Unit-1 :Introduction

Meaning - scope and functions of Finance -

Financial management – Nature,
Characteristic, Functions, Scope & Process -
Objectives of financial management – profit
maximization - wealth maximization - Time
value of money - present value of money –
concepts-simple practical problems.
• Finance:-
– It is the flow of money.
• Management:-
– Control or Managing of money
• Financial Management:-
– It is the process of managing or controlling flow of
money or fund.
 Role of a Financial 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.
2. Allocation of Funds
– The funds should be allocated in such a manner
that they are optimally used.
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.
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 financial
manager. When securities are traded on stock
market there involves a huge amount of risk
involved. Therefore a financial manger
understands and calculates the risk involved in this
trading of shares and debentures.
5. Forecasting Financial Requirements
• It is the primary function of the Finance
Manager. He is responsible to estimate the
financial requirement of the business concern.
He should estimate, how much finances
required to acquire fixed assets and forecast
the amount needed to meet the working
capital requirements in future.
6. Interrelation with Other Departments
• Finance manager deals with various functional
departments such as marketing, production,
personnel, system, research, development, etc.
Finance manager should have sound knowledge
not only in finance related area but also well
versed in other areas. He must maintain a good
relationship with all the functional departments
of the business organization.
 TYPES OF FINANCE
• Finance can be classified into two major parts:
– Private Finance, which includes the Individual,
Firms, Business or Corporate Financial activities to
meet the requirements.
– Public Finance which concerns with revenue and
disbursement of Government such as Central
Government, State Government and Semi-
Government Financial matters
 Financial Management
• Financial Management it is a process of acquitting of
funds from various sources to meet the business
needs in order to accomplish overall objectives of
the firm.
– 1. Maximization of wealth.
– 2. Maximization of profit.
• "Financial management is concerned with raising
financial resources and their effective utilization
towards achieving the organizational goals”.
– Dr. S. N. Maheshwari,
• The term Financial Management means:
– To collect finance for the company at a low cost
and
– To use this collected finance for earning maximum
profits.
 Scope of Financial Management
1. Investment Decision
2. Financing Decision
3. Dividend Decision
4. Working Capital Decision
 1. Investment Decision:
• The investment decision involves the
evaluation of risk, measurement of cost of
capital and estimation of expected benefits
from a project. Capital budgeting and liquidity
are the two major components of investment
decision.
 2. Financing Decision:
• While the investment decision involves decision
with respect to composition or mix of assets,
financing decision is concerned with the
financing mix or financial structure of the firm.
• The raising of funds requires decisions regarding
the methods and sources of finance, relative
proportion and choice between alternative
sources, time of floatation of securities, etc.
 3. Dividend Decision:
• In order to achieve the wealth maximisation
objective, an appropriate dividend policy must
be developed. One aspect of dividend policy is
to decide whether to distribute all the profits
in the form of dividends or to distribute a part
of the profits and retain the balance. While
deciding the optimum dividend payout ratio
(proportion of net profits to be paid out to
shareholders).
 4. Working Capital Decision:
• Working capital decision is related to the
investment in current assets and current
liabilities. Current assets include cash,
receivables, inventory, short-term securities,
etc. Current liabilities consist of creditors, bills
payable, outstanding expenses, bank
overdraft, etc. Current assets are those assets
which are convertible into a cash within a year.
 Objectives of Financial Management
• The financial management is generally concerned with procurement,
allocation and control of financial resources of a concern. The objectives can
be-
1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders which will depend upon the
earning capacity, market price of the share, expectations of the
shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they
should be utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe
ventures so that adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair
composition of capital so that a balance is maintained between debt and
equity capital.
 Nature of Financial Management
1. Financial Management is an integral part of
overall management. Financial considerations
are involved in all business decisions.
Acquisition, maintenance, removal etc.
2. The central focus of financial management is
valuation of the firm. Financial decisions are
directed at increasing/maximization/optimizing
the value of the institution.
3. Financial management essentially involves risk-
return trade-off. Decisions on investment involve
choosing of types of assets which generate returns
accompanied by risks.
4. Financial management affects the survival, growth
and vitality of the institution. Finance is said to be
the life blood of institutions.
5. Financial management of an institution is
influenced by the external legal and economic
environment.
 Functions of Financial Management

1. Estimation of capital requirements:

– A finance manager has to make estimation with
regards to capital requirements of the company.
This will depend upon expected costs and profits
and future programmes and policies of a concern.
2. Determination of capital composition:
– Once the estimation have been made, the capital
structure have to be decided. This involves short-
term and long- term debt equity analysis.
3. Choice of sources of funds: For additional
funds to be procured, a company has many
choices like-
– Issue of shares and debentures
– Loans to be taken from banks and financial
institutions
– Public deposits to be drawn like in form of bonds.
4. Investment of funds:
– The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and
regular returns is possible.
5. Disposal of surplus: The net profits decision have to
be made by the finance manager.
– Dividend declaration - It includes identifying the rate of
dividends and other benefits like bonus.
– Retained profits - The volume has to be decided which will
depend upon expansional, innovational, diversification plans
of the company.
6. Management of cash:
– Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment
of wages and salaries, payment of electricity and water bills,
payment to creditors, meeting current liabilities, maintainance
of enough stock, purchase of raw materials, etc.
7. Financial controls:
– The finance manager has not only to plan, procure and utilize
the funds but he also has to exercise control over finances. This
can be done through many techniques like ratio analysis,
financial forecasting, cost and profit control, etc.
 Profit-Maximisation:
• The primary objective of financial
management has been held to be profit-
maximisation.
• Profit maximization means maximizing the
rupee income of a firm.
• No business can survive without earning
profit. Profit is a measure of efficiency of a
business enterprise.
Arguments for profit maximization
1. When profit earning is the aim of business,
the profit maximization should be the
main objective.
2. Profitability is a barometer for measuring
efficiency and economic prosperity of a
business enterprise.
3. Profits are the main source of finance for the
growth of a business.
4. Profitability is essential for fulfilling social
goals.
5. A business will be able to survive under
unfavorable situation only if it has some past
earnings.
Criticism of Profit Maximization: -
1.It is vague: - The price meaning of profit
maximization objective is unclear. Whether short
term or long term profit, profits before tax or after
tax, total profit or earning per share and so on.
2. Ignores the timing of the return: - The profit
maximization objective ignores the time value of
money. If values benefits received today and benefits
received after a period as the same, it avoids the fact
that cash received today is more important than the
same amount of cash received after some years.
3. It ignores risk: - The streams of benefit may
possess different degree of certainty. Two firms
may have same total expected earnings, but if
the earnings of one firm fluctuate considerably
as compared to the other, it will be more risky.
Profit maximization objective ignores this factor.
4. The effect of dividend policy on the market
price of share is also not considered in the
objective of profit maximization.
5. Profit maximization criteria fail to take into
consideration the interest of govt., workers
and other persons in the enterprise.
6. The firm’s goals cannot be to maximize profit
but to attain a certain level or rate of profit,
holding a certain shares of the market or a
certain level of sales.
 Wealth Maximization: -
• It is assumed that the goal of the firm should be to
maximize the wealth of its current shareholders.
Wealth maximization is the appropriate objective
of an enterprise.
• A stockholder’s current wealth in the firm is the
product of the number of shares owned, multiplied
with the current stock price per share.
Stockholder’s current wealth in a firm = (Number
of shares owned) x (Current stock price per share).
Arguments against Wealth Maximization: -

1.The objective of wealth maximization is not necessarily

socially desirable.
2.The firm should not to increase the shareholders wealth
but also to see the interest of customers, creditors,
suppliers, community and others.
3.There is some controversy as to whether the objective is to
maximize the shareholders wealth or the wealth of the
firm, which includes other financial claim holders such as
debenture holder’s preference stock holders etc.
4.The objective is not descriptive of what the firms actually
do to maximize the wealth.
What is a Financial Management Process?

• A Financial Management Process is a method by which

costs (or expenses) incurred on the project are formally
identified, approved and paid. Typical types of costs
include:
–  Labor (e.g. staff, external suppliers, contractors and consultants)
– Equipment (e.g. computers, furniture, building facilities,
machinery and vehicles)
– Materials (e.g. stationery, consumables, building materials,
water and power)
– Administration (e.g. legal, insurance, lending and accounting
fees).
 Time value of money
• The time value of money (TVM) is the idea that
money available at the present time is worth more
than the same amount in the future due to its
potential earning capacity.
• Time Value of Money is a concept that recognizes
the relevant worth of future cash flows arising as a
result of financial decisions by considering the
opportunity cost of funds.
• Why does Money have Time Value?
• Suppose you are one of the lucky people to win the lottery.
You are given two options on how to receive the money.
– Option 1: Take Rs. 50,00,000 right now.
– Option 2: Get paid Rs. 6,00,000 every year for the next 10 years.
• In option 1, you get Rs. 50,00,000 and in option 2 you get
Rs. 60,00,000. Option 2 may seem like the better bet
because you get an extra Rs. 10,00,000, but the time value
of money theory says that since some of the money is paid
to you in the future, it is worth less. By figuring out how
much option 2 is worth today (through a process called
discounting), you'll be able to make an apples-to-apples
comparison between the two options. If option 2 turns out
to be worth less than Rs. 50,00,000 today, you should
choose option 1, or vice versa.
 Reasons for TVM
• Risk & Uncertainty
• Inflation
• Consumption – Individuals generally prefer
current consumption to future consumption.
• Investment Opportunities – An investor can
profitably employ a rupee received today to
give a better value to be received tomorrow.
• There are two techniques to reveal
meaningful comparisons between cash flows.
– Compounding
– Discounting
• Further TMV can be broken into two areas
– Present Value and
– Future Value.
 Future Value Present Value
Simple Interest Even Cash Flow

Compound Interest (Annual & Non Uneven Cash Flows

Annual)

Annuity (Ordinary Annuity & Annuity Annuity

due)
 Doubling Period
• It is the time required for an investment to
double in size or value, i.e. amount invested
fetches 100% return.
• There are different approaches in doubling
period,
– Rule of 72
– Rule of 70
– Rule of 69
 Rule of 72
• It determines the anticipated duration
required to double the investment.

– Rule of 72 = 72/( i or n)
• Where, i = Interest Rate
– n = No. of Investment years
 Rule of 70
• The rule of 70 states that in order to estimate
the number of years for a variable to double,
take the number 70 and divide it by the
growth rate of the variable.

– Rule of 70 = 70/Growth rate

 Rule of 69
• This the rational and scientific method to
determine doubling period. It is been given by,

– Rule of 69 = 35 + (69/i)
• Where, i = Interest rate