FM_-_Introduction

7/29/2019 FM_-_Introduction

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Finance - Introduction

Finance may be defined as the art andscience ofmanaging money.

The major areas of finance are financial

services and managerialfinance/corporate finance/financialmanagement.

Financial services is concerned with the

design and delivery of advice andfinancial products to individuals,businesses and governments.


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In modern competitive business world

finance is the key store of each and

every operational activities of the

business.

No business can be started without

adequate financial resources .

All business concern needs money tomake more money.


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Finance is defined as the provision of

money at the time when it is required.

Without adequate finance, no enterprise

can possibly accomplish its objectives.

Finance has been traditionally classified

into two classes: 1. Public finance; and

2. Private finance.


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Public finance deals with the

requirements, receipts and disbursements

of funds in the government institutions like

states, local self-governments and centralgovernment.

Private finance is concerned with

requirements, receipts and disbursements

of funds in case of an individual, a profitseeking business organization and a non-

profit organization.


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Private finance can be classified into: 1.Personal finance, 2. Business finance; and3. Finance of non-profit organizations.

Personal finance deals with the analysis of

principles and practices involved inmanaging ones own daily need of funds.

The study of principles, practices,procedures, and problems concerning

financial management of profit makingorganizations engaged in the field ofindustry, and commerce is under takenunder the discipline ofbusiness finance.


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The finance of non-profit organization is

concerned with the practices,

procedures and problems involved in

financial management of charitable,religious, educational, social and the

other similar organizations.


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Financing ofsole traderand partnership

is easy and the financial requirements

are limited.

In case ofcompany type of organizationfinancial requirements are huge volume

of finance which cannot be contributed

by a few investors.


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Financial Management

Financial management is concernedwith raising of funds, creating value tothe assets of the business enterprises

by efficient allocation of funds. It means manage the finance is called

financial management.

Financial management is the overall

management effort which is closelyassociated with planning and controllingof companys financial resources.


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Financial Management

It is a specialized function of general

management.

It gives the special attention for the

effective management of funds.

In any finance manager must

understand the real problems

associated with procurement of funds toidentify the way for optimum utilization of

funds.


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Financial Management -

Definition Financial Management is the operational

activity of a business that is responsible forobtaining and effectively utilizing the fundsnecessary for efficient operations.

Financial Management is the area ofbusiness management devoted to a

judicious use of capital and a carefulselection of sources of capital in order toenable a business firm to move in thedirection of reaching its goals.


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Financial Management -

Definition

Financial Management is an area of

financial decision making, harmonizing

individual motives and enterprise goals.


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Basic Principles of financial

Management

Risk and Return

Time value of Money

Cash flow concept

Incremental cash flow analysis

Wealth Maximization


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Management

Risk and Return: Every financialdecision has two aspects these are riskand return. Every decision involves a

risk. Financial Management decisionsare taken to optimize returns through thecalculations of risk and return.

Time Value of money: It refers to the

mathematics of finance for calculatingfuture values and present values ofcash.


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Management Cash Flow Concept: Financial

management is based on the inflows andoutflows of cash. It uses cash revenuesand cash-expenses to find out the returnon its investments.

Incremental cash flow analysis: Cashflows are measured of those proposalswhich are an addition to the alreadyexisting projects. This concept helps in

judging whether the new project is good forthe firm.


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Management

Wealth Maximization: maximization of

shareholders wealth considers all cash

flows pertaining to futures decisions. It is

the concept based on cash flows tomeasure the economic value of a firm.


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Evolution of Financial

Management The evolution of financial management can

be discussed undertwo distinctapproaches these are 1. Traditionalapproach and 2. Modern approach.

The traditional phase was from 1920 to1950 and the modern phase began in1950.

The traditional phase was called theoutsider looking approach and the modernphase is called the insider lookingapproach.


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Traditional Approach

Procurement of funds: This approach

was concerned with the procurement of

funds through an analysis offinancial

instruments, institutions and sources offunds.

Outsider looking approach: It only

considered the interest of the outsidersand there was no emphasis on the

investment of funds.


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Traditional Approach

Capital Budgeting: The attention given

by financial management was towards

the procurement of funds for long-term

use. Working capital was notconsidered at all.

Financial instruments: Its function for

procuring funds was through the issue offinancial instruments like equity share,

preference shares and debt securities.


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Modern Approach

The modern approach to financialmanagement gave the subject increasedresponsibilities and brought about an

integrated and analytical scope offinance.

Integrated finance function: Finance asa subject is a study of capital markets

and institutions. It also covers securitymarkets and studies security analysisand portfolio management


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Modern Approach

Management Function: Finance is no longeran outsider looking approach. It covers theallocation of funds not only in long-term usagebut also in day-to-day routine matters.

Techniques: Modern financial managementcovers tool and techniques of evaluation in thefollowing areas.

1. Capital budgeting

2. Cost of capital3. Leverage

4. Working Capital


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Importance of Financial

Management Acquiring financial resources: It involves

the organization has to decide where toobtain fund for theirbusiness needs. Itrequires tapping the potential sources of

funds and raising the funds at low cost forboth short term as well as long termfinancial needs of the company.

Anticipating of financial needs: Financialmanagement of the organization has toestimate financial needs with the help ofthe cash flow statements, cash budgetsand other related tools.


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Management Guide to Decision making: Financial

management contributes valuable guidance toconcern with regard to important financialaspects.

Allocating the funds in business: It indicatesallocation and deployment of funds to variousassets enable to achieve the maximum return.

Analyzing financial performance: Allentrepreneurs must expect a continuous and

consistent return on investment. The cost ofeach financial decision and return of eachmust be analyzed


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Management

Finance for Business promotion:

Adequate finance is very much essential

for the successful operation of the any

business. Accounting and reporting: It indicates

financial management of the concern

should advise and supply informationabout the financial performance to the

top management.


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Finance Function

Finance function is the most important of allbusiness functions.

It is not possible to substitute or eliminate thisfunction because the business will close down

in the absence of finance. The development and expansion of business

ratherneeds more commitment for funds.

The funds will have to be raised from various

sources. The sources will be selected in relation to the

implications attached with them.


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Aims of finance function

Acquiring sufficient funds: The main aim

of finance function is to assess the financial

needs of an enterprise and then finding out

suitable sources for raising them. Proper Utilization of funds: Though raising

of funds is important but their effective

utilization is more important. The funds

should be used in such a way thatmaximum benefit is derived from them.


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Aims of finance function

Increasing Profitability: The planning

and control of finance function aims at

increasing profitability of the concern.

To increase profitability, sufficient fundswill have to be invested.

Maximizing Firms Value:


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Financial Decisions

Investment Decisions

Financing Decisions

Dividend Decisions


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Investment Decision

The investment decision relates to theselection of assets in which funds will beinvested by the firm.

The assets may be 1. Long term assetsand 2. Short-term or current assets.

Long-term assets which will yield a returnover a period of time in futures.

Short-term or current assets defined asthose assets which in the normal course ofbusiness are convertible into cash shortly.


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Investment Decision

The first category of assets is popularlyknown as capital budgeting in the financialliterature and the second category isknown as working capital management.

Capital Budgeting: It is the long terminvestment decision. It is probably themost crucial financial decision of a firm.

It relates to the selection of an assets orinvestment proposal or course of actionwhose benefits are likely to be available infuture over the life-time of the project.


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Investment Decision

The long-term assets can be either new

or old/existing ones.

It involves decision relates to the choice

of the new assets.

Decision relates to risk and uncertainty

Decision relates to evaluation of worth

of the long term project.


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Investment Decision

Working Capital Management: It isconcerned with the management of thecurrent assets.

Current assets means the assets that canbe converted into cash shortly.

When there is no sufficient working capitalorganization become illiquid and may not

have ability to meet its current obligation. Working capital = CA - CL

The optimum expected current ratio is 2:1


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Financing Decision

It is broadly concerned with financing mixor capital structure or leverage.

The term capital structure relates to theoptimum combination of Debt and Equity.

The best combination indicates thatcombination which give more return to theshareholders.

It is the duty of the financial manager to

identify the proper proportion of thesources of funds that maximize return tothe shareholders.


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Financing Decision

The source of funds that maximize

return to the shareholders.

Financing decision involves

1. Capital structure theory

2. Capital structure decision.


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Dividend policy decision

Dividend is that part of profit paid to theshareholders.

Here it is very important to decide

1. Whether to pay dividend to the

shareholders2. whether to retain the dividend by theorganization for future development andexpansion.

When the entire profit is given to theshareholders as dividend, dividend payoutratio (D/P) is 100%.


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Dividend policy decision

If the entire profit is retain by theorganization, D/P ratio is 0% andDividend retention ratio is 100%.

Ifcost of equity is less than return oninvestment dividend may be retained bythe organization.

Ifcost of equity is greaterthat the return

on investment, D/p ratio should be100%.


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Goal or Objectives of Financial

Management

Objective of financial management is the

decision making or goal of financial

management.

Profit Maximization

Wealth Maximization


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Profit Maximization as a

decision Criterion

According to this approach, actions thatincrease profit should be undertakenand that those that decrease profits are

to be avoided. In specific operational terms, as

applicable to financial management, theprofit maximization criterion implies that

investment, financing and dividendpolicy decision of a firm should beoriented to the maximization of profits.

f


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decision Criterion

The term profit can be used in two senses.They are

1. Owner-oriented concept

2. Operational concept

According to owner-oriented concept profit isamount of share paid to owners.

According to operational concept, profit isreferred as profitability.

According to operational concept we selectassets, projects and decisions which areprofitable and reject those which are not.


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decision Criterion

In the literature of financial

management, profit maximization is

concerned as on the basis of operational

concept and we avoid profit on the basisof owners concept.

Profit is a test ofeconomic efficiency. It

provides the yard stick by whicheconomic performance can be judged.


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decision Criterion

Profit maximization criteria has however,

being questioned and criticized several

grounds.

1. Ambiguity (confusion)

2. Timing of benefit

3. Quality of benefit


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Ambiguity

Profit maximization criteria for financial decisionmaking is based on the term profit which is vagueand ambiguous.

It conveys different meaning to different people.

To illustrate, profit may be short-term or long-term, it

may be total profit or rate of profit; it may be before-tax profit or after tax; and so on.

If profit maximization is an objective, which one ofthe above profit should be maximized. It leads toconfusion.


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Ambiguity

Project I Project II

Investment

Profit before tax

Tax Rate

Profit after tax

Rs. 3,00,000

Rs. 1,00,000

50%

Rs. 50,000

Rs. 3,00,000

Rs. 60,000

10%

Rs. 54,000


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Timing of Benefit

If profit maximization is the objective, wechoose the project which gives more returnthat is we apply bigger the better principle.Let us consider the following example.

Time pattern of benefits (Profits)Project A Project B

Period I Rs.5000 ----

Period II 10000 10000

Period III 5000 10000----------- ---------

20000 20000


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Timing of Benefit

Both the project A and project B areidentical. It profit maximization is theobjective, when we apply the bigger thebetter principle, both the project are ranked

equally and we cannot choose the betterprinciple.

Actually here we apply earlier the betterprinciple.

Project A gives more return to the earlierstage. So it is concluded that profitmaximization does not considered timing ofbenefit.


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Quality of benefit

Profit maximization technique does not

consider quality of benefits.

The term quality here refers to the

degree of certainty with which benefitcan be expected.

That is more certainty, the higher the

quality of benefit. when uncertainty is more, risk is more.

U t i t b t t d


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Uncertainty about expected

benefits (profits)Project A Project B

Recession

Normal

Boom

900

1000

1100______

3000

----

1000

2000______

3000

U t i t b t t d


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Uncertainty about expected

benefits (profits)

When we apply profit maximization

technique, we cannot conclude the

better projects.

But applying quality of benefits, ProjectA has less fluctuation and has more

certainty.

Project B has wide fluctuation and hasmore uncertainty. So we choose project

A.


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Finally we arrive the following results.

Profit maximization technique

1. Has Ambiguity

2. Does not consider the time value of

money

3. Does not consider quality of benefits.

Therefore profit maximization objective

is ignore.


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Wealth Maximization

The shareholders wealth is reflected inthe market value of the share.

The shareholders economic value is the

dividend that he receives presently andthe future dividend benefits and capitalappreciation of the share.

The market price of a share is the

present value of all the future cash flowsin terms of benefits and dividendexpected from the firm.


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Wealth Maximization

The three important financing decisions

are taken through the cash flow concept

of finding out the present value of the

share. Wealth maximization has the advantage

ofconsidering the time value of money,

which is the basic principle of financialmanagement.


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Wealth Maximization

This concept measures risk anduncertainty.

The value of the firms share is measuredthrough the net present value.

This removes any doubt about the conceptofrisk, which is useful to understand themarket value of the share.

Thus wealth maximization can beconsidered to be consistent with theobjective of maximizing owners wealth.


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Time Value of Money - Concept

Time value of money means that thevalue of a unit of money is different indifferent time periods.

Under this concept the value of moneyreceived today is more than the value ofsame amount of money received after acertain period.

Time value of money is analyzedbecause the value of money keeps onchanging.


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Most people think that money has amuch greater value today than theamount of money that is received at alater date.

If the money received at a later date iscompensated by receiving a higheramount at the end of the period than it is

today. The time preference of money is usually

because of a rate of interest.


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The individual will try to receive a

compensation for the postponement of

his receipt of money.

He will also have some risk attached topostponement.

His required rate of return is called the

opportunity cost of capital.


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Time value of money is based on three importantaspects:

1. Compensation for uncertainty: An individual is keento possess money in the present date because he iscertain that the money with him is liquid. The future

is full of uncertainties. For these reasons money ispreferred at a current date.

2. Preference for present consumption: Many peoplefeel that money received today can provide theacquisition of goods and services that they requirefor their needs. At a future they may not be able topurchase goods because of risk in the market dueto inflation.


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3. The re-investment opportunity: The

relevance of possessing money

currently is a justification forinvesting

funds whenever he can earn a higheramount.

If an individual has an availability of

cash he can determine alternativeopportunities to re-invest his funds in

those available outlets.

Techniques of Time value of


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Techniques of Time value of

Money

Compounding Technique

Discounting or Present Value Technique


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According to the compounding

technique the interest earned on the

principal amount becomes a part of

principal at the end of the compoundingperiod.

Under this method the interest received

is actually reinvested. Compounding technique is used to

determine the future value of money.


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Compound Value: The compound value

is the future value(FV) of money. This is

calculated forsingle cash flow orfor a

series of cash flows.The future value(FV) consists of the

present value(PV), the rate of interest

and the number of years for which it isinvested.

FM_-_Introduction

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