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Financial Management Foundations of Finance
Financial Management Foundations of Finance
Financial Management Foundations of Finance
UNIT - I
FOUNDATIONS OF FINANCE
Meaning
Profit maximization should serve as the basic criterion for decisions arrived at by
financial managers of privately owned and controlled firms. Different alternatives
are available to a business enterprise in the process of decisions- making. Each
alternative has its own implications. Different courses of actions have to be
evaluated on the basis of some analytical framework and for this purpose,
commercial strategies of an enterprise have to be taken into consideration. The
availability of funds depend upon the kind of commercial strategies adopted by a
firm during a particular period of time. Various different theories of financial
management provides an analytical framework for an evaluation of courses of
action.
(b) The concept of maximization of earnings per share does not include the risk
of streams of alternative earnings. A project may have an earning steam that will
attain the goal of maximum earnings per share; but when compared with the risk
involved in it, it may be totally unacceptable to a stockholder, who is generally
hostile to risk-bearing activities.
(c) This concept of maximization of earnings per share does not take into
account the impact of dividend policy upon market price or value of the firm.
Theoretically, a firm would never pay a dividend if the objective is to maximize
earnings per share. Rather, it would reinvest all its earnings so as to generate
greater earnings in the future.
1. Given a firm’s market position, the market demand for its products, its
productive capacity and investment opportunities, what specific assets
should it purchase? This Indirectly emphasizes the approach to capital
budgeting.
2. Given a firm’s market position and investment opportunities, what is the
total volume of funds that it should commit? This indirectly emphasizes the
composition of a firm’s assets.
3. Given a firm’s market position and investment opportunities, how should it
acquire the funds which are necessary for the implementation of its
investment decisions? This underscores the approach to capital financing.
PROFIT MAXIMIZATION Vs WEALTH MAXIMIZATION
Increase in Profits: A firm should increase its revenues in order to maximize its
value. For this purpose, the volume of sales or any other activities should be
stepped up. It is a normal practice for a firm to formulate and implement all
possible plans of expansion and take every opportunity to maximize its profits. In
theory, profits are maximized when a firm is in equilibrium. At this stage, the
average cost is minimum and the marginal cost and marginal revenue are equal.
A word of caution, however, should be sounded here. An increase in sales will
not necessarily result in a rise in profits unless there is a market for increased
supply of goods and unless overhead costs are properly controlled.
Reduction in Cost: Capital and equity funds are factor inputs in production. A
firm has to make every effort to reduce cost of capital and launch economy drive
in all its operations.
Sources of Funds: A firm has to make a judicious choice of funds so that they
maximize its value. The sources of funds are not risk-free. A firm will have to
assess risks involved in each source of funds. While issuing equity stock, it will
have to increase ownership funds into the corporation. While issuing debentures
and preferred stock, it will have to accept fixed and recurring obligauons. The
advantages of leverage, too, will have to be weighed properly.
Minimum Risks: Different types of risks confront a firm. "No risk, no gain" - is a
common adage. However, in the world of business uncertainties, a corporate
manager will have to calculate business risks, financial risks or any other risk that
may work to the disadvantage of the firm before embarking on any particular
course of action. While keeping the goal of maximization of the value of the firm,
the management will have to consider the interest of pure or equity stockholders
as the central focus of financial policies.
Wealth maximization is a clear term. Here, the present value of cash flow is
taken into consideration. The net effect of investment and benefits can be
measured clearly. (Quantitatively)
It considers the concept of time value of money. The present values of cash
inflows and outflows helps the management to achieve the overall objectives of a
company.
The concept of wealth maximization considers the impact of risk factor, while
calculating the Net Present Value at a particular discount rate, adjustment is
made to cover the risk that is associated with the investments.
As corporations have grown bigger and more powerful, their influence has
become more pervasive; they have created an imbalance which is widely
believed to have been instrumental in generating a movement to promote more
socially conscious business behaviour. Academicians and corporate officers alike
have urged the advisability of more socially conscious business management.
Financial management will then have to rise equal to the acceptance of social
responsibility of business.
The wealth of owners of a firm is maximized by raising the price of the common
stock. This is achieved when the management of a firm operates efficiently and
makes optimal decisions in areas of capital investments, financing, dividends and
current assets management. If this is done, the aggregate value of the common
stock will be maximized.
To participate in the process of putting funds to work within the business and
to control their productivity; and
To identify the need for funds and select sources from which they may be
obtained.
The functions of financial management may be classified on the basis of liquidity,
profitability and management.
(a) Forecasting cash flows, that is, matching the inflows against cash outflows;
(b) Raising funds, that is, financial management will have to ascertain the
sources from which funds may be raised and the time when these funds are
needed;
(c) Managing the flow of internal funds, that is, keeping its accounts, with a
number of banks to ensure a high degree of liquidity with minimum external
borrowing.
(2) Profitability: While ascertaining profitability, the following factors are taken
into account:
(c) Forecasting Future Profits: Expected profits are determined and evaluated.
Profit levels have to be forecasted from time to time in order to strengthen the
organization.
(d) Measuring Cost of Capital: Each source of funds has a different cost of capital
which must be measured because cost of capital is linked with profitability of an
enterprise.
(3) Management: The financial manager will have to keep assets intact, for
assets are resources which enable a firm to conduct its business. Asset
management has assumed an important role in financial management. It is also
necessary for the financial manager to ensure that sufficient funds are available
for smooth conduct of the business. In this connection, it may be pointed out that
management of funds has both liquidity and profitability aspects. Financial
management is concerned with the many responsibilities which are thrust on it by
a business enterprise. Although a business failure may not always be the result
of financial failures, financial failures do positively lead to business failures. The
responsibility of financial management is enhanced because of this peculiar
situation.
The main stream of academic writing and teaching followed the scope and
pattern suggested by the narrower and by now traditional definition of the finance
function. Financial management, as it was then more generally called, emerged
as a separate branch of economics. The traditional approach to the entire subject
of finance was from the point of view of the investment banker rather than that of
the financial decision-maker in an enterprise. The traditional treatment placed
altogether too much emphasis on corporation finance and too little on the
financing problems of non-corporate enterprises.
The sequence of treatment was built too closely around the episodic phases
during the life cycle of a hypothetical corporation in which external financial
relations happened to be dominant. Matters like promotion, incorporation,
merger, consolidation, recapitalization and reorganization left too little room for
problems of a normal growing company. Finally, it placed heavy emphasis on
long-term financial instruments and problems and corresponding lack of
emphasis on problems of working capital management. The basic contents of the
traditional approach may now be summarised.
The central issue of financial policies is a wise use of funds and the central
process involved is a rational matching of advantages of potential uses against
the caution of advantages of potential uses against the caution of alternative
potential sources so as to achieve broad financial goals which an enterprise sets
for itself. The new or modern approach is an analytical way of looking at the
financial problems of a firm. Financial problems are a vital and an integral part of
overall management. In this connection, Ezra Solomon observes: If the scope of
financial management is re-defined to cover decisions about both the use and
the acquisition of funds, it is clear that the principal content of the subject should
be concerned with how financial management should make judgements about
whether an enterprise should hold, reduce, or increase its investments in all
forms of assets that require company funds.
A Large number of empirical studies on the subject have already been conducted
on different portfolios of Financial Management, some of which have been
tested, while others, which were not tested, were rejected by corporate decision-
makers. For example, capital structure and, more particularly, the cost of different
sources of funds, dividend policies, depreciation policies, retention of surpluses,
liquidity, profit planning and control - these are among the subjects which have
captured the attention of different schools of thoughts from time to time. The
functional areas of financial management is elaborated below.
Determining the Sources of Funds: The financial manager has to choose the
various sources of funds. He may issue different types of securities. He may
borrow from a number of financial institutions and the public. When a firm is new
and small and little known in financial circles, the financial manager faces a great
challenge in raising funds. Even when he has a choice in selecting sources of
funds, he should exercise it with great care and caution. A firm is committed to
the lenders of finance and has to meet various terms and conditions on which
they offer credit. To be precise, the financial manager must definitely know what
he is doing.
Profit Planning and Control: Profit planning and control have assumed great
importance in the financial activities of modern business. Economists have long
before considered the importance of profit maximization in influencing business
decisions. Profit planning ensures attainment of stability and growth. In view of
the fact that earnings are the most important measure of corporate performance,
the profit test is constantly used to gauge success of a firm’s activities.
Fixed Assets Management: A firm’s fixed assets include tangibles such as land,
building, machinery and equipment, furniture and also intangibles such as
patents, copyrights, goodwill, and so on. The acquisition of fixed assets involves
capital expenditure decisions and long-term commitments of funds. These fixed
assets are justified to the extent of their utility and/or their productive capacity.
Because of this long-term commitment of funds, decisions governing their
purchase, replacement, etc., should be taken with great care and caution. Often,
these fixed assets are financed by issuing stock, debentures, long-term
borrowings and deposits from public. When it is not worthwhile to purchase fixed
assets, the financial manager may lease them and use assets on a rental basis.
To facilitate replacement of fixed assets, appropriate depreciation on fixed assets
has to be formulated. It is because of these facts that management decisions on
the acquisition of fixed assets are vital. If they are ill-designed, they may lead to
over-capitalisation. Moreover, in view of the fact that fixed assets are maintained
over a long period of time, these assets are exposed to changes in their value,
and these changes may adversely affect the position of a firm.
Capital Budgeting: Capital budgeting decisions are most crucial; for they have
long-term implications. They relate to judicious allocation of capital. Current funds
have to be invested in long-term activities in anticipation of an expected flow of
future benefits spread over a long period of time. Capital budgeting forecasts
returns on proposed long-term investments and compares profitability of different
investments and their cost of capital. It results in capital expenditure investments.
The various proposal assets ranked on the basis of such criteria as urgency,
liquidity, profitability and risk sensitivity. The financial analyser should be
thoroughly familiar with such financial techniques as pay back, internal rate of
return, discounted cash flow and net present value among others because risk
increases when investment is stretched over a long period of time. The financial
analyst should be able to blend risk with returns so as to get current evaluation of
potential investments.
The traditional notion that the finance function is simply a process of ‘managing
cash and capital’ or planning and controlling profits, fails to cover the scope of
modern financial management. Today’s finance manager is engaged in such
activities for the construction of models as to direct the search for new
information, set performance standards, rationalise operating rules, and establish
operating control. It is, in brief, an all-encompassing function. Its objective is first
to select the items of financial information which are relevant to a particular
problem, and second, to fit these items into a coherent picture of the problem in
relation to the firm’s aims and financial resources. The final objective of financial
management is to suggest alternative solutions to problems. However, in actual
practice, the modern executive, who is buried in a maze of seemingly endless
statistics and voluminous reports, is constantly struggling to gain real financial
control, The financial controller is often behaviorally more concerned with
expenditure than with profits. He tends to become a person who wants to keep
his financial resources intact, spends nothing, and completely avoids undertaking
risk. Infact, the management of finance should have the optimal use of funds as
its focal point. The auditing approach should give place to a decision-making
approach. The new demands on the finance manager call for a basic
transformation in his approach because he plays a crucial role in the future
success of the organisation. And this is a challenge which he has to face.
An analysis of financial data with the help of scientific tools and techniques to
improve performance of an undertaking (and to achieve better operating results
and better quality of products) is essential n0wdays a day. It is necessary to take
a fresh look at finance management in most Indian industries. The management
of capital in Indian industries is generally anchored to traditional legacies and
practices. This is true for both private and public sectors.
Financial Decisions
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Money has time value. A rupee today is more valuable than a rupee a year
hence. Why? There are several reasons:
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Risk
Return
The return from an investment is the realisable cash flow earned by its owner
during a given period of time. Typically, it is expressed as a percentage of the
beginning of period value of the investment. To illustrate, suppose you buy a
share of the equity stock of Olympic Limited for Rs. 80 today. After a year you
expect that (i) a dividend of Rs. 2 per share will be received and (ii) the price per
share will rise to Rs. 90.:
What is the relationship between the risk of a security measured by its beta and
its required rate of return? According to the capital asset pricing model (CAPM)
the following equation represents the relationship between risk and return.
As per the above equation the required rate of return of a security consists of two
components: (1) the risk-free rate of return (R ) and (ii) the risk premium (k -R ).
f m f
The risk premium, it may be noted, is the product of the level of risk () and the
compensation per unit of risk (k -R ). Thus, for a risky security j, if R is 8 per cent,
m f f
It is evident that, ceteris paribus, the higher the beta, the greater the required rate
of return, and vice versa.
Security Market Line
The graphical version of the CAPM is called the security market lines (SML),
which shows the relationship between beta and the required rate of return. The
figure below shows the SML for the basic data given above. In this figure, the
required rate of return for three securities, A. B and C, is shown. Security A is a
defensive security with a beta of 0.5.
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Valuation Concept
From a financial point of view, the value of an asset is equal to the present value
of the benefits associated with it. Symbolically,
a) Terminology
Coupon Rate and Interest A bond carries a specific interest rate which is called
the coupon rate. The interest payable to the bondholder is simply, par value of
the bond x coupon rate. For example, the annual interest payable on a bond
which has a par value of Rs. 100 and a coupon rate of 13.5 percent is Rs. 13.5
(Rs. 100 x 13.5 per cent).
of maturity
Example: A Rs. 100 par value bond, bearing a coupon rate of 12 per cent, will
mature after 8 years. The required rate of return on this bond is 14 per cent.
What is the value of this bond?
Since, the annual interest payment will be Rs. 12 for 8 years and the principal
repayment will be Rs. 100 at the end of 8 years, the value of the bond will be:
Example: A Rs. 1,000 par value bond, bearing a coupon rate of 14 per cent, will
mature after 5 years. The required rate of return on this bond is 13 per cent.
What is the value of this bond? Since, the annual interest payment will be Rs.
140 for 5 years and the principal repayment will be Rs. 1,000 at the end of 5
years, the value of the bond will be:
c) Bond Value Theorems
Based on the bond valuation model, several bond value theorems have been
derived. They state the effect of the following factors on bond values:
1. Relationship between the required rate of return and the coupon rate.
2. Number of years to maturity.
The following theorem show how bond values are influenced by the relationship
between the required rate of return and the coupon rate.
Ia When the required rate of return is equal to the coupon rate, the value of a
bond is equal to its par value.
lb When the required rate of return is greater than the coupon rate, the value of a
bond is less than its par value.
Ic When the required rate of return is less than the coupon rate, the value of a
bond is more than its par value.
Suppose the market price of a Rs. 1,000 par value bond, carrying a coupon rate
of 9 percent and maturing after 8 years, is Rs. 800. What rate of return would an
investor earn if he buys this bond and holds it till its maturity? The rate of return
that he earns, called the yield to maturity (YTM hereafter), is the value of led in
the following equation:
To find the value of led which satisfies the above equation, we may have to try
several values of led till we ‘hit’ on the right value. Let us begin, with a discount
rate of 12 percent. Putting a value of 12 percent for led we find that the right-
hand side of the above expression becomes equal to:
Since, this value is greater than Rs. 800, we have to try a higher value for led.
Let us try led = 14 percent. This makes the right-hand side equal to:
Since, this value is less than Rs. 800, we try a lower value for k, Let us k = 13d
Using the approximate formula the yield to maturity on the bond of Zion works
out to:
Most of the bonds pay interest semi-annually. To value such bonds, we have to
work with a unit period of six months, and not one year. This means that the
bond valuation equation has to be modified along the following lines:
The annual interest payment, 1, must be divided by two to obtain the semi-
annual interest payment.
The number of years to maturity must be multiplied by two to get the number of
half-yearly periods.
The discount rate has to be divided by two to get the discount rate applicable
to half-yearly periods.
With the above modifications, the basic bond valuation equation becomes:
(b) Find the difference between the present value corresponding to the lower rate
(Rs. 808 at 13 per cent) and the target value (Rs. 800). which in this case is Rs.
8.0.
(c) Divide the outcome of (b) with the outcome of (a), which is 8.0139.9 or 0.2.
Add this fraction to the lower rate, i.e., 13 percent. This gives the YTM of 13.2
percent.
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