Finance

The firms success and to say the least, its survival depends upon how efficiently it is able to generate funds, as and when needed.

 Finance holds the key to all activities.

Arthahsachivah finance reigns supreme

 Finance-Latin word finis

Finance is defined as the issuance of, distribution of and purchase of liability and equity claims issued for the purpose of generating revenueproducing assets.

 Paul G. Hasings Finance is the management of monetary affairs of a company. It includes determining what has to be paid for raising the money on the best terms available and devoting available funds to the best uses.

Kenneth Midgley and Ronald Burns

Financing is the process of organizing 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 all due.

 Money-it is any countrys currency , which is in the hands of a person or an organization.

Finance-it is also any countrys currency, which is owned by a person or organization, that is given to others as loan to buy an asset or to invest in investment opportunities.

 Currency as long as you have with you it is money only and when you lend it to others to buy or invest in investment opportunities it becomes finance.

 Eg;- a bank, which has raised money from public through various types of deposits, when it grants the same money to others, it becomes finance.

 Car finance, house finance

Organizations raise funds from public to buy assets or invest in business.

Financial Management

Financial management is the managerial activity which is concerned with the planning and controlling of the firms financial resources

Definitions
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

 Financial management is defined as that area or set of administrative functions in an organization which relate with the arrangement of cash and credit so that the organization may have the means to carry out its objective as satisfactorily as possible. Howard and Opton

Financial management is concerned with the acquisition, financing and management of assets with some overall goal in mind.

Van Horne & Wachowicz

SCOPE OF FINANCIAL MANAGEMENT (Finance functions )

The functions of raising funds, investing them in assets and distributing returns earned from assets to share holders are respectively known as financing decision, investment decision and dividend decision.

 The firm attempts to balance cash flows and out flows while performing these functions. This is called liquidity decision.

Finance functions include: Long-term asset mix or investment decision Capital mix or financing decision Profit allocation or dividend decision Short-term asset-mix or liquidity decision

Investment Decision
The investment decision relates to the selection of assets in which funds will be invested by a firm..

Firms investment decision involve capital expenditures. Capital budgeting decision.

 Capital budgeting decisions involves the decision of allocation of capital or commitment of funds to long term asset that would yield benefits (cash flow) in future.

 The first aspect of capital budgeting decision relates to the choice of the new asset out of the alternatives available or the reallocation of capital when an existing asset fails to justify the funds allocated. Whether an asset will be accepted or rejected will depend upon the relative benefits and returns associated with it.

 The second element is the analysis of risk and uncertainty. Since the benefit from the investment is extended into the future, their accrual is uncertain . The element of risk in the sense of uncertainty of future benefit .
The returns from capital budgeting decisions should be evaluated in relation to the risk associated with it.

 Two important aspect of investment decisions are: 1. The evaluation of the prospective profitability of new investments 2. The measurement of a cut-off rate against that the prospective return of new investment could be compared.

 rate of return that is necessary to maintain market value (or stock price) of a firm, also called a hurdle rate, cutoff rate, or minimum required rate of return. It is the opportunity cost of capital.

 Decision of recommitting the funds when an asset becomes less productive or non-profitable -replacement decisions

Financing Decision
The concern of financing decision is with the financing mix or capital structure or leverage.
The term capital structure refers to the proportion of debt and equity capital.

 The financial manager must decide when, where from and how to acquire funds to meet the firms investment needs.

The central issue before them is to determine the appropriate proportion of equity and debt .

 The financing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirements. The financial manager must strive to obtain the best financing mix or the optimal capital structure.

 The firms capital structure considered optimum when the market value of the shares is maximized.

Analysis of the above based on different sources of Finance

Type of fund
Own fund (Equity)

Risk
Low- since repayment only at the time of liquidation

Cost
High- since dividend expectation higher. Also dividend is not tax deductible

Control
Dilution of controlsince New share holders/ public will be involved

Loan funds

High-since repayment as per agreement

Comparative No dilution ly cheaperof control interest is tax deductible

Dividend decision
The financial manager must decide whether the firm should distribute all profits, or retain them or distribute a portion and retain the balance.

 The proportion of the profit distributed as dividends is called the divided payout ratio. And the retained portion of profits is known as retention ratio.

The final decision will depend upon the preference of the shareholders and investment opportunities available.

 Optimum dividend policy should be followed-maximizes the market value of the firms share.

Cash dividend
Bonus shares- shares issued without any charge.

Liquidity Decision
It is concerned with the management of current assets. Investment in current assets affects the firms profitability and liquidity. Current assets should be managed efficiently for safeguarding the firm against the illiquidity.

 A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid and therefore, risky.. But it will lose profitability, as idle current assets would not earn anything. Thus a proper trade-off must be achieved between profitability and liquidity.

 The profitability-liquidity trade-off requires that the financial manager should develop sound techniques of managing current assets.

The financial manager should estimate firms needs for current assets and make sure that funds would be made available when needed.

Role of finance manager

A financial manager is a person who is responsible in a significant way to carryout the finance functions.

 Now a days, the financial manager occupies a key position. He or she is one of the members of the top management team and his or her role, day-by-day, is becoming more pervasive, intensive and significant in solving the complex management problems.

 Now their functions are neither confined that of a store keeper maintaining records, preparing reports and raising funds when needed nor a staff officer.

 The finance manager is now responsible for shaping the fortunes of the enterprise and is involved in the most vital decision of the allocation of capital. In their new role, they need to have a broader and far-sighted outlook and must ensure that the funds of the enterprise are utilized in the most efficient manner

 He or she must realize that their actions have far-reaching consequences for the firm because they influence the size, profitability, growth, risk and survival of the firm and as s consequence affect the over all value of the firm.

 The finance manager, therefore, must have a clear understanding and strong grasp of the nature and scope of finance functions.

 The financial managers responsibilities include

Performing financial analysis and planning

The concern of financial analysis and planning is with (a) transforming financial data into a form that can be used to monitor financial condition.(b) evaluating the need for increased (reduced) productive capacity.. and (c) determining the additional or reduced financing required.

Making investment decisions

Investment decisions determine both the mix and the type of assets held by a firm. The mix refers to the amount of current assets and fixed assets. The financial manager must determine and maintain the optimal levels of CAs and also decide the best FAs to acquire and when existing FAs need to be replaced/modified/liquidated.

Making financing decisions

Financing decisions involve two major areas: first, the most appropriate mix of short-term and long-term financing ; second, the best individual short-term or longterm sources of financing at a given point of time.

Profit planning
Profit planning refers to the operating decisions in the areas of pricing, costs and volume of output and the firms selection of product lines. The cost structure of a firm has significant influence on a firm's profitability.

 Fixed costs remain constant while variable costs change in direct proportion to volume changes.

Because of the fixed costs, profits fluctuate at a higher degree than the fluctuations in sales. This is known as operating leverage.
Profit planning helps to anticipate the relationships between volume, costs and profits and develop action plans to face unexpected surprises.

Understanding capital markets

Capital market brings investors and firms together. Hence the financial manager has to deal with capital markets.

He or she should fully understand the operations of capital markets and the way in which capital market value securities.
He or she should also know how risk is measured and how to cope with it in investment and financing decision.

 Eg-if a firm uses excessive debt to finance its growth, investors may perceive it as risky. The value of the firms share may, therefore decline. It is through their operations in capital markets that investors continuously evaluate the actions of the financial manager.

 In a large firm, these financial responsibilities are carried out by the treasurer and controller.

 Treasurer- the main concern of the treasurer is with mainly to financing activities and investing activities. Functions include cash management; relationship management with bankers, credit management, portfolio management, inventory management, risk management, investors relations, dividend disbursement.

 Controller-the functions of controller related to the accounting and control of assets. The main functions include, cost accounting, financial accounting, internal audit, financial statement preparation, budget preparation, taxation, data processing etc.

BOD

MD/CHAIRMAN

VICE PRESIDENT/DIRECTOR(FINANCE)/CFO

TREASURER

CONTROLLER

Capital expenditure manager

Financial planning and fund raising mgr

Cash manager

Tax manager

Cost accounting mgr

Pension fund mgr

Foreign exchange mgr

Credit manager

Corporate accounting mgr

Financial accounting manager

Objectives of financial management

The term 'objective' is used in the sense of a goal or decision criterion. The three decisions - Investment decision, financing decision and dividend policy decision are guided by the objective

Profit/EPS maximization decision criterion According to this approach, actions that increase profits or EPS should be undertaken and those that decrease profits/EPS are to be avoided..

 In specific operational terms, as applicable to financial management, the profit maximization criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented to the maximization of profits/EPS.

 The term 'profit' is used in two senses. In one sense it is used as an owner-oriented concept.

In this concept it refers to the amount and share of national Income that is paid to the owners of business.

 The second way is an operational concept i.e. profitability. This concept signifies economic efficiency. It means profitability refers to a situation where output exceeds Input. It means, the value created by the use of resources is greater that the Input resources. Thus in all the decisions, one test is used I.e. select asset, projects and decisions that are profitable and reject those which are not profitable

DEMERITS OF PROFIT MAXIMIZATION The term profit is vague. It does not clarify what exactly it mean. It conveys different meaning to different people. Eg- Profit may be in short period or long period etc. Many risky propositions yield high profit. Higher the risk, higher is the possibility of profit. If profit maximization is the only goal, then risk factor is altogether ignored. In practice, risk is to be balanced with the profit objective. Profit Maximization as an objective does not take into account the time pattern of return.

Shareholders wealth Maximization

The most widely accepted objective of the firm is to maximize the value of the firm for its owners; that is, to maximize equity shareholder wealth. Equity shareholder wealth is represented by the market price of the equity shares of the firm.

 The SWM goal states that the management should seek to maximize the present value of the expected future returns to the owners (shareholders) of the firm. The returns can take the form of periodic dividend payments or proceeds from the sale of equity shares.

 SWM means maximizing the net present value of a course of action to shareholders.

NPV or wealth of a course of action is the difference between the present value of its benefits and present value of its costs.

 A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable.
A financial action resulting in negative NPV should be rejected since it would destroy shareholders wealth. Between mutually exclusive projects the one with highest NPV should be adopted

Why wealth maximization is superior to the profit maximization

1. The value of an asset should be viewed in terms of the benefit it can produce. The worth of a course of action can similarly be judged in terms of the value of the benefits it produces less the cost of undertaking it.

 The wealth maximization criterion is based on the concept of cash flows generated by the decision rather than accounting profit which is the basis of the measurement of benefits in the case of profit maximization.

2.SWM considers both the quantity and quality dimensions of benefits. At the same time, it also incorporates the time value of money..

The operational implication of the uncertainty and timing dimensions of the benefit emanating from a financial decision is that adjustments should be made in the cash flow pattern, firstly to incorporate risk and secondly to make an allowances for differences in the timing of benefits. .

 The value of a stream of cash flows with value maximization criterion is calculated by discounting its element back to the present at a capitalization rate that reflects both time and risk

 Strategy is a flexible approach for achieving the desired results, with sustainable success.

 Strategic financial management demands that every executive be a strategist in the real sense..
strategist should observe financial management from a long term point of view for sustainable success based on short-term, flexible tactics.

Economic Value Added (EVA)

It is a popular measure currently being used by several firms to determine whether an existing/proposed investment positively contributes to the owners/share holders wealth.

 The EVA is equal to after tax operating profits of a firm less the cost of funds used to finance investments.
A positive EVA would increase owners value/wealth. Therefore, only investments with positive EVA would be desirable from the viewpoint of maximizing shareholders wealth.

 Eg:- assuming an after tax profit o Rs.40 crore and associated cost of financing the investment of Rs.38 crore, the EVA=Rs.2 crore.
With a positive EVA, the investment would add value and increase the wealth of the owners and should be accepted.

 Merits Simple Strong link to share prices. Positive EVA-increase the value of shares.

Would you prefer to have Rs.1crore now or Rs.1 crore 10 years from now? Of course, we would all prefer the money now! This illustrates that there is an inherent monetary value attached to time.

TIME VALUE OF MONEY

 Time value of money means that the value of a unit of money is different in different time periods. The value of a sum of money received today is more than its value received after some time. Conversely, the sum of money received in future is less valuable than it is today.

 The main reason for the time preference for money is to be found in the reinvestment opportunities for funds which are received early.

The funds so invested will earn a rate of return; which would not be possible if the funds are received at a later time.

 The time preference for money is, therefore, expressed generally in terms of a rate of return or more popularly as discount rate.

 EXAMPLE
Suppose Mr.X is given a choice of receiving Rs.1,000 either now or one year later. His choice would obviously be for the first alternative as he can deposit the amount in his saving bank account and earn a nominal rate of interest, say, five per cent. At the end of the year, the amount will accumulate to Rs.1,050.

 In other words, the choice before Mr.X is between Rs.1050 and Rs.1000 at the end of the year.

As a rational person, Mr.X should be expected prefer the large amount (Rs.1050)

 Here we say that the time value of money, that is, the rate of interest is five percent.

It may thus, be see that future cash flows are less valuable because of the investment opportunities of the present cash flows.

Why TVM is to be considered in Finance Management?

The finance Manager is required to make decisions on investment, finance and dividend keeping in view the objectives of the company.

The investment/financing decisions such as purchase of fixed assets or procurement of funds affect the cash flow in different time period
Eg:- If a fixed asset is purchased, it will require cash outflow immediately and cash inflow will generate over a period of Time.

 Now, the above inflows and outflows at different time periods are not comparable because a rupee received today is not comparable with a rupee to be received in future. Hence for financial decisions the finance manager has to consider the TVM. Ie, he should take the decision by making the cash flows at different periods of time a comparable one.

How to make the cash flows at different period of time a comparable one ?

The cash flow at different period can be made comparable by introducing the interest factor. For this two techniques are used
Compounding technique compounding the present money to a future date using interest factor. Discounting techniques Discounting the future money to present date using interest factor

 The interest factor is termed as targeted rate or Hurdle rate or Opportunity cost of capital or cost of capital or Time value of money.

Future Value or Compounding Technique

Future value is the future value of a current amount. present sums are converted into future sums Compounding is the process of finding the future values of cash flows by applying the concept of compounded interest

Methods of Calculating Interest

Simple interest: the practice of charging an interest rate only to an initial sum (principal amount). Compound interest: the practice of charging an interest rate to an initial sum and to any previously accumulated interest that has not been withdrawn.

Future Value
If you invested Rs.2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals?

6%

Rs.2,000

FV

Future value of a single cash flow

FV1 = PV (1+i)n = 2,000 (1.06)2 = $2,247.20 FV PV i n = future value = present value = rate of interest = number of years

The above formula can be written as

FV = PV( FVF) Where FVF = (1+r)n

example
Suppose your father gave you Rs.100 on your 22nd birthday. You deposited this amount in a bank at 10% rate of interest for one year . How much future sum would you receive after one year?

FV=100(1+0.10) =110

Future value of an Annuity

Annuity means fixed payment or receipt each year for a specified number of years. Annuity can be classified into two (i) Annuity due (ii) Ordinary Annuity or Annuity

Annuity due means fixed payment or receipt at the beginning of each year.

Ordinary Annuity or Annuity means the fixed cash flow at the end of each year

Now Future value of an Annuity is calculated as (FVA)n= A [( 1+r)n 1]/r Where A- Annuity rTime value of money/rate of interest n Number of years

 The formula can be written as

(FVA)n = A( FVAF)

Present Value or Discounting Technique

This concept is the exact opposite of that of compounded value. in compounding approach, present sums are converted into future sums In present value approach we convert future sums into present sums

 Present value is the current value of a future amount. The amount to be invested today at a given interest rate over a specified period to equal the future amount. Given positive rate of interest, the present value of future rupees will always be lower

 It is for this reason, that the procedure of finding present values is commonly called discounting. Discounting is determining the present value of a future amount.

example
Mr.X has been given an opportunity to receive Rs.1060 one year from now. He knows that he can earn 6 per cent interest on his investments. What amount will he be prepared to invest for this opportunity?

P(1+0.06)=1060 P=1060/1.06 =1000

Thus Rs.1000 would be the required investment to have Rs.1060 after the expiry of one year.

The present value of Rs.1060 received one year from now, given the interest of 6 per cent is Rs.1000

Present value of a single flow

PV= FV/(1+r)n It can also be written as, PV = FV(PVF) Where PVF = 1/(1+r)n

 Present value factor is the multiplier used to calculate at a specified discount rate the present value of an amount to be received in a future period

example
Mr.X wants to find the present value of Rs.2000 to be received 5 years from now, assuming 10 per cent rate of interest.

Present value of a series of cash flows

In financial analysis we can come across uneven cash flow streams. Eg:cash flow associated with investment project.

In order to determine the present value of mixed stream of cash inflows, all that is required is to determine the present value of each future payment and then to aggregate them to find the total present value of the stream of cash flows.

symbolically
PV= C1/(1+r) + C2/ (1+r)2 +..+ Cn/(1+r)n
where C1, C2..Cn are cash flows at the end of year 1,2.n

PV=C1(PVF1)+C2(PVF2)+..Cn(PVFn)

Case 5: Present value of an Annuity

The present value of an Annuity is calculated as (PVA)n=A[(1+r)n 1]/r(1+r)n Where A- Annuity r Time value of money n Number of years

 The formula can be written as (PVA)n = A( PVAF)

Conclusion

These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.