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Financial Management is indeed the key to successful business operations. Without proper administration and effective utilization of finance, no business enterprise can utilize its potentials for growth and expansion. The importance of financial management can be ascertained from the study of the following points:
2. Smooth Running: Since finance is required at each stage of the business such as
promotion, incorporation, development, expansion and management of day-to-day expenses, proper financial administration becomes necessary for the smooth running of a business enterprise.
3. Decision making: Financial management provides scientific analysis of all facts and
figures through various financial tools such as ratio analysis, variance analysis, budgets etc., Such an analysis helps the management to evaluate the profitability of the plan in the given circumstances so that a proper decision can be taken to minimize the risk.
4. Solutions to Financial Problems: The efficient Financial Management helps the top
management by providing solutions to the various financial problems faced by it.
The importance of Financial Management in an enterprise may very well be realized by the following words: Financial Management is properly viewed as an integral part of overall management rather than as a staff speciality concerned with fund raising operation. In addition to raising funds, financial management is directly concerned with production, marketing and other functions within an enterprise whenever decisions are made about the acquisition or distribution of assets.
Thus, financial management has attained a good deal of importance in modern business.
Q.2 What is the importance of studying future value and present value concepts.
In this concept the interest earned on the initial principal becomes a part of the principal at the end of a compounding period.
Compounding of Interest Over N years: The compounding of interest can be calculated by the following equation.
A = P (1 + i)n
In which A = Amount at the end of period n P = Principal at the beginning of the period. i = Interest rate. n = Number of years.
Computation by this formula can also become very time consuming if the number of years become large, say 10, 20 or more. In such cases to save upon the computational efforts, Compound Value table* can be used. The table gives the compound value of Re. 1, after n years for a wide range of combination of i and n.
For instance, in the above illustration Table III gives the compound value of Re. 1 at 10% p.a. at the end of 3 years as 1.331. Hence, the compound value of Rs. 1,000 will amount to: 1000 1.331 = Rs. 1331
Interest can be compounded, even more than once in a year. For calculating the multiple compounded value, above logic can be extended. For instance, in case of Semi-annual compounding, interest is paid twice a year but at half the annual rate. Similarly in case of quarterly compounding, interest rate effectively is 1/4th of the annual rate and there are four quarter years.
Formula:
Where, A = Amount after a period. P = Amount in the beginning of the period. i = Interest rate M = Number of times per year compounding is made. n = Number of years for which compounding is to be done.
So far we have considered only the future value of a single payment made at time zero. The transactions in real life are not limited to one. An investor investing money in installments may wish to know the value of his saving after n years.
An annuity is a stream of equal annual cash flows. Annuities involve calculations based upon the regular periodic contribution or receipt of a fixed sum of money.
The concept of present value is the exact opposite of that of compound value.
In case of compounding we calculate the future value of a sum of money or series of payments, while in case of present value concept, we estimate the present worth of a future payment/installment or series of payments adjusted for the time value or money.
The basis of present value approach is that opportunity cost exists for money lying idle. That is to say, that interest can be earned on the money. This return is termed as discounting rate.
Given a positive rate of interest, the present value of future rupee will always be lower. The technique for finding the present value is termed as discounting.
Formula:
Where: PV = principal amount the investor is willing to forego at present. i = Interest rate. A = Amount at the end of the period n. n = Number of years.
With this formula, we can directly calculate the amount, any depositor would be willing to sacrifice at present, with a time preference rate or discount rate of x%.
In a business situation, it is very natural that returns received by a firm are spread over a number of years. An investment made now may fetch returns for a period after some time. Every businessman will like to know whether it is worthwhile to invest or forego a certain sum now, in anticipation of returns he expects to earn over a number of years. In order to take this decision he will need to equate the total anticipated future returns, to the present sum he is going to sacrifice. To estimate the present value of future series of returns, the present value of each expected inflow will be calculated.
The present value of series of cash flows can be represented by the following
formula:
C3 ..
In the above case there was a mixed stream of cash inflows. An individual or depositor may receive only constant returns over a number of years. This implies that the cash flows are equal in amount. To find out the present value of annuity either we can find the present value of each cash flow or use the annuity table. The annuity table gives the present value of an annuity Re. 1 for interest rate r over number of years n.
Q.3 Discuss how financial management helps in maximizing shareholder wealth through effective utilization of resources.
1. Investment Decisions: This is concerned with the allocation of capital. It has to show the
funds can be invested in assets which would yield benefit in future. This is a decision based on risk and uncertainty. Finance manager has to evaluate the investment in relation to their expected return and risk to determine whether the investment is feasible or not. Besides the financial manager is also entrusted with the management of existing assets. The whole exercise is called "Capital Budgeting". This was the first technique developed in financial management. This technique helps to know Net Present Value of assets. To have a more profitable investment, the companies can think of amalgamations and mergers internally and externally. That is why we have seen the emergence of multinational companies.
2. Finance Decisions: This decision is concerned with the mobilization of finance for
investment. The finance manager has to take decisions regarding the acquisition of finance. Whether entire capital required should be raised in the form of equity capital, or the amount should be borrowed totally or a balance should be struck between equity and borrowed capital has to be decided. Even the timing of acquisition of capital should also be perfectly made. While determining the ratio between debt and equity, the finance manager should ascertain the risk involved in obtaining each type of capital. Thus
determining the best "Finance Mix" is another important task of the finance manager. The best capital structure will always ensure wealth maximization.
3. Dividend Decision: This decision is concerned with the divisible profits of the company.
i) ii) iii)
How much profit is to be flown back by capitalization? How much cash dividend should be paid to the shareholders? Maintenance of stable dividend rate over the period, are some of the issues connected with this decision.
The dividend decision involves the determination of the percentage of profit earned by the enterprise which is to be paid to its shareholders. The dividend pay out ratio must be evaluated in the light of the objective of maximizing shareholders wealth. Thus, the dividend decision has become a vital aspect of financing decision.
4. Current Assets Management: The finance manager should also manage the current
assets to have liquidity in the business. Investment of funds in current assets reduces the profitability of the firm. However the finance manager should also equally look after the current financial needs of the firm to maintain optimum production. While investing funds in current assets, he must see that proper balance (trade off) is maintained between the profitability and liquidity.
Every financial decision involves this trade off. At this level the market value of the companys shares would be the maximum.
The inter-relationship between market value, financial decisions, risk-return and trade off is depicted in the chart.
In conclusion we can say that to maximize the wealth of the owners, the finance manager has to take carefully the decisions relating to (i) Investment (ii) Dividend (iii) Financing and (iv) Current Assets.
Compound Value Concept In this concept the interest earned on the initial principal becomes a part of the principal at the end of a compounding period. Illustration: Rs. 1,000 invested at 10% is compounded annually for three years. Calculate the Compounded value after three years.
This compounding process will continue for an indefinite time period. Compounding of Interest Over N years: The compounding of interest can be calculated by the following equation. A = P (1 + i)n In which A = Amount at the end of period n P = Principal at the beginning of the period. i = Interest rate. n = Number of years. By taking illustration 2.1 we get
A = P (1 + i)n A = 1000 (1 + .10)3 A = 1,331 Computation by this formula can also become very time consuming if the number of years become large, say 10, 20 or more. In such cases to save upon the computational efforts, Compound Value table* can be used. The table gives the compound value of Re. 1, after n years for a wide range of combination of i and n. For instance, in the above illustration Table III gives the compound value of Re. 1 at 10% p.a. at the end of 3 years as 1.331. Hence, the compound value of Rs. 1,000 will amount to: 1000 1.331 = Rs. 1331 Multiple Compounding Periods: Interest can be compounded, even more than once in a year. For calculating the multiple compounded value, above logic can be extended. For instance, in case of Semi-annual compounding, interest is paid twice a year but at half the annual rate. Similarly in case of quarterly compounding, interest rate effectively is 1/4th of the annual rate and there are four quarter years. Formula:
Where, A = Amount after a period. P = Amount in the beginning of the period. i = Interest rate M = Number of times per year compounding is made.
Discounting or present value concept The concept of present value is the exact opposite of that of compound value. In case of compounding we calculate the future value of a sum of money or series of payments, while in case of present value concept, we estimate the present worth of a future payment/installment or series of payments adjusted for the time value or money. The basis of present value approach is that opportunity cost exists for money lying idle. That is to say, that interest can be earned on the money. This return is termed as discounting rate. Given a positive rate of interest, the present value of future rupee will always be lower. The technique for finding the present value is termed as discounting. Present value after n years: Formula:
Where: PV = principal amount the investor is willing to forego at present. i = Interest rate. A = Amount at the end of the period n. n = Number of years. With this formula, we can directly calculate the amount, any depositor would be willing to sacrifice at present, with a time preference rate or discount rate of x%. Example: If Mr X, depositor, expects to get Rs. 100 after one year at the rate of 10%, the amount he will have to forego at present can be calculated as follows:
Similarly, the present value of an amount of inflow at the end of n years can be computed. Present Value of a Series of Cash Flows: In a business situation, it is very natural that returns received by a firm are spread over a number of years. An investment made now may fetch returns for a period after some time. Every businessman will like to know whether it is worthwhile to invest or forego a certain sum now, in anticipation of returns he expects to earn over a number of years. In order to take this decision he will need to equate the total anticipated future returns, to the present sum he is going to sacrifice. To estimate the present value of future series of returns, the present value of each expected inflow will be calculated. The present value of series of cash flows can be represented by the following formula:
Above steps are essential to any capital budgeting process. But individual situations of capital budgeting may demand for any other steps relevant to the situation to make the process effective one.
a) i) Proposals to add new product to the product line. ii) Proposal to expand capacity in existing product lines.
b) Proposals to reduce the costs of the output of the existing products without altering the scale of operation.
The investment proposals of any type can originate at any level; from top management level to the level of workers. The proposals may originate systematically or haphazardly.
i)
Estimation of benefits and costs. The benefits and costs must be measured in terms of cash flows.
ii)
4. Project Execution: The funds are appropriated for capital expenditure after the final
selection of investment proposals. The formal planning for the appropriation of funds is called the capital budget. The project execution committee or the top management must
ensure that the funds are spent in accordance with appropriations made in the capital budget.
Q.6 What are the factors on which the working capital requirements of a Two wheeler manufacturing company will be based.
A host of factors influencing the levels of working capital needs for a firm can be categorized into two groups, viz., internal factors and external factors.
A. Internal Factors :
thus incur greater inventory costs and risk. The effect of seasonal fluctuations upon working capital can be offset by pursuing the policy of adjusting production plan to seasonal changes. In this case, inventories are kept at minimum levels but the production manager must shoulder the responsibility of constantly varying production schedules in accordance with the changing demand. Obviously, working capital needs of a firm with level production plan will be higher than the one with varying production plan.
Distribution of high proportion of profits in the form of cash dividend results in a drain on cash resources and thus reduces Companys working capital to that extent. Where the management follows conservative dividend policy and retains larger portion of net profits, the Companys working capital position is strengthened.
B. External Factors:
2. Business expands during the period of prosperity and declines during the period of depression. Consequently, more working capital is required during the period of prosperity and less during the period of depression.
capital. If a firm switches over to new manufacturing process and installs new equipments with which it is able to cut period involved in converting raw materials into finished goods, permanent working capital requirements of the firm will decrease. If the new machine can utilize less expensive raw materials, the inventory needs may be reduced.
4. Import Policy: Import policy of the government may also have its
bearing on the levels of working capital of the enterprises since they have to arrange funds for importing goods at specified times.
Thus, there are several factors affecting the working capital requirements. However, as a general rule, it can be concluded that in most cases the period which elapses between the purchase of materials and the receipt of sale proceeds of the finished goods will determine the working capital requirements of any business. This requires that there should not be any unnecessary delay in the production process and also in the realization of money from debtors. The Just in time approach, as explained below, greatly helps in reducing processing time and thereby preventing Locking of unnecessary funds in working capital.
Just in Time (JIT) Approach: This is an approach to manufacturing developed in Japan. Its Philosophy is that items should be received at the exact time, at the exact place and in perfect condition. The objective is to have a perfect matching between the output of a manufacturing firm and needs of the market. In case something is not needed immediately, it is not manufactured. Effort is made to minimize the time interval between starting the manufacturing process and the product being ready for delivery to the customer. This time interval is known as throughput time, which is the total of: processing time + Inspection Time + Conveyance Time + Waiting time.
In case of JIT approach, the ultimate objective is that throughput time does not exceed the processing time. In other words, material is not allowed to wait at the store, factory floor or after processing operation. This results in considerable elimination of buffer stocks and consequently unnecessary locking of funds in working capital. .