Professional Documents
Culture Documents
Intro To FM PDF
Intro To FM PDF
Intro To FM PDF
2. Deciding the capital structure + \The capital structure refers to the different types and proport of securities for raising funds.pAfter deciding about the quantun funds required,.a decision about the type of securities to be iss and the proportion in which these securities should be used, is t made. 3. Selecting a source of finance After preparing a capital structure scheme, an appropr source of finance is selected. Various sources from which fine may be raised include share capital, debentures, loan from finar 3, commy ks, public deposits, ‘tor institutions, commercial Banks, p lic deposits sits, trade credit, factor forfaiting, commercial paper, discounting of bill ete. The fac commer Paper, escounting of bills. influencing the selection of suitable source of financing are the r purpose, object and cost involved. If finance is needed for short pet ‘Scanned with Camseanner' Introduction to Financial Management 21 ‘then banks, public deposits, financial institutions, discounting of bills, factoring, etc are appropriate sources. If finance is required for long - ayterm then share capital and debentures may be useful. 4. Selecting a pattern of investment After acquiring necessary funds, decision about investment ‘© pattern, ie how to use funds, is to be made. A decision about which assets are to be purchased will have to be taken. The funds will have istto be spent first on fixed assets and then an appropriate amount will eabe retained for working capital. 5. Proper Cash Management Finance Manager has to assess the various cash needs at atdifferent times and make arrangements for acquiring cash The cash* (management! should be such that neither there is a shortage of it nor anthere is a surplus. 6. Implementing Financial Controls. An efficient system of Financial Management gives utmost importance on the use of various financial control devices. It includes io Return on Investment, Break Even Analysis, Budgetary Control, Ratio Analg etc to evaluate the performance of various financial policies b 9. Proper use of surplus fund te A judicious use of surplus fund is essential for expansion and for protecting the interests of shareholders, The ploughing back of profit is the best policy for expansion and protecting the interest of a shareholders. But a balance has to be kept for paying dividend and ¢ for ploughing back of profit. ; OBJECTIVES OF FINANCIAL MANAGEMENT : Financial management is concerned with procurement and use ; of funds. Its main aim is to use business funds in such a way that (firm’s value is maximised. The main objective of a business is to =< — = el ‘Scanned wth CameannerFINANCIAL MANAGEMENT maximise the owner’s economic welfare. This objective can achieved by: J} Profit Maximisation, and v2. Wealth Maximisation PROFIT MAXIMISATION Profit earning is the most important aim of every econom activity. It can be considered as a measuring scale for assessing tk economic efficiency of any business concern. Therefore the Supportei of profit maximisation concept argue that a firm should take it financial decisions in such a way as to maximise its profit. Moreove the main objective of Financial Managemiént is to safeguard th economic interest of the persons who are directly or indirect! connected with the company such as shareholders, creditors employees and the general public. These parties have contribute funds with which the company is carrying on its operations. Henc all these interested parties must get maximum profit for thei contributions. According to this view, the aim of financial managemen is to earn maximum profit. ARGUMENTS IN FAVOUR OF PROFIT MAXIMISATION 1, Profitability is the barometer for measuring efficiency and economii prosperity of,a business enterprise. Thus profit maximisation i: ee * jdstified on the grounds of rationality. 2.” Profit is the main source of finance for the growth of a business “So a business should aim at maximisation of profit for enabliny its growth and development. : 3. Profit serves as a protection against risk which cannot be ensured Economic and business conditions do not remain same at all the times. There may be adverse business conditions like recession depression, severe competition etc. A business will be able tc survive under unfavourable situation, only if has some pas! earnings to rely upon. ‘Scanned with Cascanner“2 Introduction to Financial Management 2 © bel AMenciel welfare Can be achieved through profit maximisation. 5. Profit attracts investors to invest their savings in securities. penance eB CRITICISMS OF PROFIT MAXIMISATION 1. The term profit is vague and it cannot be precisely defined. Profit means different things to different people. Profit may be short omic term or long term or before tax Profit or after tax profit etc. sthe ‘ters 2: Ighores time value of money — > its Profit maximisation objective ignores the time value of money. over It treats all earnings as equal even though they occur in different -the periods. It does not consider the fact that cash received today is more ctly important than the same amount of cash received after some years. 28; 3, Ignores Risk factor. 1 ted ince {It does not take into account the risk factor of the future earnings ? reir Stream. Some projects are more risky than others. Two firms may ent have same expected Earnings Per Share, but if the earning stream of one is more risky then the market value of its shares will be comparatively less. : 4. Dividend policy: nic : a The dividend policy will always affect the market price of shares. i But this is not considered in the objective of profit maximisation. 5.It attracts cut throat competition ig 6.It leads to exploiting workers and consumers, WEALTH MAXIMISATION —— According to Solomon Ezra, the ultimate goal of the Financial Management is maximisation of owner’s wealth. Maximisation of —akimisation of wealth means maximisation of market price per share in the lon; _ Prof. Solomon is of the view that Wealth maximisation also Maximises the achievement of other objectives of the firm. ‘Scanned with CaseannerFINANCIAL MANAGEMENT Maximisation of wealth objective provides a useful and meaningj, objective and serves as basic guideline by which financial decision should be evaluated. If an enterprise does not pursue the goal of maximisin, shareholder's wealth, it leads to the conclusion that funds Provide; by shareholders are not properly utilised and there is lower rate o economic growth. ; According to Prasanna Chandra, Equity shareholders provid: the venture (risk) capital required to start a business and appoint th: Management of the firm indirectly through the board of directors Hence it is the responsibility of the management to promote the welfare of equity shareholders. E ARGUMENTS IN FAVOUR OF WEALTH MAXIMISATION 1 The objective of wealth maximisation is always consistent with the objective of owner's economic welfare gtowner's economic welfar 2) Wealth maximisation protects the interest of all the stakeholders of a company and the society as a whole. 3 It ensures long term growth and survival of the company term growth and survival o 4) Ittakes into consideration the risk factor and time value of money — atu of mon — It guides the management in. framing a suitable dividend policy Decisions regarding payment of dividend are taken so_as fo increase the market value of the shares. e 6) It ensures that the resgurces ofan organisation have been use! effectively to accomplish the objectives of the organisation. CRITICISMS OF WEALTH MAXIMISATION The limitations of wealth maximisation approach are as follows 1) The wealth maximisation objective is not descriptive of what firms actually do. 5) ed ‘Scanned with CamSeanner2 . 25 Introduction to Financial Management —————_——_ 2) There is some difference of opinion as to whether the objective is to maximise the shareholder's wealth or the wealth of the firm. ca a 3) The objective of wealth maximisation is not necessarily socially, desirable. 4) The objective of wealth maximisation may also face difficulties when ownership and_man: separated. When the managers act as agénts of real owners there is a possibility for a conflict of interests between shareholders and the managerial interests. In spite of all criticisms wealth maximisation is considered superior to profit maximisation because: a) Profit maximisation measures performance of the firm in terms of profit only where as wealth maximisation objective considers all future cash flows, dividend, earning per share and impact of risk on decisions. b) A firm which adopts profit maximisation objective may not opt to declare any dividend at all, whereas the objective of wealth maximisation allows regular payment of dividend. PROFIT MAXIMISATION Vs WEALTH MAXIMISATION Wealth Maximisation Profit Maximisation 1) Short term objective Long term objective Aims at maximising the wealth of the shareholders 2) Aims at maximising the profit of the firm 3) Measures the effectiveness of | Measures the financial stability the organisation of the organisation 4) Does not consider time value | Considers time value of money of money Distributes the earnings among shareholders as dividend. 5) Provides no clarity on whether thé earnings would be _ distributed or retained in the _ firm. ‘Scanned with CascannerFINANCIAL MANAGEMENT F TIME VALUE OF MONEY ~ The finance manager of a firm has to take appropriate decisions on financing, investment and dividend. While taking these decisions the finance manage? must keep the time factor in mind and should consider the money value. 26 The time value of money is that the value of money received today is more than the value of same amount’of money received after @ certain period. In other words money received in the future is not as valuable as money received today. Purchasing power of money decreases because of inflation. In inflationary economy a rupee today represents a greater purchasing power than a rupee to be received after one year. It is therefore, desirable to calculate the present value of future earnings by discounting them with the rate of inflation for ascertaining present value of earnings. Money has a time value because of the following reasons: i) Individuals generally prefer current consumption ii) An investor can profitably employ a rupee received today to give him a higher value on tomorrow or after a certain period. iii) In an inflationary economy the money received today has more purchasing power than money to be received in future. Thus the fundamental principle behind the concept of ‘time value of money’ is that a sum of money received today is worth more than the sum received after sometime, TECHNIQUES OF TIME VALUE OF MONEY There are two techniques for adjiisting the time value of money: i) Compounding technique, and ii) Discounting or Present Value Technique. I. COMPOUNDING TECHNIQUE The compounding technique is used to find out the future value of present money. It is same as the concept of compound interest. In ‘Seamed with CamScanneroF Introduction to Financial Management —————————_—_ 7 this concept, the interest earned on the initial principal amount becomes a part of the Principal at the end of compounding period. For eg:- An investor invests = 1,000 for 3 years in a savings account that pays 10% interest per year at a compounded rate. The investment of investor will grow as follows: "year: Principal amount 1,000 Interest for 1% year (1000 x 10%) 100 Principal at the end 1,100 Ind year: Principal amount at the beginning 1,100 Interest 3rd the year (1100 x 10%) 110 Principal at the end Illrd year : Principal amount at the beginning 1,210 Interest for 3" year (1210 x 10%) 121 Principal at the end of 3“ year 1,331 Thus in case of compounding the principal amount together with interest are reinvested each year till the end of maturity year. In case the future value for longer period is to be calculated, suppose for 20 years or 30 years, it is difficult to calculate the principal and interest by using the method followed in the above example. Therefore a generalised procedure for calculating the future value of a single amount compounded annually is formulated as: FV, = PV(1 +r) ‘ FV, = Future value of the principal amount at the end of ‘n’ years. PV = Initial cash flow r= Annual rate of interest n = Number of years. ‘Scanned with Camscanner- i! ere FINANCIAL MANAGEMENT —$§£$-_$£-—_+$£+_>——+$$__ Illustration: 1 8 If an investor invests € 50,000 in a bank which is Paying 8% interest on a ten year time deposit. How much the investor Would get at the end of 10 year? Solution: FV, = PV (1 +r)" oof 18 |” = 50,0 (8) = 50,000 x (1.08)! i = 50000 x 2.159 | = %1,07,950 Note: compound value of one rupee at specified interest rate at Specified period is given in the compound vatue table. (Here, itis 2 159), MULTIPLE COMPOUNDING PERIODS In the above case it is assumed that is made on annual or yearly basis, But half yearly, ‘n’is a year, a compounding interest can be compounded quarterly or monthly or annually. In case interest is compounded annually ‘m’ (ie number of times compounding is done in a year) is 1. In case interest is co 1. times and if compounding is do: \ done 12 times. | Then the formula will be: ' Fv, = py ([teZ}™ i FVa = Future value of principal amount at the end of ‘n’ years, | PV = Initial cash investment Tr = Annual interest rate Number of times compounding is done during the year. n= Number of years ‘Scanned with CamcannerIntroduction to Financial Management 8 Illustration: 2 Calculate the compound value when % 10,000 is invested for 3 Years and rate of interest is 10% p.a. a) If compounding is done half yearly. b) If compounding is done quarterly. Solution: a) If compounding is done half yearly, m = 2 FV, = PV (5) stad 5 m. 0.10) 2x3 = 10000 (1-229) * = 10000 (1.05)° = 1000 x 1.340 = % 13400 b) If compounding is done quarterly: m = 4: r)m xn : wt Fy, = pv(i+2) = 10,000 (1-22) c = 10,000 (1.025)12 = 10,000 x (1.347) = % 13,470 NB: Compounding factor is calculated at 2.5% for 12 years ie 1.347 DOUBLING PERIOD Compound factor tables can be used to calculate the doubling period. The doubling period is the length of period which an amount is going to become double at a given rate of interest. It is calculated by following Rules of thumb: ‘Scanned with Cascanner~ FINANCIAL MANAGEMENT 30 % Rule 72 : . . 72 Doubling period = ote of Interest Rule 69 . . 69 Doubling period = 0.35 + Rosortnterest Illustration : 3 If ‘A’ invests = 10,000 @ 10% interest, then in how many years will this amount double? Rule of 72 7 Doubling period = 75 = 7.2 yrs Rule of 69 69 Doubling period = 0.35 + [>= 7.25 yrs COMPOUND VALUE OF AN ANNUITY An annuity is a series of equal payments lasting for some specified duration. The premium payments of life insurance company are example of an annuity. When the cash flows occur at the end of each period the annuity is called ‘a regular annuity’ or a ‘deferred annuity’, If the cash flows occur at the beginning of each period, the annuity is called ‘annuity due ie Making use of Annuity compound factor table we can calculate the future value of an annuity due as FV = PV (ACFyn) (1 + 1) Where ACF = Annuity Compound Factor at rate of 4” and at the end of specified ‘n’ period Illustration : 4 Mr. P deposits & 1,000 at the beginning of each year for 5 years in a bank and earns an interest on deposit at the rate of 8% p.a. Calculate how much money he will have at the end of 5 years. ‘Scanned with CamScannerIntroduction to Financial Management 31 FV = 10,000 (5.867) (1 + 0.08) = 10,000 (5.867) 1.08 = % 63,363.60 2. DISCOUNTING OR PRESENT VALUE TECHNIQUES Present value is exact opposite of compound or future value. While future value shows how much a sum of money becomes at some future period, present value shows what the value is today of some future sum of money. Using discounting technique one can estimate the present value of future earnings. In normal case money value gets reduced due to passage of time. Estimation of present value of future sum is called discounting. Present value is the sum to be invested at a given rate of interest to get a specified sum after a given period, The equation to find out discounted value is: PV = (ay? PV = Present value FV = Future value T = rate of interest per annum n = number of years Using present value factor PV = Future value x DF pp DF = Discount factor at ‘”’ rate of interest for ‘n’ Illustration : 5 years Mr. X is to receive % 20,000 after 5 years, Assuming interest rate is 8% p.a. determine the present value of amount. Solution FV PV = agnor PV=FV x DFyy 20000 = (1¥0.08) 5 = 20000) = % 13611.92 * [4603 ~ € 1961.9: ‘Scanned with Camscanner— a 82 _—_— FINANCIAL MANAGEMENT 7 Using present value table : PV = FV x DF 2 = 20,000 x 0.681 = ¥ 13,620 7 (Difference is due to approximation in present value table) PRESENT VALUE OF A SERIES OF CASH FLOWS Ina business situation, the returns received by a firm are spreaq over a number of years. An investment made now may re returns for a period after some time. Any businessman will like to know whether it is worth to invest or forego certain sum now in anticipation of returns he will earn over a number of years. In order to take decision he will need to equate the total anticipated future returns, to the present sum he is going to sacrifice. To estimate the present value of future series of returns, the present value of each expected inflows will be calculated. ] The present value of a series of cash inflows can be represented | by following formula: ye ne 2 co Pn ; (+r) (+r)? > +n) (14r Where, PV = Present Value P,P, &P, = Principal amount of cash flows after 1% year, 2” year and 3" year T = Discount rate 1 nm = number of years Illustration 6 Find out the present value of . future cash infl . received over next four years if the eos that will be discount factor is 10% Year cash flows “ g 10,000 20,000 30,000 40,000 ‘Scanned with Cascanner— x Teaq urns mow ation ision ' the Je of lows nted 33 - eee Introduction to Financial Management Solution: inflows we In order to find out the present value of 4 years cash i have to find the present value of cash folw. (Discounting rate = 10%) Year cash flows | present value factor | Present value Q) 2) 8) (4) 1 10,000 0.909 9,090 2 20,000 0.826 16,520 3 30,000 * 0.751 22,530 4 40,000 0.683 27,320 | Total present value = 75,460 PRACTICAL APPLICATIONS OF THE CONCEPT OF TIME VALUE OF MONEY The time value techniques of compounding and present value can be applied by the financial man important financial decisions: 1) Sinking Fund Problem can apply the concept of time value of mo: be 2) Capital Recovery Problem equal A financial Manager may be inter instalment to be paid every year t. of loan raised from some finan and in a fixed period. ager while taking a number of ney. ‘ested to know the amount of 0 discharge a specified amount cial institution at a given rate of interest 3) Finding out implicit rate of interest Implicit rate of intere: the help of time value of m; St for an. investment can be calculated with any techniques. For example Deep discount aaa ‘Scanned with CamScannerFINANCIAL MANAGEMENT 2a en Bonds have been issued by money financial institutions where | invester is required to pay a specific amount per bond at the time issue and receives of much larger amount at the end of specifi Period. The rate of interest in such a case is not given. The technic of time value can be applied to find out the implicit rate of interes 4) Compound Growth Rate A Gnance tranager may be require to calculate the compou rate of growth for sales of profits to know the growth of business | can do this by wee compound factor table 5) Ascertaining tine period Investors may be interested to find out period over which specified amount will grow at a given rate of interest to a certs amount. This cam te aacertained by time value of compound a: present value factor 1 Short Answer Questions Tj What @ Finance? 2) Define Business Pinance? x Define Pinanctal Management 4) What ie Public Pinance? 3) What ie Private finance? 6} What ia Time value of money? 7) What is Compounding? a What is Discounting technique? 9%) What are Executive Finance Punctiona? 10) What are Routine finance functions? uy What is Doubling period? 32) What Finance Punetion? ‘Scanned with Camscanner