Finance

• The firm’s success and to say the

least, its survival depends upon how
efficiently it is able to generate
funds, as and when needed.
• Finance holds the key to all activities.

• Arthahsachivah – finance reigns

supreme
• Finance-Latin word “finis”

• Finance is defined as the issuance of,

distribution of and purchase of
liability and equity claims issued for
the purpose of generating revenue-
producing assets.
• Paul G. Hasings –

“Finance is the management of

monetary affairs of a company. It
includes determining what has to be
paid for raising the money on the
best terms available and devoting
available funds to the best uses.”
Kenneth Midgley and Ronald
Burns

• “Financing is the process of

organizing the flow of funds so that a
business firm can carry out its
objectives in the most efficient
manner and meet its obligations as
they all due”.
• Money-it is any country’s currency ,
which is in the hands of a person or
an organization.

• Finance-it is also any country’s

currency, which is owned by a person
or organization, that is given to
others as loan to buy an asset or to
invest in investment opportunities.
• Currency as long as you have with
you it is money only and when you
lend it to others to buy or invest in
investment opportunities it becomes
finance.
• Eg;- a bank, which has raised money
from public through various types of
deposits, when it grants the same
money to others, it becomes finance.
• Car finance, house finance…

• Organizations raise funds from public

to buy assets or invest in business.
 Financial Management

• Financial management is the

managerial activity which is
concerned with the planning and
controlling of the firm’s financial
resources
 Definitions
• “Financial management is the
operational activity of a business that
is responsible for obtaining and
effectively utilizing the funds
necessary for efficient operations.”

Joseph and Massie

• “Financial management is defined as
that area or set of administrative
functions in an organization which
relate with the arrangement of cash
and credit so that the organization
may have the means to carry out its
objective as satisfactorily as
possible”.

Howard and Opton

 “Financial management is
concerned with the acquisition,
financing and management of assets
with some overall goal in mind”.

Van Horne & Wachowicz

 Finance functions

• The functions of raising funds,

investing them in assets and
distributing returns earned from
assets to share holders are
respectively known as financing
decision, investment decision
and dividend decision.
• The firm attempts to balance cash
flows and out flows while performing
these functions.

• This is called liquidity decision.

 Finance functions include:-

• Long-term asset mix or investment

decision
• Capital mix or financing decision
• Profit allocation or dividend decision
• Short-term asset-mix or liquidity
decision
 Investment Decision

• Firm’s investment decision involve

capital expenditures.

• Capital budgeting decision.

• Capital budgeting decisions involves
the decision of allocation of capital or
commitment of funds to long term
asset that would yield benefits (cash
flow) in future.
• Two important aspect of investment
decisions are:
1. The evaluation of the prospective
profitability of new investments

2. The measurement of a cut-off rate

against that the prospective return of
new investment could be compared.
• rate of return that is necessary to
maintain market value (or stock
price) of a firm, also called a hurdle
rate, cutoff rate, or minimum
required rate of return

• Opportunity cost of capital

• Future benefits of investments are
difficult to measure and can not be
predicted with certainty.
• Risk in investment arises because of
the uncertain returns.
• Investment proposal should,
therefore, be evaluated in terms both
expected return and risk.
• Decision of recommitting the funds
when an asset becomes less
productive or non-profitable --
replacement decisions
 Financing Decision
• The financial manager must decide
when, where from and how to
acquire funds to meet the firm’s
investment needs.

• The central issue before them is to

determine the appropriate proportion
of equity and debt .
• The mix of debt and equity is know
as the firm’s capital structure.

• The financial manager must strive

obtain the best financing mix or the
optimal capital structure.
• The firm’s capital structure
considered optimum when the
market value of the shares is
maximized.
 Analysis of the above based on
different sources of Finance

Type of Risk Cost Control

fund
Own fund Low- since High- since Dilution of
(Equity) repayment dividend control-
only at the expectation since New
time of higher. Also share
liquidation dividend is holders/
not tax public will be
deductible involved

Loan funds High-since Comparative No dilution

repayment as ly cheaper- of control
per interest is tax
agreement deductible
 Dividend decision
• The financial manager must decide
whether the firm should distribute all
profits, or retain them or distribute a
portion and retain the balance.
• The proportion of the profit
distributed as dividends is called the
divided payout ratio.

• And the retained potion of profits is

known as retention ratio.
• Optimum dividend policy should be
followed-maximizes the market value
of the firm’s share.

• Cash dividend

• Bonus shares- shares issued without

any charge.
 Liquidity Decision
• Investment in current assets affects the
firm’s profitability and liquidity.

• Current assets should be managed

efficiently for safeguarding the firm
against the illiquidity.

• Lack of liquidity (illiquidity) in extreme

situations can lead to the firm’s
insolvency.
• A conflict exists between profitability
and liquidity while managing current
assets.
• If the firm does not invest sufficient
funds in current assets, it may
become illiquid and therefore, risky…..
But it will lose profitability, as idle
current assets would not earn
anything.
• Thus a proper trade-off must be
achieved between profitability and
liquidity.
• The profitability-liquidity trade-off requires
that the financial manager should develop
sound techniques of managing current
assets.

• The financial manager should estimate firm’s

needs for current assets and make sure that
funds would be made available when needed.
 Role of finance manager

• A financial manager is a person who

is responsible in a significant way to
carryout the finance functions.
• Now a days, the financial manager
occupies a key position.

• He or she is one of the members of

the top management team and his or
her role, day-by-day, is becoming
more pervasive, intensive and
significant in solving the complex
management problems.
• Now their functions are neither
confined that of a store keeper
maintaining records, preparing
reports and raising funds when
needed nor a staff officer.
 • The finance manager is now
responsible for shaping the fortunes
of the enterprise and is involved in
the most vital decision of the
allocation of capital.

• In their new role, they need to have

a broader and far-sighted outlook
and must ensure that the funds of
the enterprise are utilized in the
most efficient manner…
 • He or she must realize that their
actions have far-reaching
consequences for the firm because
they influence the size, profitability,
growth, risk and survival of the firm
and as s consequence affect the over
all value of the firm.
• The finance manager, therefore, must
have a clear understanding and strong
grasp of the nature and scope of
finance functions.
• The financial managers responsibilities
include—
Performing financial analysis and
planning
• The concern of financial analysis and
planning is with (a) transforming
financial data into a form that can be
used to monitor financial condition….
(b) evaluating the need for increased
(reduced) productive capacity….. and
(c) determining the additional or
reduced financing required.
 Making investment decisions

• Investment decisions determine both the

mix and the type of assets held by a firm.
• The mix refers to the amount of current
assets and fixed assets.
• The financial manager must determine and
maintain the optimal levels of CAs and
also decide the best FAs to acquire and
when existing FAs need to be
replaced/modified/liquidated.
 Making financing decisions

• Financing decisions involve two

major areas: first, the most
appropriate mix of short-term and
long-term financing ; second, the
best individual short-term or long-
term sources of financing at a given
point of time.
• In a large firm, these financial
responsibilities are carried out by the
treasurer and controller.
• Treasurer- the main concern of the
treasurer is with mainly to financing
activities and investing activities.

• Functions include cash management;

relationship management with bankers,
credit management, portfolio
management, inventory management, risk
management, investors relations, dividend
disbursement.
• Controller-the functions of controller
related to the accounting and control
of assets.

• The main functions include, cost

accounting, financial accounting,
internal audit, financial statement
preparation, budget preparation,
taxation, data processing etc.
 Objectives of financial
management

• The term 'objective' is used in the

sense of an objective, a goal or
decision criterion. The three
decisions - Investment decision,
financing decision and dividend
policy decision are guided by the
objective
Profit/EPS maximization decision
criterion

According to this approach, actions

that increase profits or EPS should be
undertaken and those that decrease
profits/EPS are to be avoided..
 • In specific operational terms, as
applicable to financial management,
the profit maximization criterion
implies that the investment,
financing and dividend policy
decisions of a firm should be oriented
to the maximization of profits/EPS.
• The term 'profit' is used in two
senses. In one sense it is used as an
owner-oriented concept.

• In this concept it refers to the

amount and share of national
Income that is paid to the owners of
business.
• The second way is an operational concept i.e.
profitability. This concept signifies economic
efficiency. It means profitability
refers to a situation where output exceeds
Input.

• It means, the value created by the use of

resources is greater that the Input resources.

• Thus in all the decisions, one test is used I.e.

select asset, projects and decisions that are
profitable and reject those which are not
profitable
DEMERITS OF PROFIT MAXIMIZATION

• The term profit is vague. It does not clarify

what exactly it mean. It conveys different
meaning to different people. Eg- Profit may be
in short period or long period etc.
• Many risky propositions yield high profit. Higher
the risk, higher is the possibility of profit. If
profit maximization is the only goal, then risk
factor is altogether ignored. In practice, risk is
to be balanced with the profit objective.
• Profit Maximization as an objective does not
take into account the time pattern of return.
 Shareholders wealth
Maximization
• The most widely accepted objective
of the firm is to maximize the value
of the firm for its owners; that is, to
maximize equity shareholder wealth.

• Equity shareholder wealth is

represented by the market price of
the equity shares of the firm.
• The SWM goal states that the
management should seek to
maximize the present value of the
expected future returns to the
owners (shareholders) of the firm.

• The returns can take the form of

periodic dividend payments or
proceeds from the sale of equity
shares.
• SWM means maximizing the net
present value of a course of action to
shareholders.

• NPV or wealth of a course of action is

the difference between the present
value of its benefits and present
value of its costs.
• A financial action that has a positive
NPV creates wealth for shareholders
and therefore, is desirable.

• A financial action resulting in negative

NPV should be rejected since it would
destroy shareholders wealth.

• Between mutually exclusive projects

the one with highest NPV should be
adopted
 Why wealth maximization is
superior to the profit maximization
1. The value of an asset should be
viewed in terms of the benefit it can
produce.

• The worth of a course of action can

similarly be judged in terms of the
value of the benefits it produces less
the cost of undertaking it.
• A significant element in computing the
value of a financial course of action is the
precise estimation of the benefits
associated with it.

• The wealth maximization criterion is

based on the concept of cash flows
generated by the decision rather than
accounting profit which is the basis of the
measurement of benefits in the case of
profit maximization.
2.SWM considers both the quantity and quality
dimensions of benefits. At the same time, it
also incorporates the time value of money..

The operational implication of the uncertainty

and timing dimensions of the benefit emanating
from a financial decision is that adjustments
should be made in the cash flow pattern, firstly
to incorporate risk and secondly to make an
allowances for differences in the timing of
benefits.
.
• The value of a stream of cash flows with
value maximization criterion is calculated
by discounting its element back to the
present at a capitalization rate that
reflects both time and risk
• “Strategy is a flexible approach for
achieving the desired results, with
sustainable success”.
• Strategic financial management
demands that every executive be a
strategist in the real sense..

• strategist should observe financial

management from a long term point
of view for sustainable success based
on short-term, flexible tactics.
 Economic Value Added
(EVA)

• It is a popular measure currently

being used by several firms to
determine whether an
existing/proposed investment
positively contributes to the
owners/share holders wealth.
• The EVA is equal to after tax
operating profits of a firm less the
cost of funds used to finance
investments.

• A positive EVA would increase

owners value/wealth.

• Therefore, only investments with

positive EVA would be desirable from
the viewpoint of maximizing
shareholders wealth.
• Eg:- assuming an after tax profit o
Rs.40 crore and associated cost of
financing the investment of Rs.38
crore, the EVA=Rs.2 crore.

• With a positive EVA, the investment

would add value and increase the
wealth of the owners and should be
accepted.
• Merits-
• Simple
• Strong link to share prices.
• Positive EVA-increase the value of
shares.