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FINANCIAL MANAGEMENT

MEANING OF FINANCE :
Finance may be defined as the art and science of managing money. It includes financial service
and financial instruments. 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 concerns.
The concept of finance includes capital, funds, money, and amount. But each word is having
unique meaning. Studying and understanding the concept of finance become an important part
of the business concern.
FINANCIAL MANAGEMENT
DEFINITION OF BUSINESS FINANCE:

According to the Wheeler, “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”.

According to the Guthumann and Dougall, “Business finance can broadly be defined
as the activity concerned with planning, raising, controlling, administering of the
funds used in the business”.

In the words of Parhter and Wert, “Business finance deals primarily with raising,
administering and disbursing funds by privately owned business units operating
in nonfinancial fields of industry”.

Corporate finance is concerned with budgeting, financial forecasting, cash


management, credit administration, investment analysis and fund procurement of
the business concern and the business concern needs to adopt modern technology
and application suitable to the global environment.
FINANCIAL MANAGEMENT
Financial Management – Definition
According to Weston and Brigham, financial management is an area of financial
decision making, harmonizing individual motives and enterprise goals.

In the words of Phillippatus, financial management is concerned with the managerial


decisions that result in the acquisition and financing of long-term and short-term
credits for the firm.
FINANCIAL MANAGEMENT
SCOPE OF FINANCIAL MANAGEMENT :
Financial management is one of the important parts of overall management, which is
directly related with various functional departments like personnel, marketing and
production. Financial management covers wide area with multidimensional approaches.
The following are the important scope of financial management.

1. Financial Management and Economics

2. Financial Management and Accounting

3. Financial Management or Mathematics

4. Financial Management and Production Management

5. Financial Management and Marketing

6. Financial Management and Human Resource


FINANCIAL MANAGEMENT
OBJECTIVES OF FINANCIAL MANAGEMENT :

Effective procurement and efficient use of finance lead to proper utilization of the
finance by the business concern. It is the essential part of the financial manager. Hence,
the financial manager must determine the basic objectives of the financial management.

Objectives of Financial Management may be broadly divided into two parts such as:

1. Profit maximization

2. Wealth maximization.
FINANCIAL MANAGEMENT
1. 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.

2. Wealth maximization.
Wealth maximization is one of the modern approaches, which involves latest innovations
and improvements in the field of the business concern. The term wealth means
shareholder wealth or the wealth of the persons those who are involved in the business
concern.
Wealth maximization is also known as value maximization or net present worth
maximization. This objective is an universally accepted concept in the field of business.
FINANCIAL MANAGEMENT
FUNCTIONS OF FINANCE MANAGER :

Finance manager is one of the important role players in the field of finance function.
He must have entire knowledge in the area of accounting, finance, economics and
management. His position is highly critical and analytical to solve various problems
related
to finance. A person who deals finance related activities may be called finance manager.
Finance manager performs the following major functions:

1. Forecasting Financial Requirements

2. Acquiring Necessary Capital

3. Investment Decision

4. Cash Management

5. Interrelation with Other Departments


FINANCIAL MANAGEMENT
IMPORTANCE OF FINANCIAL MANAGEMENT

Financial Planning
Financial management helps to determine the financial requirement of the business
concern and leads to take financial planning of the concern. Financial planning is an
important part of the business concern, which helps to promotion of an enterprise.

Acquisition of Funds
Financial management involves the acquisition of required finance to the business
concern. Acquiring needed funds play a major part of the financial management, which
involve possible source of finance at minimum cost.

Proper Use of Funds


Proper use and allocation of funds leads to improve the operational efficiency of the
business concern. When the finance manager uses the funds properly, they can reduce
the cost of capital and increase the value of the firm.
FINANCIAL MANAGEMENT
IMPORTANCE OF FINANCIAL MANAGEMENT

Financial Decision
Financial management helps to take sound financial decision in the business concern.
Financial decision will affect the entire business operation of the concern. Because there
is a direct relationship with various department functions such as marketing, production
personnel, etc.

Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper utilization of
funds by the business concern. Financial management helps to improve the profitability
position of the concern with the help of strong financial control devices such as
budgetary control, ratio analysis and cost volume profit analysis.

Increase the Value of the Firm


Financial management is very important in the field of increasing the wealth of the
investors and the business concern. Ultimate aim of any business concern will achieve
the maximum profit and higher profitability leads to maximize the wealth of the investors
as well as the nation.
FINANCIAL MANAGEMENT
IMPORTANCE OF FINANCIAL MANAGEMENT

Promoting Savings
Savings are possible only when the business concern earns higher profitability and
maximizing wealth. Effective financial management helps to promoting and mobilizing
individual and corporate savings.

ASSIGNMENT QUESTIONS

1. Discuss the objectives of financial management.

2. Explain the scope & Importance of financial management.

3. Discuss the role of financial manager.


Chapter 2
Time Value of
Money
After studying Chapter 3, you should be
able to:

1. Understand what is meant by "the time value of money."


2. Understand the relationship between present and future value.
3. Describe how the interest rate can be used to adjust the value of cash flows
– both forward and backward – to a single point in time.
4. Calculate both the future and present value of: (a) an amount invested
today; (b) a stream of equal cash flows (an annuity); and (c) a stream of
mixed cash flows.
5. Distinguish between an “ordinary annuity” and an “annuity due.”
6. Use interest factor tables and understand how they provide a shortcut to
calculating present and future values.
7. Use interest factor tables to find an unknown interest rate or growth rate
when the number of time periods and future and present values are known.
8. Build an “amortization schedule” for an installment-style loan.
The Time Value of Money

• The Interest Rate


• Simple Interest
• Compound Interest
• Amortizing a Loan
• Compounding More Than Once per Year
The Interest Rate

Which would you prefer -- Rs.10,000


today or Rs.10,000 in 5 years?

Obviously, Rs.10,000 today.

You already recognize that there is TIME


VALUE TO MONEY!!
Why TIME?

Why is TIME such an important element


in your decision?

TIME allows you the opportunity to


postpone consumption and earn INTEREST.
Types of Interest

 Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
•Compound Interest
Interest paid (earned) on any previous interest
earned, as well as on the principal borrowed
(lent).
Simple Interest Formula

Formula SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
Simple Interest Example

•Assume that you deposit Rs.1,000 in an


account earning 7% simple interest for 2 years.
What is the accumulated interest at the end of
the 2nd year?

•SI = P0(i)(n) =
Rs.1,000(.07)(2) =
Rs.140
Simple Interest (FV)

•What is the Future Value (FV) of the deposit?

FV = P0 + SI =
Rs.1,000 + Rs.140 = Rs.1,140
• Future Value is the value at some future time of a
present amount of money, or a series of payments,
evaluated at a given interest rate.
Simple Interest (PV)

•What is the Present Value (PV) of the previous


problem?
The Present Value is simply the
Rs.1,000 you originally deposited. That
is the value today!
• Present Value is the current value of a future
amount of money, or a series of payments,
evaluated at a given interest rate.
Why Compound Interest?

Future Value of a Single Rs.1,000 Deposit

20000
Future Value (INR)

10% Simple
15000 Interest
7% Compound
10000
Interest
5000 10% Compound
Interest
0
1st Year 10th 20th 30th
Year Year Year
Future Value
Single Deposit (Graphic)

Assume that you deposit Rs.1,000 at a


compound interest rate of 7% for 2 years.

0 1 2
7%

Rs.1,000
FV2
Future Value
Single Deposit (Formula)

FV1 = P0 (1+i)1 = Rs.1,000 (1.07)


= Rs.1,070
Compound Interest
You earned Rs.70 interest on your Rs.1,000
deposit over the first year.
This is the same amount of interest you would
earn under simple interest.
Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = Rs.1,000 (1.07)
= Rs.1,070
FV2 = FV1 (1+i)1
= P0 (1+i)(1+i) = Rs.1,000(1.07)(1.07)
= P0 (1+i)2 = Rs.1,000(1.07)2
= Rs.1,144.90
You earned an EXTRA Rs.4.90 in Year 2 with
compound over simple interest.
General Future Value Formula

FV1 = P0(1+i)1
FV2 = P0(1+i)2

General Future Value Formula:


etc.
FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See Table I
Valuation Using Table I

FVIFi,n is found on Table I


Period
at the end of the book.
6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
Using Future Value Tables

FV2 = Rs.1,000 (FVIF7%,2)


Period = Rs.1,000
6% (1.145)
7% 8%
1 = 1.060
Rs.1,145 1.070
[Due to Rounding]
1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
Story Problem Example

Julie Miller wants to know how large her deposit of


Rs.10,000 today will become at a compound annual interest
rate of 10% for 5 years.

0 1 2 3 4 5

10%
Rs.10,000
FV5
Story Problem Solution

 Calculation based on general formula:


FVn = P0 (1+i)n
FV5 = Rs.10,000 (1+ 0.10)5

= Rs.16,105.10
•Calculation based on Table I: FV5
= Rs.10,000 (FVIF10%, 5) =
Rs.10,000 (1.611) =
Rs.16,110 [Due to Rounding]
Present Value Single Deposit
(Graphic)

Assume that you need Rs.1,000 in 2 years. Let’s


examine the process to determine how much you
need to deposit today at a discount rate of 7%
compounded annually.
0 1 2
7%

Rs.1,000
PV0 PV1
Present Value
Single Deposit (Formula)

PV0 = FV2 / (1+i)2 = Rs.1,000 / (1.07)2 = FV2 / (1+i)2 = Rs.873.44

0 1 2
7%

Rs.1,000
PV0
General Present Value Formula

PV0 = FV1 / (1+i)


1

PV0 = FV2 / (1+i)


2

etc.
General Present Value Formula:
PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n) -- See Table II
Valuation Using Table II

PVIFi,n is found on Table II


Period
at the end of the book.
6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
Using Present Value Tables
PV2 = Rs.1,000 (PVIF7%,2)
Period = Rs.1,000
6% (.873)
7% 8%
1 = Rs.873
.943 [Due to Rounding]
.935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
Story Problem Example
Julie Miller wants to know how large of a deposit
to make so that the money will grow to Rs.10,000
in 5 years at a discount rate of 10%.

0 1 2 3 4 5

10%
Rs.10,000
PV0
Story Problem Solution

• Calculation based on general formula:


PV0 = FVn / (1+i)n PV0 =
Rs.10,000 / (1+ 0.10)5 =
Rs.6,209.21
• Calculation based on Table I: PV0 =
Rs.10,000 (PVIF10%, 5) =
Rs.10,000 (.621) =
Rs.6,210.00 [Due to Rounding]
Types of Annuities

 An Annuity represents a series of equal


payments (or receipts) occurring over a
specified number of equidistant periods.
•Ordinary Annuity: Payments or receipts occur at
the end of each period.
•Annuity Due: Payments or receipts occur at the
beginning of each period.
Examples of Annuities

• Student Loan Payments


• Car Loan Payments
• Insurance Premiums
• Mortgage Payments
• Retirement Savings
Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

Rs.100 Rs.100 Rs.1


Today
Equal Cash Flows
Each 1 Period Apart
Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

Rs.100 Rs.100 Rs.100


Today Equal Cash Flows
Each 1 Period Apart
Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

R R R
R = Periodic
Cash Flow

FVAn = R(1+i)n-1 + R(1+i)n-2 + FVAn


... + R(1+i)1 + R(1+i)0
Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%

Rs.1,000 Rs.1,000 Rs.1,000


Rs.1,070
Rs.1,145
FVA3 = Rs.1,000(1.07)2 +
Rs.1,000(1.07)1 + Rs.1,000(1.07)0 Rs.3,215 =
= Rs.1,145 + Rs.1,070 + Rs.1,000 FVA3
= Rs.3,215
Hint on Annuity Valuation

The future value of an ordinary


annuity can be viewed as occurring
at the end of the last cash flow
period, whereas the future value of
an annuity due can be viewed as
occurring at the beginning of the last
cash flow period.
Valuation Using Table III

FVAn = R (FVIFAi%,n)
FVA3 = Rs.1,000
Period 6% (FVIFA
7% 7%,3)8%
1 = 1.000
Rs.1,000 1.000
(3.215) = 1.000
Rs.3,215
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
Overview View of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 n-1 n
. . .
i%
R R R R R

FVADn = R(1+i)n + R(1+i)n-1 + FVADn


... + R(1+i)2 + R(1+i)1 = FVAn
(1+i)
Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000 Rs.1,070

Rs.1,145
Rs.1,225
FVAD3 = Rs.1,000(1.07)3 +
Rs.1,000(1.07)2 + Rs.1,000(1.07)1
Rs.3,440 =
= Rs.1,225 + Rs.1,145 + Rs.1,070
FVAD3
= Rs.3,440
Valuation Using Table III

FVADn = R (FVIFAi%,n)(1+i)
FVAD
Period
3 = Rs.1,000
6% (FVIFA
7% 7%,3)(1.07)
8%
1 = Rs.1,000
1.000 1.000(3.215)(1.07)
1.000 =
Rs.3,440
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

R R R

R = Periodic
Cash Flow
PVAn
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%

Rs.1,000 Rs.1,000 Rs.1,000


Rs.934.58
Rs.873.44
Rs.816.30
Rs.2,624.32 = PVA3 = Rs.1,000/(1.07)1 +
PVA3 Rs.1,000/(1.07)2 +
Rs.1,000/(1.07)3
= Rs.934.58 + Rs.873.44 + Rs.816.30
= Rs.2,624.32
Hint on Annuity Valuation

The present value of an ordinary


annuity can be viewed as occurring at
the beginning of the first cash flow
period, whereas the future value of an
annuity due can be viewed as
occurring at the end of the first cash
flow period.
Valuation Using Table IV

PVAn = R (PVIFAi%,n)
PVA3 = Rs.1,000
Period 6% (PVIFA
7% 7%,3)8%
1 = 0.943
Rs.1,000 0.935
(2.624) = 0.926
Rs.2,624
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
Overview of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 n-1 n
i% . . .

R R R R

R: Periodic
PVADn Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1


= PVAn (1+i)
Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%

Rs.1,000.00 Rs.1,000
Rs.1,000
Rs. 934.58
Rs. 873.44

Rs.2,808.02 = PVADn

PVADn = Rs.1,000/(1.07)0 + Rs.1,000/(1.07)1 +


Rs.1,000/(1.07)2 = Rs.2,808.02
Valuation Using Table IV

PVADn = R (PVIFAi%,n)(1+i)
PVAD
Period
3 = Rs.1,000
6% (PVIFA
7% 7%,3)(1.07)
8%
1 = Rs.1,000
0.943 0.935(2.624)(1.07)
0.926 =
Rs.2,808
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
Steps to Solve Time Value of
Money Problems
1. Read problem thoroughly
2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if it is a PV or FV problem
5. Determine if solution involves a single CF, annuity
stream(s), or mixed flow
6. Solve the problem
7. Check with financial calculator (optional)
Mixed Flows Example
Julie Miller will receive the set of cash flows
below. What is the Present Value at a discount
rate of 10%.

0 1 2 3 4 5

10%
Rs.600 Rs.600 Rs.400
PV0 Rs.400 Rs.100
How to Solve?

1. Solve a “piece-at-a-time” by
discounting each piece back to t=0.
2. Solve a “group-at-a-time” by first
breaking problem into groups of annuity
streams and any single cash flow groups.
Then discount each group back to t=0.
“Piece-At-A-Time”

0 1 2 3 4 5

10%
Rs.600 Rs.600 Rs.400
Rs.545.45Rs.400 Rs.100
Rs.495.87
Rs.300.53
Rs.273.21
Rs. 62.09
Rs.1677.15 = PV0 of the Mixed Flow
“Group-At-A-Time” (#1)

0 1 2 3 4 5
10%
Rs.600 Rs.600 Rs.400
Rs.400 Rs.100
Rs.1,041.60
Rs. 573.57
Rs. 62.10
Rs.1,677.27 = PV0 of Mixed Flow [Using Tables]

Rs.600(PVIFA10%,2) = Rs.600(1.736) = Rs.1,041.60


Rs.400(PVIFA10%,2)(PVIF10%,2) = Rs.400(1.736)(0.826) =
Rs.573.57
Rs.100 (PVIF10%,5) = Rs.100 (0.621) = Rs.62.10
“Group-At-A-Time” (#2)

0 1 2 3 4

Rs.400 Rs.400 Rs.400


Rs.1,268.00 Rs.400
0 1 2 PV0 equals
Plus
Rs.200 Rs.1677.30.
Rs.347.20 Rs.200
0 1 2 3 4 5
Plus
Rs.62.10 Rs.100
Frequency of Compounding

General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Years m:
Compounding Periods per Year i: Annual
Interest Rate FVn,m: FV at the end of
Year n
PV0: PV of the Cash Flow today
Impact of Frequency

Julie Miller has Rs.1,000 to invest for 2 Years at an annual interest rate of
12%.
Annual FV2 = 1,000(1+ [.12/1])(1)(2) = 1,254.40
Semi FV2 = 1,000(1+ [.12/2])(2)(2) = 1,262.48
Impact of Frequency

Qrtly FV2 = 1,000(1+ [.12/4])(4)(2) = 1,266.77


Monthly FV2 = 1,000(1+ [.12/12])(12)(2) = 1,269.73
Daily FV2 = 1,000(1+[.12/365])(365)(2) =
1,271.20
Effective Annual
Interest Rate

Effective Annual Interest Rate


The actual rate of interest earned (paid) after
adjusting the nominal rate for factors such
as the number of compounding periods per
year.
(1 + [ i / m ] )m - 1
BWs Effective
Annual Interest Rate

Basket Wonders (BW) has a Rs.1,000 CD at the bank. The interest rate is
6% compounded quarterly for 1 year. What is the Effective Annual
Interest Rate (EAR)?
EAR = ( 1 + .06 / 4 )4 - 1 = 1.0614 - 1 =
.0614 or 6.14%!
Steps to Amortizing a Loan
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan Balance at t-1) x (i% / m)
3. Compute principal payment in Period t.
(Payment - Interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step 3)
5. Start again at Step 2 and repeat.
Amortizing a Loan Example
Julie Miller is borrowing Rs.10,000 at a compound
annual interest rate of 12%. Amortize the loan if
annual payments are made for 5 years.
Step 1: Payment
PV0 = R (PVIFA i%,n)
Rs.10,000 = R (PVIFA 12%,5)
Rs.10,000 = R (3.605)
R = Rs.10,000 / 3.605 = Rs.2,774
Amortizing a Loan Example
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000

[Last Payment Slightly Higher Due to Rounding]


Usefulness of Amortization
1. Determine Interest Expense -- Interest expenses may reduce
taxable income of the firm.

2. Calculate Debt Outstanding -- The quantity of outstanding


debt may be used in financing the day-to-day activities of the
firm.
FINANCIAL MANAGEMENT
ASSIGNMENT QUESTIONS

1. Jim makes a deposit of Rs.12,000 in a bank account. The deposit is to earn interest
annually at the rate of 9 percent for seven years.

a) How much will Jim have on deposit at the end of seven years?
b) Assuming the deposit earned a 9 percent rate of interest compounded
quarterly, how much would he have at the end of seven years?
c) In comparing parts (a) and (b), what are the respective effective annual yields?
Which alternative is better?

2. How many years will it take for Rs. 5000 invested today at 12% p.a. rate of interest
to grow to Rs. 160,000? Use rule of 72.

3. In how much period your Rs. 10,000 becomes Rs. 20,000 at 15% rate of interest,
using (a) Rule of 72, (b) Rule of 69.
FINANCIAL MANAGEMENT
ASSIGNMENT QUESTIONS

4. What is the present value of following cash flow stream at 10% p.a. rate of interest.

YEAR 0 1 2 3 4 5

Cash flows (in -10,000 2000 3000 4000 5000 2000


rupees)

5. Mr. X deposits Rs. 10,000 at the end of every year for 5 years in his savings
account paying 5% p.a. interest. How much money he will get at the end of 5
years?
6. Mr. X is planning to buy a car after 5 years when it is expected to cost Rs. 5 Lakh.
How much he should save annually to reach his target if his savings earn a
compound annual interest rate of 12%?
7. A travel operator announces that it can take anybody on a world tour at a price of
Rs. 2,00,000. I wish to avail this offer. I can save Rs. 25,000 annually and my
savings earn 10% p.a. compound interest. How long I will have to wall?
8. You invest Rs. 3000 a year for 3 years and Rs. 5000 a year for 7 years thereafter at
interest rate of 12% p.a. What will be the maturity value at the end of 10 years?
FINANCIAL MANAGEMENT
ASSIGNMENT QUESTIONS

8. You invest Rs. 3000 a year for 3 years and Rs. 5000 a year for 7 years thereafter at
interest rate of 12% p.a. What will be the maturity value at the end of 10 years?

8. Sunil is due to retire 20 years from now. He wants to invest a lump sum now so as
to be able to withdraw Rs. 10,000 every year, beginning from the end of the 20th
year. How much he should invest now if r = 12%?
9. “Individuals have a time preference for money”. Give reasons for such a preference
and explain the relation between time preference rate and required rate of return.
10. What is the relevance of “Time value of Money in financial decision making”.
11. Write Short notes on.
a. Annuity.
b. Sinking fund
c. Effective rate of return.
FINANCIAL MANAGEMENT
SOURCES OF FINANCE
INTRODUCTION
Arrangement of the required finance to each department of business concern is highly
a complex one and it needs careful decision. Quantum of finance may be depending
upon the nature and situation of the business concern. But, the requirement of the
finance may be broadly classified into two parts:

Long-term Financial Requirements or Fixed Capital Requirement

Short-term Financial Requirements or Working Capital Requirement


FINANCIAL MANAGEMENT
SOURCES OF FINANCE
Long-term Financial Requirements or Fixed Capital Requirement :
Long-term financial requirement means the finance needed to acquire land and
building for business concern, purchase of plant and machinery and other fixed
expenditure. Long term financial requirement is also called as fixed capital
requirements. Fixed capital is the capital, which is used to purchase the fixed assets of
the firms such as land and building, furniture and fittings, plant and machinery, etc.
Hence, it is also called a capital expenditure.

Short-term Financial Requirements or Working Capital Requirement :


Apart from the capital expenditure of the firms, the firms should need certain
expenditure like procurement of raw materials, payment of wages, day-to-day
expenditures, etc. This kind of expenditure is to meet with the help of short-term
financial requirements which will meet the operational expenditure of the firms. Short-
term financial requirements are popularly known as working capital.
FINANCIAL MANAGEMENT
SOURCES OF FINANCE
Sources of finance mean the ways for mobilizing various terms of finance to the
industrial concern. Sources of finance state that, how the companies are mobilizing
finance for their requirements.

Sources of finance may be classified under various categories according to the


following important heads:

1. Based on the Period

2. Based on Ownership

3. Based on Sources of Generation

4. Based in Mode of Finance


FINANCIAL MANAGEMENT
SOURCES OF FINANCE
1. Based on the Period :
Long-term sources - When the finance mobilized with large amount and the
repayable over the period will be more than five years, it may be considered as long-
term sources.
Long-term sources of finance include:

● Equity Shares

● Preference Shares

● Debenture

● Long-term Loans

● Fixed Deposits
FINANCIAL MANAGEMENT
SOURCES OF FINANCE
Short-term sources: Apart from the long-term source of finance, firms can
generate finance with the help of short-term sources like loans and advances from
commercial banks, moneylenders, etc. Short-term source of finance needs to meet
the operational expenditure of the business concern.

Short-term source of finance include:


● Bank Credit
● Customer Advances
● Trade Credit
● Factoring
● Public Deposits
● Money Market Instruments
FINANCIAL MANAGEMENT
SOURCES OF FINANCE
2. Based on Ownership
An ownership source of finance include
● Shares capital, earnings
● Retained earnings
● Surplus and Profits
Borrowed capital include
● Debenture
● Bonds
● Public deposits
● Loans from Bank and Financial Institutions.
FINANCIAL MANAGEMENT
SOURCES OF FINANCE
3. Based on Sources of Generation
Sources of Finance may be classified into various categories based on the period.
Internal source of finance includes
● Retained earnings
● Depreciation funds
● Surplus
External sources of finance may be include
● Share capital
● Debenture
● Public deposits
● Loans from Banks and Financial institutions
FINANCIAL MANAGEMENT
SOURCES OF FINANCE
4. Based in Mode of Finance
Security finance may be include
● Shares capital
● Debenture
Retained earnings may include
● Retained earnings
● Depreciation funds
Loan finance may include
● Long-term loans from Financial Institutions
● Short-term loans from Commercial banks.
FINANCIAL MANAGEMENT
Ownership Securities
The ownership securities also called as capital stock, is commonly called as shares.
Shares
are the most Universal method of raising finance for the business concern. Ownership
capital consists of the following types of securities.
● Equity Shares
● Preference Shares
● No par stock
● Deferred Shares
EQUITY SHARES
Equity Shares also known as ordinary shares, which means, other than preference
shares. Equity shareholders are the real owners of the company. They have a control
over the management of the company. Equity shareholders are eligible to get dividend if
the company earns profit. Equity share capital cannot be redeemed during the lifetime of
the company. The liability of the equity shareholders is the value of unpaid value of
shares.
FINANCIAL MANAGEMENT
Features of Equity Shares
Equity shares consist of the following important features:
1. Maturity of the shares: Equity shares have permanent nature of capital, which
has no maturity period. It cannot be redeemed during the lifetime of the company.
2. Residual claim on income: Equity shareholders have the right to get income
left after paying fixed rate of dividend to preference shareholder. The earnings or the
income available to the shareholders is equal to the profit after tax minus preference
dividend.
3. Residual claims on assets: If the company wound up, the ordinary or equity
shareholders have the right to get the claims on assets. These rights are only
available to the equity shareholders.
4. Right to control: Equity shareholders are the real owners of the company.
Hence, they have power to control the management of the company and they have
power to take any decision regarding the business operation.
5. Voting rights: Equity shareholders have voting rights in the meeting of the
company with the help of voting right power; they can change or remove any
decision of the business concern. Equity shareholders only have voting rights in the
company meeting and also they can nominate proxy to participate and vote in the
meeting instead of the shareholder.
FINANCIAL MANAGEMENT
7. Limited liability: Equity shareholders are having only limited liability to the value
of shares they have purchased. If the shareholders are having fully paid up shares, they
have no liability. For example: If the shareholder purchased 100 shares with the face
value of Rs. 10 each. He paid only Rs. 900. His liability is only Rs. 100.

Advantages of Equity Shares

1. Permanent sources of finance: Equity share capital is belonging to long-term


permanent nature of sources of finance, hence, it can be used for long-term or fixed
capital requirement of the business concern.
2. Voting rights: Equity shareholders are the real owners of the company who
have voting rights. This type of advantage is available only to the equity
shareholders.
3. No fixed dividend: Equity shares do not create any obligation to pay a fixed
rate of dividend. If the company earns profit, equity shareholders are eligible forprofit,
they are eligible to get dividend otherwise, and they cannot claim any dividend from
the company.
FINANCIAL MANAGEMENT
Advantages of Equity Shares

1. Less cost of capital: Cost of capital is the major factor, which affects the value
of the company. If the company wants to increase the value of the company, they have
to use more share capital because, it consists of less cost of capital (Ke) while
compared to other sources of finance.
5. Retained earnings: When the company have more share capital, it will be
suitable for retained earnings which is the less cost sources of finance while compared
to other sources of finance.

Disadvantages of Equity Shares


1. Irredeemable: Equity shares cannot be redeemed during the lifetime of the
business concern. It is the most dangerous thing of over capitalization.
2. Obstacles in management: Equity shareholder can put obstacles in
management
by manipulation and organizing themselves. Because, they have power to contrast
any decision which are against the wealth of the shareholders.
3. Leads to speculation: Equity shares dealings in share market lead to
secularism
during prosperous periods.
FINANCIAL MANAGEMENT
Disadvantages of Equity Shares
1. Irredeemable: Equity shares cannot be redeemed during the lifetime of the
business concern. It is the most dangerous thing of over capitalization.
2. Obstacles in management: Equity shareholder can put obstacles in
management by manipulation and organizing themselves. Because, they have
power to contrast any decision which are against the wealth of the shareholders.
3. Leads to speculation: Equity shares dealings in share market lead to
secularism during prosperous periods.
4. Limited income to investor: The Investors who desire to invest in safe
securities with a fixed income have no attraction for equity shares.
5. No trading on equity: When the company raises capital only with the help of
equity, the company cannot take the advantage of trading on equity.
FINANCIAL MANAGEMENT
PREFERENCE SHARES
The parts of corporate securities are called as preference shares. It is the shares, which
have preferential right to get dividend and get back the initial investment at the time of
winding up of the company. Preference shareholders are eligible to get fixed rate of
dividend and they do not have voting rights.

Preference shares may be classified into the following major types:


1. Cumulative preference shares: Cumulative preference shares have right to
claim dividends for those years which have no profits. If the company is unable to
earn profit in any one or more years, C.P. Shares are unable to get any dividend but
they have right to get the comparative dividend for the previous years if the company
earned profit.
2. Non-cumulative preference shares: Non-cumulative preference shares have no
right to enjoy the above benefits. They are eligible to get only dividend if the
company earns profit during the years. Otherwise, they cannot claim any dividend.
3. Redeemable preference shares: When, the preference shares have a fixed
maturity period it becomes redeemable preference shares. It can be redeemable
during the lifetime of the company. The Company Act has provided certain
restrictions on the return of the redeemable preference shares.
FINANCIAL MANAGEMENT
Irredeemable Preference Shares can be redeemed only when the company goes for
liquidator. There is no fixed maturity period for such kind of preference shares.
Participating Preference Shares holders have right to participate extra profits after
distributing the equity shareholders.
Non-Participating Preference Shares holders are not having any right to participate
extra profits after distributing to the equity shareholders. Fixed rate of dividend is
payable to the type of shareholders.
Convertible Preference Shares holders have right to convert their holding into equity
shares after a specific period. The articles of association must authorize the right of
conversion.
Non-convertible Preference Shares There shares, cannot be converted into equity
shares from preference shares.