Managerial Finance

Introduction
Define Finance

In simple term, finance is concerned with the decisions about money.

Financial decision deals with how business, government and individual raise and use money.

Finance may be defined as the art and science of managing money.

Finance also is referred as the provision of money at the time when it is needed. Finance function
is the procurement of funds and their effective utilization in business concern.
Webster’s Ninth New Collegiate Dictionary defines finance as “the Science on study of the
management of funds’ and the management of fund as the system that includes the circulation of
money, the granting of credit, the making of investments, and the provision of banking facilities.

"Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation of funds.
It also deals with profits that adequately compensate for the cost and risks borne by the business."

Definition of Business Finance

Business finance is that business activity which concerns with the acquisition and conversation
of capital funds in meeting financial needs and overall objectives of a business enterprise”.

Activities of business concern relevant to financial planning, coordinating, control and their
application is called business finance.

Function of finance
Finance is concerned with the process, institution, market and instrument relevant to these that
cause transfer of money among the individual, business and government.
The main functions of finance are-
1. Finance determine required amount of fund.
2. Finance finds out the sources of fund
3. It finds out the nominal and effective cost of fund.
4. It raises fund from the source of least cost sources and use collected fund properly and
optimally.

Course: MKT-102: Managerial Finance, EMBA Program, Patuakhali Science Technology University, PSTU | 1
 Internal Sources

Types of finance
Central bank, local
Government Finance commercial bank

Finance

Foreign aid, grants,

Finance assistance, loan, donation

Personal Finance

Non-Government Finance
Business Finance

Non-business Finance

International Finance

Principles of finance

1. Risk return trade-off: At the heart of most financial decisions is the concern about two
specific factors-risk and return. An underlying assumption of finance is that investors
should demand compensation for bearing risk. According to this concept of risk aversion,
investors should expect a higher return for taking higher levels of risk.
2. Time Value of Money: Money has a time value. One dollar received today is worth more
than a dollar received one year from now. So, the main view of this principle is that before
taking investment decision one should consider the time value of money.
3. Principles of net-Cash flow- Net cash flow is a profitability measurement that represents
the amount of money produced or lost during a period by calculating the difference
between cash inflows from outflows.
4. Profitability & Liquidity-Profitability refers to firm’s ability to generate profit and
liquidity refers to the ability to convert near cash asset to cash or ability to meet up the debt
obligation.
5. Wealth Maximization-The concept of wealth maximization means the maximization of
wealth of the owner. It is measured by the price of the stock. The price of the stock depends
on return of the assets employed and risk contained.

Course: MKT-102: Managerial Finance, EMBA Program, Patuakhali Science Technology University, PSTU | 2
 6. Business cycle-Business cycle refers to the radical changes of investment, employment,
production, national income throughout of the year. Fluctuations in the level of business
activity in an economy brought about by changes in demand conditions, particularly
increases and decreases in investment spending. The business cycle is characterized by
four phases, with the economy moving upwards from ‘depression’ through ‘recovery’ to
‘boom’ and back through ‘recession’ to depression once again.
The depression stage of the cycle is characterized by a very low level of demand relative
to supply capacity, accompanied by low levels of output, unsold stock and high
unemployment. As demand picks up in the recovery stage, stock levels fall and output and
employment increases. Boom conditions are characterized by full-capacity levels of
output and employment, but with a tendency for the economy to ‘overheat’, producing
inflationary pressures. The ending of a boom is followed by a period of recession, with
falling demand leading to modest falls in output and employment at first but then
accelerating into depression as demand continues to fall.
7. Dividend Policy-Dividend policy is intimately connected to the firm’s investment and
financing decisions because the dividend payout ratio determines the amount of earnings
that a firm can retain.
8. Optimal Capital Structure-Optimal capital structure may be defied as the capital
structure or combination of debt and equity that leads to the maximum value of the firm.
9. Principle of Minimum Cost of Capital-Cost of capital is the rate of return the firm
required from investment in order to increase the value of the firm in the market place.
Cost of capital is an integral part of investment decision as it is used to measure the worth
of investment proposal provided by the business concern.

Corporate of form of business Organization

Three major forms of business organization
 Sole proprietorship-
- Owned and controlled by a single person.
- In Bangladesh 85% of business are sole proprietorship.

 Partnership
- Partnership business owned by two or more individual

Course: MKT-102: Managerial Finance, EMBA Program, Patuakhali Science Technology University, PSTU | 3
 - Partnership is an association of two or more persons carry on co-owners of business for
profit.
 Corporation
- Corporation is legal entity separate and distinct from the owners.
- Company means a entity that is formed and organized under the Company Act-1994.

Advantages of Corporations
 Unlimited life-a corporation can continue after its original owners and managers are
deceased.
 Limited liability-Because the owners, who are the stockholders, are not liable for the debts
of the corporation, they have limited liability.
 Ease of ownership transfer-for publicly held corporations, stockholders can readily sell
their stock in the open market.
 Ability to raise funds-The previous three advantages enhance the corporation’s ability to
raise large sums of money. That is, corporations can raise funds by selling additional shares
of stock.
 Proportional distribution of Income-Corporations distribute income, often by paying
dividends, in proportion to ownership interest.

Disadvantage of Corporations
 Cost & complexity to start-Setting up a corporation involves preparing a charter, writing
a set of bylaws, and filing the many required state and federal reports, which is more
complex and time consuming than creating a proprietorship or a partnership.
 Double Taxation- Corporate earnings may be subject to double taxation—the earnings of
the corporation are taxed at the corporate level, and then earnings paid out as dividends
are taxed again as income to the stockholders.
 Separation of ownership and management-In many corporations, especially larger ones,
managers and owners represent separate groups. Theoretically, managers should run the
corporation’s affair in the best interest of its stockholders. But in practice, the interest of
managers and owners may not always be the same. For example, managers may place their
own interest ahead of those of the shareholders.

Course: MKT-102: Managerial Finance, EMBA Program, Patuakhali Science Technology University, PSTU | 4
DEFINITION OF FINANCIAL MANAGEMENT
Financial management is an integral part of overall management. It is concerned with the duties of
the financial managers in the business firm.
The most popular and acceptable definition of financial management as given by S.C. Kuchal is
that “Financial Management deals with procurement of funds and their effective utilization in
the business”.
Weston and Brigham: Financial management “is an area of financial decision-making,
harmonizing individual motives and enterprise goals”.

Thus, Financial Management is mainly concerned with the effective funds management in the
business.

Financial Management Decision

1. Investment decision-It involves mainly two types of decisions,

- Capital budgeting-decision regarding firm’s long term
- Working capital Management
2. Financing Decision-the financing principles states that the financial manager should
choose financing mix that maximize the value of the investments made and matches the
financing to assets being financed.
3. Dividend decision-The financial manager can obtain funds for its investments and
operations either internally or externally. Internally generated funds represent the amount
of earnings that firm decides to retain after paying a cash dividend if any, to its stock
holders.

Functions of financial Manager

Finance function is one of the major parts of business organization, which involves the permanent,
and continuous process of the business concern. Finance is one of the interrelated functions which
deal with personal function, marketing function, production function and research and
development activities of the business concern. At present, every business concern concentrates
more on the field of finance because, it is a very emerging part which reflects the entire operational
and profit ability position of the concern. Deciding the proper financial function is the essential
and ultimate goal of the business organization.

Course: MKT-102: Managerial Finance, EMBA Program, Patuakhali Science Technology University, PSTU | 5
Finance manager performs the following major functions:
 Forecasting Financial Requirements:
He should estimate, how much finances required to acquire fixed assets and forecast the
amount needed to meet the working capital requirements in future.
 Acquiring Necessary Capital
After deciding the financial requirement, the finance manager should concentrate how the
finance is mobilized and where it will be available.
 Investment Decision
The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field
of capital budgeting techniques to determine the effective utilization of investment. The
finance manager must concentrate to principles of safety, liquidity and profitability while
investing capital.
 Cash Management
Present day’s cash management plays a major role in the area of finance because proper
cash management is not only essential for effective utilization of cash but it also helps
to meet the short-term liquidity position of the concern.
 Interrelation with Other Departments
Finance manager deals with various functional departments such as marketing,
production, personel, 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.
Forecasting
funds

Managing Fiancial Acquiring

funds Manager funds

Investing
funds

Course: MKT-102: Managerial Finance, EMBA Program, Patuakhali Science Technology University, PSTU | 6
OBJECTIVES OF FINANCIAL MANAGEMENT
To make wise decisions a clear understanding of the objectives which sought to be achieved in
necessary. The objectives provide a framework for optimum financial decision making. The
objective of a Financial Management is to design a method of operating the Internal Investment
and financing of a firm. The two widely used approaches are-
1. Profit Maximization and
2. Wealth maximization.

Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also functioning
mainly for the purpose of earning profit. Profit is the measuring techniques to understand the
business efficiency of the concern. Profit maximization is also the traditional and narrow approach,
which aims at, maximizes the profit of the concern.

Favorable arguments for Profit Maximization:

The following important points are in support of the profit maximization objectives of the business
concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also.

Unfavorable Arguments for Profit Maximization

The following important points are against the objectives of profit maximization:
(i) There is no proposition of profitability rate.
(ii) It does not mention time factor that may involve in it, whether it is long run profit or
short run profit is not clear.
(iii) The proposition is not clear about the risk factor, ignorance of which is a big departure
from financial value.
(iv) Profit maximization leads to exploiting workers and consumers. It creates immoral
practices such as corrupt practice, unfair trade practice, etc.

Course: MKT-102: Managerial Finance, EMBA Program, Patuakhali Science Technology University, PSTU | 7
Wealth Maximization
The concept of wealth maximization means the maximization of wealth of the owner. It is
measured by the price of the stock. The stock price depends on return of the assets employed
and risk contained. The term wealth means shareholder wealth or the wealth of the persons those
who are involved in the business concern. Shareholders’ wealth can be defined as the total market
value of all the equity shares of the company.
Financial managers itself usually involve in the activities that are directed to the maximization of
the wealth of the investors. Returns in the form of cash flows and risk are the important
determinants that involve in maximizing wealth.

Favourable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization because the main aim of
the business concern under this concept is to improve the value or wealth of the
shareholders.
(ii) Wealth maximization considers the comparison of the value to cost associated with the
business concern. Total value detected from the total cost incurred for the business
operation. It provides extract value of the business concern.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.

Unfavorable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea of the business concern but it may not
be suitable to present day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name
of the profit maximization.
(iii) Wealth maximization creates ownership-management controversy.
(iv) Management alone enjoy certain benefits.
(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.
(vi) Wealth maximization can be activated only with the help of the profitable position of
the business concern.

Course: MKT-102: Managerial Finance, EMBA Program, Patuakhali Science Technology University, PSTU | 8
Relationship of Managerial finance with other disciplines
1. Financial Management and Economics
Economic concepts like micro and macroeconomics are directly applied with the financial
management approaches. Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager. Financial management also uses
the economic equations like money value discount factor, economic order quantity etc.
2. Financial Management and Production Management
Production management is the operational part of the business concern, which helps to
multiple the money into profit. Profit of the concern depends upon the production
performance. Production performance needs finance, because production department
requires raw material, machinery, wages, operating expenses etc. These expenditures are
decided and estimated by the financial department and the finance manager allocates the
appropriate finance to production department. The financial manager must be aware of the
operational process and finance required for each process of production activities.
3. Financial Management and Accounting
Accounting records includes the financial information of the business concern. Hence, we
can easily understand the relationship between the financial management and accounting.
In the olden periods, both financial management and accounting are treated as a same
discipline and then it has been merged as Management Accounting because this part is very
much helpful to finance manager to take decisions. But nowaday’s financial management
and accounting discipline are separate and interrelated.
4. Financial Management and Human Resource
Financial management is also related with human resource department, which provides
manpower to all the functional areas of the management. Financial manager should
carefully evaluate the requirement of manpower to each department and allocate the
finance to the human resource department as wages, salary, remuneration, commission,
bonus, pension and other monetary benefits to the human resource department. Hence,
financial management is directly related with human resource management.

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Course: MKT-102: Managerial Finance, EMBA Program, Patuakhali Science Technology University, PSTU | 9
 Chapter-2

Time Value of Money

What is “time preference theory”? Describe the arguments behind the preference.

Time Preference Theory

The concept of preference of a certain amount of money now to at some future time is known as
“time preference Theory”.

This theory was developed by economist Irving Fisher. He described interest as the price of time, and "an
index of community’s preference for a dollar of present over a dollar of future income."

There are some arguments behind the preference:

1. Consumption: Human being, by nature, prefers current consumption to future

consumption. If he/she is refrained from current consumption, he/she will obviously
require some compensation.
2. Uncertainty: Future is always uncertain. If there is uncertainty, so that a risk premium as
compensation for uncertainty is must be added, otherwise it is preferable a dollar of today
to a dollar after one year.
3. Investment Opportunity: Investment opportunity should be taken under consideration
because there is an opportunity cost of money. If you would take Tk.1000 today. This
amount could further be invested to some profitable sector that could generate some return,
say @8%. So, after one year you would have a balance of Tk.1080, which you would forgo,
if you would prefer the second alternative.
4. Inflation: The purchasing power of people reduces in the passage of time due to inflation.
You cannot purchase as many goods after one year with tk. 100 as you can purchase today
with the same amount of money.

Uses of time Value of Money

 Bond Valuation
 Stock Valuation
 Accept/reject decision for project management
 Financial analysis of a firm

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The concept of Interest

Suppose, there are two alternatives-Tk.1000 today and Tk 1090 after one year. From this one may
prefer Tk 1090 as here one is getting some compensation for avoiding his current consumption.
The additional money that are offered to receive after one year is cost money or sometimes referred
to as “interest”

Money paid or earned for use of money is called interest. Another to say, it is cost of using money.
Or, “interest is the price of capital.”

Interest rate can be of two types-

 Simple interest
 Compound Interest

Simple Interest

Simple interest is interest that is paid (earned) on only the original amount, or principal, borrowed
(lent). The dollar amount of simple interest is a function three variables: the original amount
borrowed, the interest rate per time period and the number of time periods for which principal is
borrowed (lent).

The formula for calculating simple interest is-

SI  Pnr
Where

SI= Simple interest in Tk.

P= Principal amount

n= Number of years

r= Interest rate

For example, suppose Tk. 100 is deposited in a savings account paying 8% simple interest rate and
keep it there for 10 years. At the end of ten years the amount of Interest is determined as follows:

SI=Pnr
=100 (10)(0.08)
=Tk. 80.
This tk.80 is only the portion of interest.

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Future Value:

- The value at some future time of a present amount of money, or series of payments,
evaluated at a given interest rate
- The future value will include both principal amount and the interest amount. The future
value of an account at the end of n period is written under:
FV  P  SI
Or , FV  P  Pnr
Or , FV  P[1  nr ]

Where, FV= Future Value after n period

So, the future value after ten years FV=100[1+10*0.08]

=Tk. 180.

Present Value

- Sometimes it is need to know the principal amount or original investment, i.e., we know
the future value of deposit at i percent for n years, which is called present value.
- Rearranging the previous equation, we found-

FV
PV 
(1  nr )
 FV (1  nr ) 1

Compound Interest
Compound interest is the interest that is paid or earned on any previous interest earned, as well as
on the principal borrowed or lent.
The basic difference between simple interest and the compound interest is that in simple interest,
interest is charged /earned on only the principal amount, whereas in compound interest, interest is
charged /earned on previous interest as well as the principal amount. The difference can be shown
in the following table:

Year At simple interest rate Compound interest rate

2 FV  PV (1  nr )  1(1  2 * 0.08)  1.16  PV (1  r ) n  1(1  0.08) 2  1.166
20 2.60 =4.66
200 17.00 4838949.585
The table shows the future value of Tk.1 invested for various time period at an 8% interest rate.

Course: MKT-102: Managerial Finance, EMBA Program, Patuakhali Science Technology University, PSTU | 12
Future (Compound) Value: Single amount/Lump sum Value

Suppose, a person who deposit Tk. 100 into a savings account. If interest rate is 8% compounded
annually, how much will the Tk.100 be worth at the end of year….

In case of simple interest rate,

Future value after one year will be-
FV1=P [1+nr]
=100 [1+1*0.08]=Tk.108
In case of Compound interest rate,
FV1=PV(1+r)
=100 (1+0.08)=Tk. 108.
After 2 years, in case of simple interest

FV2=P [1+nr]
=100 [1+2*0.08]=Tk.116
In case of Compound interest rate,
FV2=FV1(1+r)
=108 (1+0.08)=Tk. 116.64

From the above, it is found that, the future value of compound interest rate is higher than the future
value of simple interest rate. It is because in compound interest, interest will charge on whole
amount of previous period (that is after one year). That means, interest is charged on the principal
amount as well as previous interest.

The formula of Future Value after any time period,

FV  PV (1  r ) n Compounding----Present Value Future Value

Discounting----Future ValuePresent Value
Compounded annually=1,
Semiannually=2
Where,
Quarterly=4
Monthly=12
FV=Future Value after n period Weekly=52
Daily=365
PV=Present Value or initial Investment
Future Value
r=Interest rate r nm
FV  PV (1  )
n=number of years m

Present (or discounted) Value:

n r nm
PV  FV (1  r ) PV  FV (1 
m
)

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Related Question:

1. Define the Concept of simple interest rate. How it is different from compound interest rate?
2. Describe the concept of future value under compound interest rate? Why the future value
of compound interest rate is higher than that of simple interest rate?

Problem: 1

Suppose, you deposit Tk. 100,000 for 10 years in a bank @10% compounded monthly. Calculate
amount you will get at the end of 10 years.

Given that, r nm

FV  PV (1  )
m
PV=Tk. 100,000 0.10 1012
r=10%=0.10  FV  100000(1  )
12
m=12  FV  100000(2.7070)
n=10 years
 FV  TK .270704.1491
FV=?

Problem:2

Suppose, you will get Tk.100,000 at the end of the year 10 @10% compounded quarterly. How
much money you will invest today?

Given that,
r  n m
PV  FV (1  )
FV=Tk. 100,000 m
r=10%=0.10 0.10 10 4
m=4  PV  100000(1  )
n=10 years 4
PV=?  PV  100000(0.3724)
 PV  TK .37243.062

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Problem-3

At the end of three years, how much is an initial deposit of Tk.100 worth, assuming a compound
annual interest rate of (i) 100% (ii)10% and 0%.

r n m
FV  PV (1  )
m
1
 FV  100(1  ) 31
1
 FV  100(8)
 FV  TK .800
0.10 31
FV  100(1  )
1
 FV  100(1.331)  133.10
0
FV  100(1  ) 31
1
 FV  100(1)  100

Problem-4

Tk 100 at the end of three years is worth how much today, annual discount rate of (i) 100% (ii)10%
and 0%.

r  n m
PV  FV (1  )
m
1
 PV  100(1  )  31
1
 PV  100(0.125)
 PV  TK .12.50
0.1  31
PV  100(1  )
1
 PV  100(0.7513)  75.1314
0
PV  100(1  )  31  100
1

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