Introduction to Finance Mca

8/12/2019 Introduction to Finance Mca

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INTRODUCTION TO FINANCE:

Finance is one of the requisites for all human activities like, personal, business orgovernment.

Finance refers to the money resources owned or borrowed available to

individuals, businesses or governments for their operations.Basically, finance is monetized form of capital, and capital is the saving for

investment. Amount of savings depends on income and consumption. There are certain

macro economics equations.

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DEFINITION OF FINANCE:

'()*'( "+*&$T and (T(* *)-( observes that, /finance may be

generally defined as the study of money, its nature, creation, behavior,

regulation and problems0 Finance may be defined as, /the provision of at the time when it is

required.0

FINANCIAL MANAGEMENT:

&n simple words, financial management is management principles and practices

applied to finance. Financial management refers to corporate finance or

managerial finance. &t is elaborately concerned with the acquisition and use offunds by a business firm.

Financial management may be considered to be the management of the finance

function. Financial management applies to an organization, irrespective of itssize, nature of ownership and control and whether it is a manufacturing or serviceorganization.

FINANCIAL MANAGEMENT

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3a4 1ine of business

3b4 5ode of entry

3c4 $ize of firm3d4 Assets mi6

3e4 "apital mi6

3f4 1iquidity

3g4 -ividend andpolicy

*isk

*eturn

7alue of

firm


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DEFINITION OF FINANCIAL MANAGEMENT:

According to +oward, /financial management involves the application of general

management principles to a particular financial operation.0Bonneville and -ewey defines, /financing consist in the raising, providing and

managing all money, capital or funds of any kinds to be used in connection with the

business0

FINANCE AND OTHER DISCIPLINES

FUNCTIONS OF FINANCIAL MANAGEMENT:

Financial management functions are classified into three categories. They are%

&nvestment decision

Financial decision

-ividend decision

)ther functions

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8. Accounting

9. (conomics:. Ta6ation

)T+(* -&$"&1&($23a4 operation *esearch

3b4 production

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3i4 &nvestment

3ii4 ;orking capital

3iii4 1everage3iv4 -ividend policy


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(i). Investment decisin:

&nvestment decision relates to the selection of assets in which funds will be

invested by a firm.

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Financial management covers a very large spectrum of activities of a business.

Finance knowledge is a must for all irrespective of position, place, and portfolio.

Financial management influences the profitability or return on investment of a

business.

Financial management affects the liquidity position of a business

Financial management is infle6ibility in capital structure.

Financial management influences the business credit rating, employee

commitment, suppliers confidence etc.,

Financial management increase the value of business through efficient and

effective decisions

Financial management is necessary for survival, growth, e6pansion and

diversification of a business.

O*+ECTI,ES OF FINANCIAL MANAGEMENT2

Acc'din" t R-e't +&nsn lanning and control

*aising of funds

&nvesting funds

5eeting special problems

Acc'din" t G'n/!$d Nemm!'s

&nvestment of funds

roviding liquid assets

'enerating earnings

5a6imizing market value of the firm

Acc'din" t estn 0 *'i"&!m

Financial planning and control

Fi6ed assets and working capital management

"apital structure decisions

&ndividual financing episodes

GOALS OF FINANCIAL MANAGEMENT

'oals provide the foundation for any managerial activity. They are the last

towards which all activities are directed. The purpose and direction of anorganization are seen in its goals. 'oals acts as motivators, serve as the standards for measuring performance, help

in co


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T1PES OF GOALS:

Oici!$ "!$s= official goals are the general aims of the organization. 5a6imum

return on investment and market value per share may be termed as official goals.

O#e'!tin!$ "!$s= )perational goals are more qualitative and verifiable. The

scale, mi6 and timing of specific form of finance are detailed. O#e'!tive "!$s = )perative goals indicate what the organization is really

attempting to do. They are focused and help in choice making.

PROFIT MA2IMI3ATION:

o rofit ma6imization is a stated goal of financial management.

o rofit is the e6cess of revenue over e6penses.

o rofit ma6imization is ma6imizing revenue given the e6penses.

o *evenue ma6imization is possible through pricing and scale strategies

o By increasing the selling price one may achieve revenue ma6imization.

O*+ECTI,ES OF PROFIT MA2IMI3ATION:

o rofit is measure of success in business.

o rofit is a measure of performance.

o erformance efficiency is indicated by the quantum of profit.

o rofit making is essential for the growth and survival of any undertaking.

o rofit making is accepted by the society.

ROLE OF FINANCIAL MANAGEMENT:

Anticipating financial management

Acquiring financial resources

Allocation of fund in business

Forecasting e6pected funds.

Business needs

TIME ,ALUE OF MONE1:

Time value of the money is important concept of financial management. &t

involves that the value of money is different at different points of time. 5oreover, moneycan be put to productive use.

&n simple words, the value of a certain amount of money today is more valuable

than its value tomorrow.

The value of money is die'ent !t die'ent #int time due to severalreasons.


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resence of inflation.

resence of individuals for current consumption over future consumption

&nvestment opportunities

REASONS:

8. resence of inflation2

The first reason of decreasing value of money with the increase in time is due toinflation. &nflation is all pervasive and is a universal phenomenon. For the purpose of

discussion, we will define inflation as the rise in the prices of goods, leading to a

reduction in the value of money.

9. resence of individuals for current consumption over future consumption2

The second reason for decreasing value of money is the preference of individuals

to consume now than latter. (ach one of us faces a situation of trade = off betweenpresent and future consumption.

:. &nvestment opportunities2

Thirdly, money has time value because capital can be put to productive use, evenif it is not consume now. 1ike any other commodity, money too is scarce.

CONCEPT OF TIME ,ALUE OF MONE1:

7aluation of financial securities. 7aluation of firms

7aluation of capital budgeting, merger and acquisition

ersonal finance

1easing and hire purchase transactions

REASONS FOR TIME ,ALUE OF MONE1:

&ndividual, in general, prefer current consumption to future consumption

"apital can be employed productively to generate positive returns.

An investment of one rupee today grows to 8 # r a year. * stands for rate of

return.

&n an inflationary period, a rupee today represents a greater real purchasing power

than a rupee a year hence.

RIS4 AND RETURN:

RETURNS:


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(verything held constant, individuals generally prefer current consumption to

future consumption. &n order to motivate individuals to invest, a potential investmentmust offer a positive rate of return. This will result in the investor having greater future

wealth and therefore greater future consumption opportunities than the current

consumption opportunities. &t is an incentive for the investor to postpone consumption.

Three ma>or factors which determine the return investors require in order

investing. They are2

The time preference for consumption as measured by the risk


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This will result in the security prices to move in the same direction as the stock

market inde6 3for instance the sense64. $ystematic risk is also referred to as market risk

or undiversifiable risk. (lements of systematic risk are2 5arket risk

&nterest rate risk

urchasing power risk

M!'7et Ris7:

7ariability in return on most common stocks that is due to basic sweepingchanges in investor e6pectation is called as market risk. The basis for the changes in

investor?s e6pectations may be political, social or economic.

Inte'est R!te Ris7:

The variation in the returns caused by fluctuations in the general level of interest

rates is referred to as the interest rate risk. As the interest rate goes up, the market priceof e6isting fi6ed income securities falls, and vice versa.

P'c&!sin" P/e' Ris7:

;hile market risk and interest rate risk are associated with the uncertainties in theamount of money to be received by an investor, purchasing power risk is the uncertainty

of the purchasing power of the money to be received. &t refers to the impact of inflation

or deflation on an investment. *ising prices on goods and services are normallyassociated with inflation or deflation on an investment.

or elements of unsystematic risk are2

Business *isk

Financial *isk

*siness Ris7:

Business risk arises due to the variations in the operating income and the

dividends. Factors such as management capability, consumer preferences, competition,labour strikes and so on cause the business risk.

Business risk can be divided into two broad categories 2 internal an e6ternal.

&nternal business risk is associated with the efficiency with which a firm

conducts its business.(6ternal business risk is associated with the e6ternal environment within

which a firm has to operate. The e6ternal factors may be the cost of capital, the businesscycle, demographic factors, government policies, economic factors, monetary and credit

policies, political = legal factors and so on.

Fin!nci!$ Ris7:


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The way in which a company finances its activities influences the return to the

equity shareholders. This can be ascertained from the capital structure of the firm. The

use of debt finance creates payment of fi6ed interest and hence it affects the residualprofit available to the equity shareholders

CAPITAL *UDGETING:

INTRODUCTION:

The term capital budgeting refers to long


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FEATURES OF CAPITAL *UDGETING:

&t has the potentiality of making large anticipated profits.

&t involves a high degree of risk

&t involves a relatively long time period between the initial outlay and

anticipated return. The future benefits are e6pected to be realized over a series of years.

They involve generally huge funds.

They have a long term and significant effect on the profitability of the

concern.

"apital budgeting decision involves the e6change of current funds for the

benefits to be achieved in future.

CAPITAL E2PENDITURE *UDGET:

"apital e6penditure budget is a type of functional budget. &t is the firm?s formalplan for the e6penditure of money for purchase of fi6ed assets. &t provides a guidance as

to the amount of capital that may be required for procurement of capital assets during the

budgeting period, the budget is prepared after taking into account the availableproduction capacities, probable reallocation of e6isting resources and possible

improvement in production techniques.

O*+ECTI,ES OF CAPITAL E2PENDITURE *UDGET:

o &t determines the capital pro>ects

o &t determines the e6pected rate of return on each pro>ect.

o

&t estimates e6penditure.o &t determines the source from which the required funds would be obtained.

o To coordinate inter departmental pro>ects.

o To measure the performance of onects.

o To prevent cost overects.

IMPORTANCE OF CAPITAL *UDGETING:

o &nvolvement of heavy funds.

o 1ong


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To decide the replacement of permanent assets such as building and equipments

To make financial analysis of various proposals regarding capital investments so

as to choose the best out of many alternative proposals. ;hether or not funds should be invested in longects such as setting of

industry, purchase of plant and machinery, etc.,

SIGNIFICANCE OF CAPITAL *UDGETING:

1arge investments

1ong = term involvement of funds.

7ery difficult to dispose

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rgency.

*esearch and development.

"ompetitor?s activity.

&ntangible factors.

FACTORS AFFECTING CAPITAL IN,ESTMENT DECISION: The amount of investment

"ost of new pro>ect

&nstallation cost

;orking capital

rocessed from sale of assets.

Ta6 effects

&nvestment allowance

"ut off point

*eturn e6pected from the investment

Accounting profit

"ash flows

-etermining on economic value

Accounting ambiguities.

Time value of money.

*anking of the investment proposals

*isk and uncertainty

7arious nonect. The essential property of a sound technique is

that it should ma6imize the shareholder?s worth.

The following are sound investment evolution criterion.

&t should consider all cash flows to determine the true profitability of the pro>ect.

&t should provide for an ob>ective and unambiguous way of separating good

pro>ects from bad pro>ects.

&t should help ranking of pro>ects according to their true profitability.

&t should recognize the fact that bigger cash flows are preferable to smaller ones

and easily has flows are preferable to later ones.

&t should help to choose among mutually e6clusive pro>ects that pro>ect which

ma6imizes the shareholder?s wealth.

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The importance of the capital budgeting is the equalizing of matching the

available resources with the acceptable pro>ects.

There are many ways in practice all over the sphere of capital e6pendituredecisions. ;hichever method is selected, it should%

8. rovide a basis for difference between acceptable and nonects.

9. *ank different proposals in order of priority.:. +ave a suitable approach.

C. Adopt criterion.

D. *ecognizing the time value of money.

CHART

Abbreviation2

7 ! (T *($(T 7A1(AA* ! A"")T&' *AT( )F *(T* )* A7(*A'( *AT( )F *(T*

B ! A


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TRADITIONAL METHODS:

ay = back period method

ay = back profitability method

Accounting rate of return or Average rate of return method

MODERN METHOD:

et present value method

rofitability &nde6

&nternal rate of return

PA1 = *AC4 PERIOD METHOD:

ay = back period is also called pay = out? or pay = off period?. ay = back

period is the time required in which a pro>ect pays for itselfthrough surplus cash flows.&t is the period within which investment in fi6ed assets or pro>ects can be recovered.

&n simple words, pay = back period is the period of time for the cost of pro>ects tobe recovered from the additional cash flows of the pro>ect itself.

COMPUTATION OF P*P:

8. ;hen cash inflows are equal

ay = back period ! &nitial cost of assets or initial investment in pro>ects

Annual cash inflows

9. ;hen cash inflows are not equal

ay = back period ! &nvestment

"ash inflows

AD,ANTAGES OF P*P METHOD:

&t is simple to understand

&t is simple to calculate&t concentrates on recovery of investment

&t takes cares uncertainty and risk

Built = in featuresrofit is determined.

&mportance to liquidity

&t acts guidelines for dividend policy5anage with lower funds.


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DISAD,ANTAGES OF PA18*AC4 PERIOD METHOD:

&t neglects postect whose pay = back period is higher than the norms or standard may be

re>ected outright. The pro>ect within the norms or standard pay = back period may be

short list for further consideration. They are acceptable pro>ects.

9. *anking of roposals2ay = back period can be used as the criterion to rank different investmentproposals. This method is very important in the case of mutually e6clusive pro>ects.

ACCOUNTING RATE OF RETURN (ARR):

Accounting rate of return takes into account the total earnings e6pected from an

investment proposals over its full life time. The method is called Accounting rate ofreturn or Average rate of return method because the concept based on profit.

STEPS IN ARR METHOD:

A** is determined separately for each of the pro>ects.

-ifferent pro>ects are ranked in order of rate of earnings.

&f there is no cut off rate.

ro>ect with higher A** is acceptable

The cut off rate normally based on cost of capital of the firm.

ro>ect with higher rate of return than the cut off rate are acceptable pro>ects.


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AD,ANTAGES OF ARR:

&t is easy to understand.

(6act profitability of a pro>ect.

The basis for the method is according concept of profit. This method is based on net earnings.

&t provides a more comprehensive comparative assessment of pro>ects.

DISAD,ANTAGES OF ARR:

This method ignores the time value of money.

*eliability of A** method is affected due to the various concept of investment.

rofit as the criterion.

A** method is not properly assessed.

&nvestment is made in two or more installments.

CALCULATION OF ARR:

Total income method

Annual return on original investment method.

Annual return on average investment method

8. Total income method2

Total (arningsA** ! 8GG

)riginal "ost of investment < $crap

9. Annual return on original investment method2

Annual average earnings

A** ! 8GG )riginal investment

:. Annual return on average investment method2

Annual Average earnings

A** ! 8GG

Average investment

)T(2

3a4 Average &nvestment ! )riginal &nvestment

9

3b4 Average &nvestment ! )riginal &nvestment = $crap


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$horter span of life of the assets.

CALCULATION OF NP, IN CASE OF REPLACEMENT OF MACHINE:

Additional investment

et operating savings or profit Additional ta6

PROFITA*ILIT1 INDE2:

The profitability inde6 is also known as benefit cost *atio 3B@"4. it shows the

relationship between .7 of cash inflows and .7 of cash outflows.

resent value of future cash inflows

.& !

resent value of future cash outflows

Accept criterion ! .& H8

*e>ect "riterion ! .& I 8

AD,ANTAGESOF P.I:

&t recognizes time value of money.

Better than the traditional method.

True assessment

&t considers the earnings over the entire life of the pro>ect.

&t tries to ma6imize the profit.

&t favouring more profitable pro>ects.

&t is most suitable.

DISAD,ANTAGES OF PI:

"ompared to traditional methods.

&t is complicated to understand.

"omparison of pro>ects with unequal life time.

5isleading.

&t is suitable for particular pro>ect. &t is not easy to determine as appropriate discount rate.

$horter span of life of the assets.

INTERNAL RATE OF RETURN:


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The second discounted cash flow or time ad>usted method for appearing capital

investment decisions is the &** method. &** is that rate of return at which the present

value of cash inflows and cash outflows are equal.Thus, at &** the total of discounted cash inflows equal the total of discounted

cash outflows. &** discounted the total cash flows to the level of zero.

"ash inflows

&** !

"ash outflows

&** is also known as trial and error yield method.

*& !

8 # r

;here & ! cash outflows* ! "ash inflows

* ! *ate of return on the investment.

Accept "riterion ! &** H "ut off rate

*e>ect "riterion ! &** I "ut off rate

AD,ANTAGES OF IRR:

&t takes into time value of money.

True profitability of a pro>ect can be assessed.

&t considers the profitability of a pro>ect over its entire economic life.

"ost of capital or pre

Introduction to Finance Mca

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