share in the market, may lead to wealth maximization. But the cost Amity Directorate of Distance and Online Education Introduction to Financial Management 17 of borrowed funds may increase the risk of the business concern. Most of the earnings Notes will be used only on the payment of interest on the borrowed funds which is also called as ‘financial risk’. Hence the finance manager has to take a risky and tactful decision regarding the capital structure. 3. Dividend Decisions The term dividend decisions refers to quantum of profits to be distributed among shareholders and the quantum of profits to be retained earnings. The higher rate of dividend may increase the market price of the shares and thus maximize the wealth of the shareholders. A dividend decisions are the next major financial decision. The finance manager must decide whether the firm should distribute all profits or retain them or distribute a portion and retain the balance. The portion of the profit distributable as dividends is called the dividend payment ratio and the balance is termed as retained earnings. The distribution of profit as dividends should fulfill the desires of equity shareholders. Maintenance of stable dividend rate over the period attracts the investors. Hence a finance manager must take a careful decision in distribution of profits, keeping in view the psychology of investors who wish to get a better yield on the investment. 1.10 Scope of Financial Management Financial management is mainly concerned with acquisition and use of funds by an organization. Earlier the scope of financial management was limited to procurement of funds. But in current scenario, there is enormous change in the business decision making process especially in the areas of financing, investment and dividend. The key objective of financial management is to organize funds for meeting short term and long term needs of an organization. The funds procured should be at minimum costs to ensure profitability of the business. Finance manager should formulate strategies for the growth of firm. Given below is the list of activities to be performed in order to meet the needs of an organization. 1. Evaluation of financial requirement The first and foremost task of a finance manager is to estimate long term and short term financial requirements. The evaluation should be based on sound financial plan so that purchasing fixed assets and funds required for working capital will be ascertained in a right manner. The financial plan should estimate the funds accurately as excess funds may tempt the organization to indulge in unnecessary expenditure. On the contrary, inadequacy of funds may adversely affect the operations of the business and idle cash may not fetch any returns to the business. 2. Formation of capital structure After deciding the quantum of funds to be raised for the business, the task of the finance manager remains in framing the capital structure. Capital structure refers to the kind and proportion of different securities for raising such funds. A decision about various sources of funds should be linked to the cost of raising funds. A proper blend of equity and debt should be made up in the business to finance long and short term requirement. 3. Sources of finance An appropriate source of finance is selected after the formation of capital structure. Various sources from which finance may be raised, include share capital, debentures, financial institutions, commercial banks, public deposits etc. Finance required for short- Amity Directorate of Distance and Online Education 18 Financial Management Notes term include banks, financial institutions and public deposits. Whereas in long-term, share capital, debentures and borrowing from financial institutions can be selected. 4. Choice of Investment plans After procuring the required funds decision about the use of funds is to be made. i.e., a decision about the proper allocation of funds in fixed assets and working capital has to be made. While allocating funds, those assets which are appropriate to the business are to be selected so that it can provide higher returns to the enterprise. To choose the best option, various techniques may be employed such as capital budgeting, cost volume profit analysis etc. in making decisions about capital expenditures. 5. Cash Management Cash is one of the important aspects of financial management. Cash is a liquid asset which has to be maintained appropriately so as to cater to the various needs of the business on time. For example, cash may be required to purchase raw materials, make payments to creditors, pay rent, bills etc. To provide timely payment, there should be regular inflow of cash. Some of the sources of inflow are cash sales, collection of debts and short term arrangement with banks etc. There should be proper trade off between cash inflow and outflow for efficient operations in business. 6. Implementation of financial controls After allocating the funds, the task of the finance manager will not end. Proper control is essential for efficient system of financial management. Various control devices such as return on investment, budgetary control, break even analysis etc. can be used as a measure to analyze the performance. Further it helps him to make corrective measures whenever needed. 7. Usage of surpluses The scope of the finance manager implies on the effective and efficient utilization of the profits or the surpluses in the business. The surplus gained in the business may boon the expansion and diversification in the business relatively increasing the confidence in the minds of the share holders, consistently increasing the market value of shares which lead to wealth maximization. But a proper balance has to be made in using funds for paying dividend and retaining earnings for future plans in the business. 1.11 Approaches of Financial Management Financial management has undergone significant changes over the years. So as the role of finance manager. The approaches are classified into: A. Traditional Approach In traditional approach, the role of financial management is limited to raising and administering of funds needed by the business enterprises to meet their financial needs. It generally covers the following areas: i) Management of funds from financial institutions. ii) Arrangement of funds through financial instruments such as shares, bonds, debentures etc. iii) Administering of funds. Thus, the role of finance manager is limited to raising the funds externally. He is expected to keep accurate financial records, prepare reports on the company’s status. Amity Directorate of Distance and Online Education Introduction to Financial Management 19 The traditional approach evolved during 1920 confined to dominate, later in 1950’s Notes it started to be severely criticized on account of the following reasons. (i) It ignored balancing of funds for routine problems in an enterprise. (ii) It ignored non corporate enterprises. (iii) No emphasis made on allocation of funds. This approach was concentrated with the raising and administering of funds. It treated finance from the viewpoint of outsiders viz., bankers, investors, etc., It completely ignored the viewpoint of those who had to take internal financing decisions. This approach emphasized on the problems faced by long term financing but ignored short term finance or working capital. B. Modern Approach According to modern concept, financial management is concerned with both acquisitions and allocation of funds as well. The modern approach is an analytical way of looking at the financial problems of an organization. It relates to broad areas of financial management like funds requirement decision, financing decision, investment decision and dividend decision. An existing modern theory of financial management is expressly concerned with the relation between profitability and the volume of capital used, indicating clear shift from controlling the sources and application of funds to the function of efficient and effective use of funds. Finance manager should be able to perform decisions by allocating the total funds required by an organization and provision of funds at the right time. Apart from this, finance manager is also involved in evaluating different investment proposals. Eventually, the dividend policies decisions will reflect the profits earned by an organization which has to be paid to its shareholders. The modern approach in finance is of decision making related to various facets of financial planning and control. 1.12 A’s of Financial Management 1. Anticipating financial requirements Financial needs can be anticipated by forecasting expected funds for a business and recording their financial implications. The finance manager anticipates the financial needs by consulting and collection of documents such as: 1. Cash budget which is essentially a cash flow statement. 2. A Proforma of income statement summarizing sales, other costs, taxes and net income for the period. 3. A Proforma of balance sheet showing the assets and liabilities during the forecast period and 4. A statement of sources and uses of funds showing where the funds, to operate the business will come from and how they will be absorbed during the period. 2. Acquiring financial resources It refers to when, where and how to obtain the funds which a business needs. Funds should be acquired well before the need for them is actually felt. The finance manager should know how to tap different sources of funds both short term and long term. At a Amity Directorate of Distance and Online Education 20 Financial Management Notes given point of time, generating different financial sources may vary significantly according to the terms and conditions, size and strength of the borrowing corporation. The financial image of a business has to be improved in appropriate financial circles which are primarily responsible for supplying finance. 3. Allocating funds in Business Investing funds in the best plan of assets in a business is called allocation of funds. Assets are balanced by weighing their profitability against their liquidity. Profitability refers to the earning of profits. Liquidity means closeness to money. The finance manager should also be careful in controlling funds between over and under financing. This primary financial responsibility from the owner’s viewpoint may be to maximize value. To do so, he has to preserve the continuity of the flow of funds so that no essential decision of the top management is frustrated for the lack of purchasing power. 4. Administering the allocation of funds Once funds are allocated on various investment opportunities, it is the basic responsibility of the finance manager to watch the performance of each rupee that has been invested. A close supervision will ensure continuous flow of funds as per the requirements of the organization. This will help the management to increase is efficiency by reducing the cost of operations and earn fair amount of profits out of those investments. 5. Analyzing the performance of finance Once funds are administered, the finance manager should continuously analyze the performance of finance by comparing the actual with standards. The cost of each financial decision and returns of each investment must be analyzed. Wherever deviations are found necessary steps of strategies are to be adopted to overcome such events. This helps in achieving liquidity of a business unit. 6. Accounting and reporting to the management The finance manager has to advice and supply information about the performance of finance to the top management. He is also responsible for maintaining up to date records of the performance of financial decisions. The finance manager will have to keep all assets intact, which is necessary to conduct its business. It is also necessary for the finance manager to ensure that sufficient funds are available for the smooth conduct of business. Liquidity and profitability has to be given significance while considering management of funds. Financial management is concerned with many responsibilities which are the main thrust of a business enterprise. Although a business failure may not always be the result of financial failures, but financial failures do lead to business failures. Hence accounting and reporting of the performance of finance is an important aspect of financial management. 1.13 Methods or Tools of Financial Management Methods and tools of financial management are needed for financing, investment. Here we are given important methods and tools of financial management. 1. Tools of Financial Management for Financing a) Financial Leverage: In this tool, finance manager fixes his need of financing. Over and low financing estimation may be harmful for company. Optimum loan requirement is fixed with financial leverage tool. Learn about it at here. Amity Directorate of Distance and Online Education Introduction to Financial Management 21 b) Selection Best Source of Finance: In this tool, finance manager analyze Notes different source of financing. He check their rates, repayment terms and other conditions and then choose best option. 2. Tools of Financial Management for Investing Decision These tools are used to know which is best alternative of investment. Will this alternative give us best return at minimum risk. Capital budgeting, internal rate of return, net present value. In the area of investment in current assets, we use working capital management for knowing best investment in current assets. a) Capital Budgeting: Capital budgeting refers to the process of making decision regarding capital investment in fixed assets such as machinery, land, buildings, furniture etc. It is a long term plan to make and finance proposed capital outlay. b) IRR: Under this method the cashflows of a project are discounted at a suitable rate by hit and trial method, which equates the net present value so calculated to the amount of the investment. The discount rate is determined internally. The IRR can be defined as that rate of discount at which the present value of cash inflows is equal to the present value of cash outflows. c) NPV: Net present value can be explained quite simply, though the process of applying NPV may be considerably more difficult. Net present value analysis eliminates the time element in comparing alternative investments. d) Working Capital Management: Working capital management involves deciding upon the amount and composition of current assets and the manner in which it is financed. The finance manager must take utmost care in determining the appropriate level of working capital. The greater the amount of working capital level maintained, lesser the risk of running out of cash profitability will be less. 1.14 Challenges of Financial Manager in Global Scenario 1. Investment Planning: Investment planning focuses on effective investment strategies and to analyze the risk associate with it. Finance manager is responsible for analyze the risk and help management to reduce this risk so that it does not affect the financial goal of an organization. 2. Financial Structure: Financial structure is the way in which company assets are financed such as short term, borrowings long term debt and equity. Finance manager analyze the government rules and regulation, bank norms, capability of the organization and the available options in the market to finance the company’s assets. That helps management to decide which option is profitable for the organization. 3. Treasury Operations: Treasury operations is basically the overall responsibility for administering the banking functions of organization, cash management and investment services. These all activities are directly linked with the growth of organization and profit. 4. Investor Communication: Finance department provides investors with an accurate account of the company’s affairs. This helps investors to make informed buy or sell decisions. 5. Management Control: Control is one of the managerial functions like planning, organizing, directing etc. It basically includes the three steps, to set the standards, measure actual performance and taking corrective action. Finance manager help organization to set the targets and helps organization to achieve Amity Directorate of Distance and Online Education 22 Financial Management Notes that target by continuously monitoring the actual performance with set standards. Clearly, the clout of the finance manager is growing along with the change in his role and reforms in the financial sector gather speed, this trend will only increase. 1.15 Interface of Financial Management with other Functional Areas Finance is the basis of different economic activities like production, human resources, marketing and research and development. It is mandatory in every organization whether small, big, public sector, government organizations, finance becomes central focus of an organization backing other departments by utilizing proper financial tools and techniques resulting in effective functioning of an organization. The figure given below shows the relation of finance with other areas of management. Relationship to HR HR activities include recruitment, training, and development, fixing compensation, incentives, promotion and providing other benefits. All these activities need finance. Therefore before going to take any of these decisions HR managers need to consult finance manager. Finance manager takes decision after studying the impact of HR activity on organization. Therefore, there is relation of HR function. Relationship of Production Production department is another functional area that involves huge investment on fixed assets (machines and tools). For example production of new product requires new machinery, which involves capital investment. Before going to select machinery, he/she needs to evaluate the machine or equipment and select some cases changing manufacturing process. Improper evaluation involves huge consequences on the firm. Thus production manager and finance manager need to work closely for effective investment (optimum investment) on plant and machinery. Relationship of Marketing Marketing functions involves selection of distribution channel and promotion policies. These two are the primary activities of marketing department and involves huge cash outflows. Therefore, finance and marketing managers need to work with coordination for maximize value of the firm. Relationship to R&D Innovation of products and process is the only way to survive in the competitive market. Innovation needs to invest funds on R&D. But R&D department does not give guarantee of development. Therefore it does not mean that financial manager should not provide funds, or cut funds heavily to R&D. It should be given importance and try to make balance. Relationship with accounting Finance is also connected with accounting. Accounting is a staff function which supplies data to top management, financial management, sales management, production management and personnel management. The finance manager requires accurate and scientifically arranged financial records of the enterprise to guide him in managing the inflow and outflow of funds. Relationship with Purchasing Department Materials required for production of commodities should be procured on economic terms and should be utilized in efficient manner to achieve maximum productivity. In this Amity Directorate of Distance and Online Education Introduction to Financial Management 23 function the finance manager plays a key role in providing finance. In order to minimize Notes cost and exercise control various materials management techniques such as Economic Order Quantity (EOQ), determination of stock levels, perpetual inventory systems are applied. The task of finance manager is to arrange the availability of cash when the bills for purchase become due. 1.16 Summary Finance is the area of economic activity in which money is the basis of various embodiments, whether stock market investments, real estate, industrial, construction, agricultural development and so on. Financial management is the area of business management devoted to a judicious use of capital and a careful selection of sources of capital in order to enable a business firm to move in the direction of reaching its goals. Profit maximization refers to the process where in companies focus on maximizing their profit or getting the best possible profit in the particular kind of business. Under profit maximisation companies experience the best output and price levels in order to maximize its return. In simple Profit maximization implies maximizing the Rupee income of the firm. Wealth maximization refers to the gradual growth of the value of assets of the firm in terms of benefits it can offer. The wealth maximization attained by an organization is reflected by the market value of shares. It is the method of creating wealth in an organization. Working capital refers to short term investments in business such as cash receivables, inventories etc. It can be said that working capital management is the nervous system of finance. Therefore, finance manger has to administrate the activities of working capital management. Finance Manger is a person who heads the department of finance. He performs important activities in connection with each of the general functions of management. His focus is on profitability of the firm. Financial decisions refer to the decisions concerning financial matters of a business concern. There are many kinds of financial management decisions that the firm makes in pursuit of maximizing shareholder’s wealth, viz, kind of assets to be acquired, pattern of capitalization, distribution of firm’s income. 1.17 Check Your Progress I. Fill in the Blanks 1. It is argued that profit maximisation assumes………………….and in the face of imperfect modern markets, it cannot be a legitimate objective of the firm. 2. Profit cannot be ascertained well in advance to express the …………….as future is uncertain. 3. Profit is not defined precisely or correctly under ……………objective. 4. It creates some unnecessary opinion regarding earning habits of the …………….concern. 5. Short term investments in business such as cash receivables, inventories etc. is called………………… Amity Directorate of Distance and Online Education 24 Financial Management Notes II. True or False 1. Marketing refers to all activities to identify the customer, satisfy the customer and keep the customer. 2. Profit cannot be ascertained well in advance to express the probability of return as future is certain. 3. 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. 4. It does not leads to certain differences between the actual cash inflow and net present cash flow during a particular period. 5. Profit maximization objectives leads to inequalities among the stake holders such as customers, suppliers, public shareholders etc. III. Multiple Choice Questions 1. Available cash and it is an indication of positive growth of a company is termed as; [a] Finance [b] Demand [c] Liquidity [d] Financial management 2. Management of the monetary affairs of a company is called as [a] Finance [b] Finance function [c] Financial management [d] Liquidity management 3. Process that increases the current net value of business; [a] Profit [b] Profit maximization [c] Wealth [d] Wealth maximization 4. The usual sources of cash may be: [a] cash sales [b] collection of debts [c] short-term arrangements with banks [d] all the above 5. Decision of financial mathematics in management is as follows: [a] Investment Decision [b] Planning decision [c] Economic Decision [d] None of these Amity Directorate of Distance and Online Education Introduction to Financial Management 25 1.18 Questions and Exercises Notes I. Short Answer Questions 1. Give the meaning of finance. 2. What is financial management? 3. What do you mean by profit maximisation? 4. What is wealth maximisation? 5. Give the meaning of financial manager. 6. What is financial decision? II. Extended Answer Questions 1. Explain the nature and scope of financial management. 2. Explain the needs for financial management. 3. Explain the importance of financial management. 4. State and explain in brief the different objectives of financial management. 5. Explain the functions of corporate financial manager. 6. State the advantages of wealth maximisation. 7. Evaluate the Wealth and Profit Maximisation as primary objectives of a concern. 8. Discuss the Major Financial Decision. 9. Discuss the methods and tools of financial management. 10. Explain the challenges of financial manager in global scenario. 11. Discuss interface of financial management with other functional areas. 1.19 Key Terms Finance: is the management of the monetary affairs of a company. Finance function: can be defined as procurement of funds and their effective utilization in the business. Financial management: is an area of financial decision making, harmonizing individual motives and enterprise goals. Wealth maximisation: is a process that increases the current net value of business or shareholder capital gains, with the objective of bringing in the highest possible return. Liquidity: Liquidity refers to available cash and it is an indication of positive growth of a company. Working capital: refers to short term investments in business such as cash receivables, inventories etc. 1.20 Check Your Progress: Answers I. Fill in the Blanks 1. Perfect competition 2. Probability of return 3. Profit maximization Amity Directorate of Distance and Online Education 26 Financial Management Notes 4. Business 5. Working capital II. True or False 1. True 2. False 3. True 4. False 5. True III. Multiple Choice Questions 1. (c) 2. (a) 3. (d) 4. (d) 5. (a) 1.21 Case Study Case - 1 Ram is a successful business man in the paper industry. During his recent visit to his friend’s place in Bengaluru, he was fascinated by the exclusive variety of incense sticks available there. His friend tells him that Mysore region in known as a pioneer in the activity of Agarbathi manufacturing because it has a natural reserve of forest products especially Sandalwood to provide for the base material used in production. Moreover, the suppliers of other types of raw material needed for production follow a liberal credit policy and the time required to manufacture incense sticks is relatively less. Considering the various factors, Ram decides to venture into this line of business by setting up a manufacturing unit in Mysore. In context of the above case: 1. Identify of the above case: 2. Identify the three factors mentioned in the paragraph which are likely to affect the working capital requirements of his business. Case - 2 Parthoz is a company enjoying market leadership in the food brands segment. It’s portfolio includes three categories in the Foods business namely Snack Foods, Juices and Confectionery. Keeping in the with the growing demand for packaged food it now plans to introduce ready-To-Eat Foods. Therefore, the company has planned to undertake investments of nearly Rs. 500crores for its new line of business. As per the current financial report, the interest coverage ratio of the company and return on investment is higher. Moreover, the corporate tax rate is high. Amity Directorate of Distance and Online Education Introduction to Financial Management 27 In context of the above case: Notes 1. As a financial manager of company, which source of finance will you opt for debt or equity, to raise the required amount of capital? Explain by giving any two suitable reasons in support of your answer. 2. Why are the shareholder’s of the company like to gain from the issue of debt by the company? 1.22 Further Readings 1. Damodaran, A. 1995, Corporate Finance: Theory and Practice, 1st Ed., Wiley & Sons. 2. Pandey, I.M. 1999, Financial Management, 8th Ed., Vikas Publishing House 3. Brearly, R. A. and Myers, S. C. 1996, Principles of Corporate Finance, 4th Ed., Tata McGraw Hill 4. Pike, R and Neale, B. 1998, Corporate Finance and Investment: Decisions and Strategies, Prentice Hall of India 5. Van Horne, J.C. 1995, Financial Management and Policy, 10th Ed., Prentice Hall of India. 6. Rustagi, R.P. 1999, Financial Management: Theory, Concepts and Problems, Galgotia Publishing Company. 7. Chandra, P. 1999, Financial Management: Theory and Practice, 4th Ed., Tata McGraw Hill. 1.23 Bibliography 1. Financial Management, V K Bhalla,1st Edition- S.Chand 2014. 2. Fundamentals of Financial Management, Brigham & Houston, 10/e, Cengage Learning. 3. Corporate Finance, Damodaran, 2/e, Wiley India (P) Ltd., 2004 4. Financial Management - Prasanna Chandra, 8/e, TMH, 2011. 5. Financial Management, Shashi K Gupta and R K Sharma, 8th Revised Edition, Kalyani Publishers, -2014 6. Financial Management, Khan M. Y.& Jain P. K, 6/e, TMH, 2011. 7. Weston & Brigham, Essentials of Managerial Finance, The Dryden Press. 8. Financial Management, Rajiv Srivastava and Anil Misra, Second edition, Oxford University Press, 2011 9. John Hampton, Financial Decision Making – concepts, problems & cases, Prentice Hall of India 10. Meir Kohn: Financial Institutions and Markets, Tata McGraw Hill 11. Financial Management, I M Pandey, 10th Edition, Vikas Publishing House - 2014 12. Financial Management & Policy- Vanhorne, James C., 12/e, Pearson, 2002 13. Financial Management, Pralhad Rathod, Babitha &S.Harish Babu, Himalaya Publishing House, 2015 14. Financial Management, Paresh P., Shah 2/e, Biztantra. Amity Directorate of Distance and Online Education 28 Financial Management Notes 15. Fundamentals of Financial Management, Sheeba Kapil, Pearson, 2013 16. Financial Management, Sumit Gulati & Y P Singh, Mc Graw Hill, New Delhi - 2013 17. Beckman, Theodore N. (1992): Credits and Collection Management and Theory, Me Graw Hill, New Delhi. 18. Brigham, Eugene F. and Risks, R Bruce (1998): Readings in Essentials of Management, Finance, Holt, Rinehart and Winston. U.S.A. 19. Bucha, Jooseeph and Koenigsberg ernest (1970): Scientific Inventory Management, Prentice Hall of India, Pvt. Ltd., New Delhi. 20. Chakraborthy & others, Financial Management and Control, Mcmillan India Ltd. Amity Directorate of Distance and Online Education Time Value of Money 29 Notes Unit 2: Time Value of Money Structure: 2.1 Introduction 2.2 Need for Time Value of Money 2.3 Calculation of Techniques in Time Value of Money 2.4 Future Value 2.5 Present Value 2.6 Present Value Technique or Discounting Technique 2.7 Annuity 2.8 Perpetuity 2.9 Summary 2.10 Check Your Progress 2.11 Questions and Exercises 2.12 Key Terms 2.13 Check Your Progress: Answers 2.14 Case Study 2.15 Further Readings 2.16 Bibliography Objectives After studying this unit, you should be able to understand: Meaning of Time Value of Money Need for Time Value of Money Techniques in Time Value of Money Future Value Present Value Present Value Technique or Discounting Technique Annuity Types of Annuity Amity Directorate of Distance and Online Education 30 Financial Management Notes 2.1 Introduction Time value of money is the common description for the general rule that cash in hand today is worth more than the same amount of cash in the future. The concept of the time-value of money is used for investment decisions. The concept of time value of money can also be described as the value of money received today has more value than the value of money received tomorrow. In short, the value of money depreciates with time. The concept of time value of money is helpful in estimating the current worth of a future sum of money or a cash flow stream at a specific rate of interest. The future cash flows are discounted at the discount rate. A higher discount rate indicates a lower present value of the future cash flows. The time value of money refers to the value of money existing in a given amount of interest which is earned during a specific time period. The time value of money can be explained as the central concept in finance theory. Moreover, the concept of time value of money also helps in evaluating a likely stream of income in the future in a manner that the annual incomes are discounted and added thereafter, thereby providing a lump- sum present value of the complete income stream. Almost all the standard calculations related to time value of money are derived from the most crucial expression for the present value of any future value which is discounted to the present value by an amount equivalent to the time value of money. Two factors typically contribute to the time value of money: • In a period of inflation, cash will have lower purchasing power in the future. • The cash could always be invested in a risk-free alternative instead of the investment under consideration. The interest that you would receive from the risk-free choice is a baseline. Any other investment must be compared against that baseline. The time-value of money is often expressed as an interest rate or a hurdle rate. The investment must earn money better than the hurdle rate or it should be rejected. Time value of money can be understood by the following example: An amount of 100 received today is worth more than 100 received one year later. As 100 can be invested today at a 7% interest, it will then fetch 107 a year later. The time value of money suggests that earlier receipts are more desirable than later receipts, because earlier receipts can be reinvested to generate additional returns before the later receipts come in. Meaning of Time Value of Money Time value of money refers to “time has got a value”. The rupee value keeps on changing over a period of time. The purchasing power of a rupee, is there increase or decrease but never remains constant. The concept of time value of money refers to the money received today is different in its worth from the money receivable at some other time in future. In other words the same principle can be stated as that money receivable in future is less valuable than the money received today. In other words, the time value of money for the money is its rate of return which the firm can earn by reinvesting its present money. This rate of return can also be expressed as a required rate of return to make equal the worth of money of two different time periods. Amity Directorate of Distance and Online Education Time Value of Money 31 2.2 Need for Time Value of Money Notes (i) Reinvestment opportunities: Money received today can be re-invested to get further return. If the rate of return is greater than zero, money has a net productivity of time, because a given sum of money a two points of time does not have the same value. It means that with the availability of profitable investment opportunities, a given sum of money can always be made to grow with the passage of time. (ii) Uncertainty: The present is more certain than the future which is full of imponderables. As a results there is a general preference for present rupees of future rupees which may or may not be received in full because of uncertainty. (iii) Inflation: During inflation, the value of money goes decreasing or the price level goes on increasing. As a result, people generally prefer the present to the future. (iv) Personal consumption preference: Mainly individuals have a strong preference for immediate rather than delayed consumption. The promise of a boil of rice next week counts for likely to the starving man. 2.3 Calculation of Techniques in Time Value of Money There are basically two techniques for calculation of time value of money: 1. Compounding technique 2. Discounting technique (present value technique) 1. Compounding Technique Compound value concept is used to find out the future value of present money. It is the same as the concept of compound interest, wherein, the interest earned in preceding year is reinvested at the prevailing rate of interest for the remaining period. Thus the accumulated amount (principal + interest) at the end of a period becomes the principal amount for calculating the interest for the next period. 2. Discounting technique Present Value Technique is a reverse of compounding technique and is also known as discounting technique. As these are future value of sums invested now, calculated as per the compounding techniques, there are also the present values of a cash flow scheduled to occur in future. 2.4 Future Value Future value is the value of an asset at a specific date which measures the nominal future sum of money wherein the sum of money is worth at a specified time in the future assuming a certain interest rate or more rate of return. It is the present value multiplied by the accumulation function. The values do not include corrections for inflation or other factors that affect the true value of money in the future. This is used in time value of money calculations. The present value grows into the future value by the action of compound interest. This relationship can be turned the other way about and we can say that the future value can be discounted back to its equivalent present value. This relationship between Future Value and Present Value is fundamental to the measurement of the time value of money. Amity Directorate of Distance and Online Education 32 Financial Management Notes Meaning of Future Value The future value refers to the value of an asset or cash at a particular date in the future which is equivalent to the value of a specified sum at present. The future value can also be explained as the amount of money which will be reached by a present investment as a result of its growth in the future. As money features time value, the future value is, obviously, expected to be higher than the present value. FV = PV(1+r)n FV = Future value PV = Present value r = Rate of interest n = Number of years The compounding technique is to find out the future value (FV) of the present worth of money, can be explained with reference to: a) The future value of a single present cashflows b) The future value of annuity/series of cashflows c) The future value of multiple cashflows. a) Future value of a single present cashflows Future value of a single present cash flow can be: 1. In case of annual compounding: FV = PV(1+r)n Illustration - 1 Find out the future value of a sum of 2,000 after a year with a time preference money of 12%. Solution: Calculation of future value: FV PV (1 r)n Where, FV = ? PV = 2,000 r = 12% = 0.12 n = 1 year FV 2000 (1 0.12)1 2,000 112 . 2,240 Illustration - 2 X invests 1,000 for 3 years in a savings account that pays 10% interest per annum. Calculate the future value. Solution: Calculation of future value: Given, PV = 1000 Amity Directorate of Distance and Online Education Time Value of Money 33 r = 10% Notes n = 3 years FV = PV(1+r)n 1,000 (1 o.1)3 = 1000 (1.1)3 = 1,331 Illustration - 3 Find out the future value of 1,600 received after two years at 10% time preference rate. Solution: Calculation of future value: FV PV (1 r)n Where, FV = ? PV = 1,600 r = 10% = 0.10 n=2 . )2 FV 1600 (1 010 = 1,600 x ( 1. . 1 )2 1600 1.21 1936 Illustration - 4 Calculate the future value for 20,000 deposited in bank for a period of 5 years at 12% p.a. Given (112 . )5 = 1.762 Solution: Calculation of future value: FV PV (1 r)n FV 20, 000 (1 0.12)5 = 20,000 x 1.762 35,247 Illustration - 5 Arun makes a deposit of 10,000 in a bank which pays 8% interest compounded annually for 8 years. You are required to find out the amount to be received by him after 8 years. Solution: Where, FV = ? PV = 10,000 r = 8% or 0.08 n = 8 years Amity Directorate of Distance and Online Education 34 Financial Management Notes Calculation of future value: FV PV (1 r)n FV = 10,000(1 + 0.08)8 = 10,000(1.08)8 = 10,000(1.8509) = 18,509 2. In case of multiple compounding period or intra compounding In the multiple compounding periods, if the compounding period varies, interest earned will also vary, viz, if the interest is compounded semi-annually, quarterly or monthly, such future value is calculated by using the following formula: r mn FV PV(1 ) m When payments are made more frequently than once a year, or when interest is compounded more than once a year, we have to convert the stated interest rate to periodic rate and number of years to the number of periods. For example, in case of semiannually or half yearly compounding their would be two compounding periods within the year and interest at a rate of one half of the annual rate of interest because interest is actually paid after every six months. Similarly, in quarterly compounding, there are four compounding periods in a year and the rate of interest will be one-fourth of the annual rate. Where, m is the number of times per year compounding is made. For semi-annual compounding, m would be 2, while for quarterly compounding it would be equal to 4 and if interest is compounded monthly, weekly or daily it would equal to 12, 52 and 365 respectively for which the following formula are used: a) When interest is payable half yearly r FV PV(1 )2n 2 b) When interest is payable quarterly r FV PV(1 )4n 4 c) When interest is payable monthly r 12n FV PV(1 ) 12 d) When interest is payable daily r 365n FV PV(1 ) 365 Illustration - 1 Calculate the future value of 4,000 is invested for 4 years and the interest on it is compounded at 12% p.a. half yearly. Find out the compounded value or future value. Given (1.06)8 = 1.594 Amity Directorate of Distance and Online Education Time Value of Money 35 Solution: Notes r FV PV(1 )2n 2 012 . FV 4000 (1 )2 4 4000 (1 0.06)8 4000 1594 . 6370 2 Illustration - 2 Calculate the future value of 7000 invested for 5 years at a rate of interest of 15% compounded half yearly. According to compound table compound value factor for Re. 1 in 5 years at rate 15%. Solution: r FV PV(1 )2n 2 015 . FV 7000 (1 )2 5 2 7000 (1 0.07)10 7000 (1.07)10 = 7,000 x 1.967 = 13,769 Illustration - 3 Mrs. Paru deposit 6000 in bank for 5 years and the interest on it is compounded at 10% p.a. If interest is calculated quarterly. (Given (1.025)20 = 1.637 Calculate the future value quarterly. Solution: r FV PV(1 )4n 4 010 . FV 6000 (1 )4 5 4 6000 (1 0.025)20 6000 (1.025)20 = 6,000 x 1.637 = 9,822 Illustration - 4 Calculate the future value of 9000 is invested for a period of 5 years at 12% p.a. interest compound quarterly. Find out FV given (1.03)20 = 1.806 Solution: r FV PV(1 )4n 4 012 . FV 9000 (1 )4 5 4 9000 (1 0.03)20 9000 (1.03)20 = 9,000 x 1.806 = 16,254 Amity Directorate of Distance and Online Education 36 Financial Management Notes Illustration - 5 Indian bank space 12% interest compounded quarterly, if 1,000 is made as an initial deposit, how much it will be in terms of growth at the end of 5th year. Solution: Where, FV = ? PV = 1,000 i = 12% or 0.12 m=4 n=5 r FV PV(1 )4n 4 4 5 0.12 = 1,000 1.03 20 FV = 1,000 1 + = 1,000(1.806) = 1,806 4 b) The future value of annuity of cashflows or Series of equal cashflows Even cashflows of a certain period of time is known as “Annuity”. In other words Annuity is a fixed payment or receipt each year for a specified number of years. The future value of annuity can be calculated by using annuity table as well as by adopting a formula: FVA = A x CVFA (r, n) Or FVA R( 1 i )n1 R( 1 i )n2 R( 1 i )n3 ......... R 4 Where, FV = Future value of annuity R = Even cash flow i = interest rate n = numbers of year Illustration - 1 Calculate the future value of annuity of 5,000 deposited at the end of each year at 6% for a period of 5 years. Solution: FVA R( 1 i )n1 R( 1 i )n2 R( 1 i )n3 R( 1 i )n 4 R( 1 i )n5 = 8,000(1.26) + 8,000(1.19) + 8,000(1.12) + 8,000(1.06) + 8,000(1) = 10,800 + 9,520 + 8,960 + 8,480 + 8,000 = 45,040 Illustration - 2 Mr. Kumar deposits 6,000 at the end of every year for five years and the deposit earns compound interest @12% P.a. Determine how much money he will have at the end of 5 years. Amity Directorate of Distance and Online Education Time Value of Money 37 Solution: Notes FVA R( 1 i )n1 R( 1 i )n2 R( 1 i )n3 R( 1 i )n 4 R( 1 i )n5 . )51 6000 (1 012 6000 (1 012 . )52 6000 (1 012 . )53 6000 (1 012 . )5 4 . )55 6000 (1 012 = 6,000(1.57) + 6,000(1.40) + 6,000(1.25) + 6,000(1.12) + 6,000(1) = 9,420 + 8,400 + 7,500 + 6,720 + 6,000 = 38,040 Illustration - 3 Calculate the future value of annuity of 4,000 deposited at the end of each year at 6% for a period of five years. Solution: Where, FVA = ?, R = 4,000 I = 6% or 0.06 N = 5 years FVA = 4,000(1.262) + 4,000(1.191) + 4,000(1.1236) + 4,000(1.06) + 4,000(1) FVA = 5048 + 4,764 + 4,494.4 + 4,240 + 4,000 FVA = 22,546.4 Or FVA = A x CVFA (r, n) FVA = 4,000 x CVFA (6%, 5 years) FVA = 4,000 x 5.637 (Table: the compound value of an annuity of one rupee in line of five years at the rate of 6%) FVA = 22,548 c) Future Value of uneven cashflows (Multiple) As, the future value of annuity deposit made at a particular rate of interest and for a definite period of time is calculated, we can also calculate the future value of uneven cash flows made over a period of time at particular rate of interest by using the following formula: FVUECF R1( 1 i )n1 R2(1 i )n2 R3( 1 i )n3 R 4( 1 i )n 4 R5( 1 i )n5 Amity Directorate of Distance and Online Education 38 Financial Management Notes Where, FVUECF = Future value of uneven cash flow R1 , R2, R3 = Uneven cash flow i = Interest rate n = Number of years Illustration - 1 Calculate the future value of the following cash flow if it is invested @ 8% interest p.a. At the end of each year Amount Deposited 1 2,000 2 4,000 3 6,000 4 8,000 Solution: FVUECF R1( 1 i )n1 R2( 1 i )n2 R3( 1 i )n3 R 4( 1 i )n 4 2000 (1 0.08)4 1 4000 (1 0.08)42 6000 (1 0.8)4 3 8000 (1 0.8)4 4 = 2,000(1.26) + 4,000(1.16) + 6,000(1.08) + 8,000(1) = 2,520 + 4,640 + 6,480 + 8,000 = 21,640 Illustration - 2 Calculate the future value at the end of 4 years of the following series of payments at 9% rate of interest. 1,000 at the end of first year. 2,000 at the end of second year. 3,000 at the end of third year. 4,000 at the end of fourth year. Solution: FVUECF R1( 1 i )n1 R2( 1 i )n2 R3( 1 i )n3 R 4( 1 i )n 4 = 1,000(1.29) + 2,000(1.18) + 3,000(1.09) + 4,000(1) = 1,290 + 2,360 + 3,270 + 4,000 = 10,920 2.5 Present Value The Present Value of an entity can be defined as the present worth of a prospective amount of money or a stream of cash flows with a specified return rate. The Present Value is conversely related to the discount rate. Thus, a higher discount rate implies a lower present value and vice versa. Accurate determination of cash flows is, therefore, the key to appropriately valuing future cash flows, be it earnings or obligations. Amity Directorate of Distance and Online Education Time Value of Money 39 The calculation of the Present Value holds extreme importance in different financial Notes calculations like Net Present Value, spot rates, bond yields, and pension obligations. The apposite definition for Present Value (PV) is given as the current value of one or higher future cash payments which are discounted at a reasonable interest rate. Calculating the Present Value Generally, there are three factors which influence the calculation of the Present Value: (i) The size of the cash flow: The future cash flow implies the size of the cash which is expected to be received. The future cash flow and the present value are related directly. A larger future cash flow implies a higher present value. (ii) The risk involved in cash flow: With rising uncertainty, the investor anticipating the receipt of a cash flow has to presume higher risk. This presumed level of high risk lowers the value that should be paid at present for the future cash flow. The “risk” involved is calculated by the rate of return which you might require from another investment aimed at generating cash flow with the same risk level. (iii) The waiting period involved in cash flow: A longer waiting period lowers the value of cash flow. This reduction in the present value of a cash flow is accrued to two reasons: (a) The money which has been invested could be invested in some other project which would earn you interest during the years which you have been waiting. (b) If, in case, you are not sure about getting the expected cash flow , you will have to presume more risk with time passing by thereby lowering the value that would be paid by someone for that future cash flow. Calculation of Present Value Present value is the value today of a sum of money to be received at a future point of time. Present values allows us to place all the figures on a current footing so that comparisons may be made in terms today’s rupees. For example, if we want to determine the present values at the beginning of year 1 of 110, 121 and 113 to be received at the end of year 1, year 2, and year 3 respectively at 10% P.a., it would be 100 in each case. Thus, using the compound interest formula, Find present value of a given amount to be received at a point in time in future as follows: FV = PV(1+r)n FV PV = (1+ r)n Where, PV = Amount to be received at the end of year n (future value) r = Compound rate of interest PV = Present value If the value of n is small, Find the present value (PV) by solving the equation without the help of logarithms. For example: Amity Directorate of Distance and Online Education 40 Financial Management Notes FV1 110 PV1 = = 100 ( 1 r)1 11 . FV2 121 PV2 = 100 2 ( 1 r) . )2 (11 FV3 133 PV3 = 100 ( 1 r)3 . )3 (11 Present value is the opposite of future value. Consider the following example (when r = 10% p.a.): Period Present value Future value at the at the (Year) beginning of the year end of the year FV PV ( 1 r)n FV PV ( 1 r)n 1 100 110 2 110 121 3 121 133 Determining the Present Value The process of determining the present value is known as discounting. It is the reciprocal compounding, that is, the amount to be received in future (future value) at a given rate of interest and can calculate the present value (value at the beginning of the period). Thus, Present value = Future value x Discount factor [ 1 / ( 1 r)n ] The discount factor (when r = 10%) can be calculated as follows: Present value Future value Discount factor 100 End of year 1 110 100/110 = 0.909 End of year 2 121 100/121 = 0.826 End of year 1 133 100/133 = 0.752 2.6 Present Value Technique or Discounting Technique Present Value Technique is a reverse of compounding technique and is also known as discounting technique. As these are future value of sums invested now, calculated as per the compounding techniques, there are also the present values of a cash flow scheduled to occur in future. Hence this method helps to find out the present value of the future money. The discounting technique to find out the present value can be explained in terms of: a) Present value of Single cashflows b) Present value of Annuity/series of even cashflows c) Present value of uneven future cashflows. Amity Directorate of Distance and Online Education
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