[_Bhalotia Classes (9883034569): FM important theory for Hons 2024] 4. Define Financial Management. [B.com 2048 Pass] [10%] Financial management is that managerial activity which is concerned with planning and controlling of the firm’s financial resources. In other words itis concemed with acquiring, financing and managing assets to accomplish the overall goal of a business enterprise (mainly to maximise the shareholder's wealth). Financial Management comprises of forecasting, planning, organising, directing, coordinating and controlling of all ting to acquisition and application of the financial resources of an undertaking in keeping with its financial objective. Financial Management is concemed with the managerial decisions that result in the acquisition and financing of short term and long term credits for the firm. Howard and Uptron define Financial Management “as an application of general managerial principles to the area of financial decision-making” Weston and Brighem define Financial Management “as an area of financial decision making, harmonizing individual motives and enterprise goal”. tivities n 2. ;cuss the importance of Financial Management. [15 P] [30%] | ‘Some of the importance of the financial management is as follow: (a) Financial Planning: Financial management helps fo determine the financial requirement of the business concern and leads to take financial planning of the concem. Financial planning is an important part of the business concem, which helps to promotion of an enterprise (b) Acquisition of Funds: Financial management involves the acquisition of required finance to the business concer, Acquiring needed funds play a major part of the financial management, which involve possible souree of finance at minimum cost (©) Proper Use of Funds: Proper use and allocation of funds leads to improve the operational efficiency of the business concem. When the finange manager uses the funds properly, they can reduce the cost of capital and increase the value of the firm. (@) 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 concem 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 analy: () Increase the Value of the Firm: Financial management is very important in the field of increasing the wealth of the investors and the business concem. Ultimate aim of any business concem will achieve the maximum, profit and higher profitability leads to maximize the wealth of the investors as well as the nation (g) Promoting Savings: Savings are possible only when the business concer ears higher profitability and maximizing wealth. Effective financial management helps to promoting and mobilizing individual and corporate savings.Bhalotia Classes (9883034569): FM important theory for Hons 2024 3. What are the functions of Financ’ Manager? [2014 H, 2016 H] [BHALOTIA] [97%]******* Function of financial management means functional activities that an enterprise undertakes in achieving its desired objectives. These functions may be classified on the basis of its operational activities, 1. Purchase Function In this fimetion Finance Manager plays a key role in providing finance. In order to minimize cost and exercise ‘maximum control, various material management techniques such as economic order quantity (OQ), determination of stock level, perpetual inventory system ete. are applied. The task of the Finance Manager is to arrange the availability of cash when the bills for purchase become due. 2. Production Function Production function involves heavy investment in fixed assets and in working capital. Naturally, a tighter control by the Finance Manager on the investment in productive assets becomes necessary. It must be seen that there is neither over-capitalisation nor under-capitalisation, 3. Distribution Function The objective of distribution function is making available the goods to the end customer. As every aspect of distributor function involves cash outflow and every distributing activity is aimed at bringing about inflow of cash, both the functions are closely inter-related and hence should be carried out in close union, 4. Accounting Function The efficiency of the whole organization can.be greatly improved with correct recording of financial data, All the ‘ounting tools and control GeViEES. necessary for appraisal of finance policy can be correctly formulated if the accounting data are\properly recorded 5. Human Resource Function A sound HR policy includes proper wage strtiture, ihceffivessschemes, promotional opportunity, human resource developiieritaiid Other fringe befits pRovided fosthe efffployg8S. All these matters affect finance. But the finance ‘manager should know that organization can afford fO.pay only’ What it can bear. It means that expenditure incurred on HR Managenient and the expected return on such iftvestifient through labour productivity should be considered in framing a sound HR’ polieyiTherefore, the relation between the finance and HR department should be intimate, a 6. Research and Development Function In the world of innovations a constant endeavour for improvement and sophistication of an existing produet and introduction of newer varieties, the firm is bound to be gradually out marketed and out of existence - 2~-Admission Going on for B.com, M.com, CA, CMA, CS XI, XI Contact.4. The activi important deci Ss of finan ns. Briefly explain these de: OR Describe the three broad areas of financial decision making. [2018 Hons] [60%] OR Explain the inter-relationship between financing decision, investment decision and dividend decision. [2022 H] [60%] Value of a firm will depend on various finance fu decisions, namely 1. Investment Decision I managers involve taking three ions? [60%] clions/decisions. It can be broadly classified into three major These decisions relate to the selection of assets in which funds will be invested by a firm, Funds procured from different sources have to be invested in various kinds of assets. Long term funds are used in a project for various fixed assets and also for current assets. The investment of funds in a project has to be made after carefull assessment of the various projects through capital budgeting. A part of long term funds is also to be Kept for financing the working capital requirements. Asset management policies are to be laid down regarding various items of eurrent assets. The inventory policy would be determined by the production manager and the finance manager keeping in view the requirement of production and the future price estimates of raw materials and the availability of funds Financing Decision These decisions relate to acquiring the optimum finance to meet financial objectives and seeing that fixed and working capital are effectively managed. The financial manager needs to possess a good knowledge of the sources of available finds and their respective Costs and feeds to ensure that the company has a sound capital structure, ie. 4 proper balanee between equity capital and debt. Such managers also need to have a very clear understanding as to the difference between profit and cash flow, bearing in mind that profit is of litle avail unless the organisation is adequately supported by cash to pay forassets and sustain'the working capital cycle. Financing decisions also call fora good knowledge of evaluation of risk, g. excessive debt earried high risk for an organization’s equity because rights of the lenders, The dividend decision thus has two elements ~ the amount fo be paid out and the amount to be retained to support, also a the growth of the organisation, the latter b represent a significant factor shares by the stock market. 7 nancing decision; the level and regular growth of dividends determining a profit-making company’s market value, ie. the value placed on its All three types of decisions are interrelated, the first two pertaining to any kind of organisation while the third relates only to profit-making organisations, thus it can be seen that financial management is of vital importance at every level of business activity, from a sole trader to the largest multinational corporation,5. What are the objectives of financial Management? [2017] [20%] Efficient financial management requires the existence of some objectives or goals because judgment as to whether or nota financial decision is efficient must be made in the light of some objective. Although various objectives are possible but we assume two objectives of financial management for elaborate discussion. These are: 41. Profit Maximisation It has traditionally been argued that the primary objective of company is to earn profit; hence the objective of financial management is also profit maximisation. This implies that the finance manager has to make his decisions in a manner so that the profits of the concern are maximised. Each alternative, therefore. is to be seen as to whether or not it gives maximum profit. Limitations of ‘Maximisation of Profit’ as the objective of the firm. However, profit maximisation cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise. Some of these have been discussed below (a) The term profit is vague. It does not clarify what exactly it means (b) Profit maximisation has fo be attempted with a realisation of risks involved. (©) Profit maximisation as an objective does not take into account the time pattern of returns. (@) Profit maximisation as an objective is too narrow. Arguments in favour of Profit Maximization (a) When profit eaming is the main aim of business the ultimate objective should be profit maximization (b) Future is uncertain, A firm should eam more and more profit to meet the future contingencies (©) The main souree of finance for growth of a business is profit, Henee, profit maximization is required (d) Profit maximization is justified on the grounds of rationality as profits act as a measure of efficiency and economic prosperity Arguments against Profit Maximization (a) It leads to exploitation of workers and consumers. (b) It Ignores the risk factors associated with profit (©) Profit in itselfis a vague concept and means differently to different people. (@) It is narrow concept at the cost of social and moral obligations. Thus, profit maximization as an objective of Financial Management has been considered inadequate Wealth / Value Ma: Twill benefit analy'is adjusted with t So, Wealth = Present vah It is important that benefits measured by the finance manager are in terms of cash flow. Finance manager should emphasis on Cash flow for investment or financing decisions not on Accounting profit. The shareholder value ‘maximization model holds that the primary goal of the firm is to maximize its market value and implies that business decisions should seek to increase the net present value of the economic profits of the firm. So for measuring and ‘maximising shareholders wealth finance manager should follow (a) Cash Flow approach not Accounting Profit (b) Cost benefit analysis (©) Application of time value of money. n (like to define what is Wealth / Value Maximization Model. Shareholders wealth are the result of cost ir timing and risk i.e. time value of money of benefits ~ Present Value of stsArguments in favour of Wealth Maximization, (@) Due to wealth maximization, the short term money lenders get their payments in time. (>) The long time lenders too get a fixed rate of interest on their investments. (c) The employees share in the wealth gets increased (@) The various resources are put to economical and efficient use. Argument against Wealth Maximization (a) __ Itis socially undesirable. (b) _Itisnota descriptive idea (©) Onlly stock holders wealth maximization does not lead to firm’s wealth maximization (@)_— The objective of wealth maximization is endangered when ownership and management are separated 6. Distinguish Between Profit maximization & wealth maximization [BHALOTIA] [9883034569/9330960172] [67%] Profit Maximisation Wealth Maximisation’ Its traditional approach of the financial management. It is modem approach of the financial ‘management. According to this criterion, the financial activities of a firm are conducted in such a way so that the amount of profit of the firm is maximum, According to this criterion, the financial activities of a firm are conducted in such a way 50 that the net wealth of the firm is The concept of profit is not clear in the profit maximisation criterion, ‘The concept of wealth is clear in the wealth maximisation criterion. In this ease wealth refers to the net present value of a project. The aspects of risk and uncertainty arc ignored in profit ‘maximisation riterion, The aspects of risk and uncertainty are considered in wealth maximisation criterion, In this ease, itis not necessary to know the rate of discount for determining the profit, In this case, it is necessary to know the rate of discount for determining the net wealth. Time value of money is not considered in this etiterion. Time value of money is considered in this criterion It measures the performance of a business firm only on the basis ofits profit. It measures the performance of a business firm on the basis of the shareholders’ wealth (Gt the current market price of the equity shares) It is based on the assumption of perfect competition in the product market. It assumes an efficient capital market It does not also consider the impacts of eamings per share. dividend payments and other returns to the shareholders on. shareholder’ s wealth or on the value of the firm. It takes into account the present value of the future cash inflows, dividend payments, eammings per share and their influence on olders’ wealth. A firm may not pay regular dividends to its shareholders and reinvest its retained earning to achieve this goal. ‘A. firm pays regular dividends to its shareholders to achieve this goalBhalotia Classes (9883034569): FM important theory for Hons 2024 7. Why value maximisation (wealth ma: ation) objective is called better than profit maximisation objectives? [2017 H, 2021H] [BHALOTIA] [9883034569/9330960172] [98%]****** Although Profit and Wealth Maximization sound pretty similar, there are some major differenees between them. While profit maximization aims at increasing the profit of a firm, wealth maximization has a larger role to play and it deals with the wellbeing of the stakeholders as a whole. Profit and wealth maximization dealin different subjects and hence they are defined differently. Profit maximization refers to the management of a firm's resources and utilities to maximize profit. On the other hand, wealth maximization refers to managing the financial and managerial resources for the wellbeing of the stakeholder community as a whole, However wealth maximisation objective is held to be superior to the profit maximisation objective, because of the following reasons: (a) Wealth maximization plays a larger role in business than profit maximization (b) The main focus of profit maximization is on increasing the profit of the company while wealth maximization deals in raising the value of stakeholders in the company. The profit maximization theory is centered around the profit motive while wealth maximization looks at the wellbeing of all stakeholders, (©) Therisk and its effects on financials of the company are a core part of the wealth maximization process, while there is no focus on risk in the. profit:maximization theory. Therefore, in practice, profit maximization is not a complete theoryinitselfwhile wealth maximization is much more cohesive and inclusive in nature (@)_ Profit maximization is actually @ Concept that is basically related to day-to-day business profits, Wealth ‘maxintization i8 a more/complex pedéess of increasifig the overall wealth of the company that is reflected in the inereased price of shitresin the market (©) Profit HHAXIRHIZAtion does not coveF the ri8k.fators A¥Sociated with finance and operations but wealth maximization does (©) Profit maximization 18"aW Glderstheory. and-hence it lacks the modem approaches towards business and profitability. Wealth maximization is a new concept that deals with a larger subject area and includes as many factors as possible, Therefore, wealth maximization is a better approach than profit maximization. (g)_ Profit maximization was a very relevant theory during the early 19th century, while the wealth maximization concept is a newer concept in business. So, wealth maximization is more complex and inclusive in practice in general. (h) Profit maximization is a theory of the past, while wealth maximization is a modem theory - 6 ~Admission Going on for B.com, M.com, CA, CMA, CS XI, XIL Contact.8. Specify the itations of ‘Ma: ation of Profit’ as the objective of the firm. [2016 H, 2020H old, 2023 H] [1%] As the term suggests, Profit Maximization is a philosophy to maximize the profits from a business concern. In the free economy, there is always profitability if the goods and/or services are good. So, firms selling good products, and services increase the prices of goods to generate more revenues and profits. After the market competition for such service providers, however, a point is reached where the maximum profit halts. This is the point of profit maximization, Profit maximization was considered an ideal concept in the early 1900s when businesses were owned by one person ‘who usually paid for everything and asked all the staff to work so that the firms could eam as much as possible. The structure of the firms allowed the owners to do so. Profit maximization may seem to be a good idea but it does not fit the modern ideas of entrepreneurship and doing business, 1. The haziness of the concept “profit” The term “Profit” is a vague term. It is because different mindset will have a different perception of profit. For e.g profits can be the net profit, gross profit, before tax profit, or the rate of profit ete, There iso clearly defined profit ‘maximization rule about the profits. 2. Ignores time value of money The profit maximization formula simply stigzests “higher the profit better is the proposal”. In essence, it is considering the naked profits without considering the timing of them. Another important dictum of finance says dollar today is not equal to a dollar a year later”. So, the time value of money is completely ignored. 3. Ignores the risk A decision solely based on profit maximization model would take a decision in favor of profits. In the pursuit of Profits, the risk involved is ignored which may prove unaffordable at times simply because higher risks directly questions the survival of a business. 4. Ignores quality The most problematic aspect of profit maximization as an objective is that it ignores the intangible benefits such as quality, image, technological advancements etc. ‘The contribution of intangible assets in generating value for a business is not worth ignoring. They indireetly ereate assets for the organization. Conclusion: Profit maximization ruled the traditional business mindset which has gone through drastic changes. In the modem approach of business and financial management, much higher importance is assigned to wealth maximization in comparison of Profit Maximization vs, Wealth Maximization, The losing importance of profit maximization is not baseless and it is not only because it ignores certain important areas such as risk, quality, and the time value of ‘money but also because of the superiority of wealth maximization as an objective of the business or financial management,9. Discuss the Role of Chief financial officer (CFO) [2024 P] [1%] The role of the CFO (Chief Financial Officer) has been changing over the past twenty years. Originally, the role of the CFO revolved around producing and analyzing the financial statements. However, because of the computerization of the accounting fimetion the need for accounting skills in performing the roles and responsibilities of a CFO diminished. Though the job description of a CFO (Chief Financial Officer) remains broad the tasks comprising that fimetion fall into four distinct roles 1. The Strategist CFO The first role of the CFO is to be a strategist to the CEO. The traditional definition of suecess for a chief financial officer was reporting the numbers, managing the financial funetion, and being reactive to events as they unfold. But in today’s fast paced business environment, producing financial reports and information is no longer enough CFO's in the twenty-first century must be able to “peak around comers”. Therefore, they must be able to apply critical thinking skills, along with financial acumen, to the long term goals of the organization. 2. The CFO asa Leader The second role of the CFO hand in hand with the first one, That is one of a leader implementing the strategies of the company. As a result, itis no longer sufficient for a CFO to sit back and analyze the effort of others. The chief financial officer (CFO) of today must take ownership of the financial results of both the organization and senior ‘management team. The chief financial officer of today must be responsible for providing leadership to other senior management team, members, including the CEO. The CFOs role can sometimes force them to make the tough calls that others in the organization don’t or can’t make, Oc s can mean the difference between success and failure 3. The CFO asa Team Leader The third role of the CFO is that of a team leader to other employees function. Not only will a coach call plays for a team, but they are also responsible for getting the highest results out of the talent on their team. An aspiring and successful coach will produce superior results by finding the strengths of their team members and obtaining a higher level of performance than the individuals might achieve on their own, The role of the CFO (Chief Financial Officer) is to bring together a diverse group of talented individuals to achieve superior financial performance. both inside and outside of the financial 4. The CFO with Third Parties Last, but not least, the role of the CFO is that of a diplomat to third parties. People outside of the company look to seniot management team for inspiration and confidence in the company’s ability to perform. In almost every case the financial viability of the company is vouched for by the CFO. The CFO's role becomes that of the “face” of the company’s sustainability to customers, vendors and bankers. Often these third parties look to the CFO for the unvamished truth regarding the financial viability of the company to deliver on it’s brand promise Today's Role of the CFO In today’s fast paced environment the role of the CFO is extremely fluid. One day the CFO might be developing 4 compensation plan for employees. Then the next day taking their bankers on a tour of the facilities. Consequently, tobe a successfull CFO in the future you must be a more multi-functional executive with financial skillsBhalotia Classes (9883034569): FM important theory for Hons 2024 10. ;cuss the basic components of the financial environment under which a firm has to operate. [2015 H] [RKB] [99%]******* Definition of financial environment Financial environment of a company refers to all the financial institutions and financial market around the company that affects the working of the company as a whole, A financial environment is a part of an economy with the major players being firms, investors, and market Essentially, this sector can represent a large part of a well-developed economy as individuals who retain private property have the ability to grow their capital. Firms are any business that offer goods or services to consumers. s that place capital into businesses for financial returns. Markets represent the financial environment that makes this all possible. ‘The financial environment has a number of factors. It includes the financial institutions, government, individuals and firms around the business. Firms use their financial markets to keep their savings as property. It is extremely important for the monetary markets. Components of financial environment ‘The financial environment is composed of three key components: (1) financial managers, (2) financial markets, and (3) investors (including creditors). 1) Financial Managers Financial managers are responsible for deciding how to invest a company’s funds to expand its business and how to obtain funds (financing). The actions taken by financial managers to make financial decisions for their respective firms are referred tovasifinaneiat-management (or managerial finance). Financial managers are expected to make finanial G6¢isions that will maximize the firm’s value and therefore maximize the value of the firm’s stock pices They are usually.compensaté'in a manner that encourages them to achieve this objective. (2) The Financial Markets: Financial markets represent plac&-marKet that facilitat® the flow of funds among investors and borrowers. In financial marke{S investors and borrowers trade fiflanéfal seétrities, commodities and other fungible items at a price determined by demand and supply. Financial market® are typically defined by having transparent pricing, basic regulations on irading, Gosts and fees and market forces determining the prices of securities that trade. Hence, financial markets refer {o a OF#AHi2€C Tistitutional structure or mechanism for ereating and exchanging financial assets. An important component of these financial markets is financial institutions that act as intermediaries. Financial markets can be a) Capital markets b) Money market 3) Investor Investors are individuals or financial institutions that provide funds to firms, government agencies, or individuals ‘who need funds. In this book, our focus regarding investors is on their provision of funds to firms. Individual investors commonly provide funds to firms by purchasing their securities (stocks and debt securities). financial institutions that provide funds are referred to as institutional investors, Some of these institutions focus on providing loans, whereas others commonly purchase securities that are issued by firms. he - 9-Admission Going on for B.com, M.com, CA, CMA, CS XI, XIL Contact.11. What do you mean by time value of money? What are its reasons? [2021H] [BHALOTIA] [9883034569] [80%] Time value of money (TVM ‘Money has time value. In simpler terms, the value of a certain amount of mon today is more valuable than its value tomorrow. It is not because of the uncertainty involved with time but purely on account of timing. The difference in the value of money today and tomorrow is referred to as the time value of money. ‘The term time value of money ean be defined as “The value derived from the use of money over time as a result of investment and reinvestment, ‘The time value of money (TVM) is one of the basic concepts of finanee. We know that if we deposit money in a bank account, we will receive interest. Because of this, we prefer to receive money today rather than the same amount in the future, Money, we receive today is more valuable to us than money received in the future by the amount of interest we can eam with the money. This is referred to as the time value of money. Reasons of Time value of money (TV) ‘The reason why there is time value of money is as follows: 1 Risk and Uncertainty Future is always uncertain and risky. Outflow of cash is in our control as payments to parties are made by us. There is no certainty for future cash inflows. Cash inflows are dependent on our Creditor, Bank ete. As an individual or firm is not certain about future cash receipts, it prefers receiving cash now. 2. Inflation: In an inflationary economy. the money f¥éeived foday. has more purchasing power than the money to be received in future. In other words, a rupee today represents a greater real purchasing power than a rupee a year after 3. Consumption: Individuals generally prefer c ent consumption f future consumption 4. Investment opportunities: An investor can profitably employ a tupee received today, to give him a higher value to be re or after a certain period of time. Thus, the fimdamental principle behind the concept of time v that, a sum of money received today, is worth more than if the same is received after a certain period of time. For example, iff an individual is given an alternative either to receive Rs.10,000 now or after one year, he will prefer Rs, 10,000 now. This is because, today, he may be in a position to purchase more goods with this money than what he 2 10 get for the same amount after one year alue of money is2. Explain the significance of time value of money (TVM) i financial decision making. [2022 H] [BHALOTIA] [70%] Since the money is worth more now than the same money in the future, TVM is therefore important for financial management. You can always use the funds to make an investment and receive interest. Following are the significance of time value of money (TVM) in financial decision making 1. Opportunity costs_& Time value of money Opportunity costs exist wherever options are available. Opportunity costs are, therefore, the benefit or interest that one forgoes when one prefers one investment over another. Or, to put it simply, opportunity costs are the next best available and preferred investment. Therefore, when deciding on an investment, one should consider its opportunity costs. Opportunity costs are a TVM concept and help in decision-making, 2. Capital Budgeting And Time Value of Money TVM is very useful in capital budgeting as it helps management get an idea of their cash flows. In capital budgeting, we discount the future cash flows to their present value to determine whether the project is worthy of investment or not ‘When a company plans to make investments, for example, in machinery, to take over another company, ete,, it ‘wants fo get an idea of whether that investment will pay off or not. Or companies need to know whether the cash flows from the investment are sufficient to recoup at least the initial outlay. The TVM helps a business in deciding and analyzing this aspect with the use of a discount rate, 3. Finance Decisions And Time Value of Money ‘The importance of the time Value of money is not only for corporate decision-making but also on a personal level. Knowing the TVM concept will help you see the financial impact of every financial decision we make, It ‘would help you plan our financial goals arid help us to meet financial challenges. It would also help us to compare and evaluate two or more investment options, 4. Investing and Time Value of Money Because of inflation, prices will rise over time, And the value of the available money will decrease over time Therefore, the money you have is worth more today thanin the future, Therefore, itis very important that you invest the money instead of keeping it in yourself or in a normal bank account, And the TVM helps you make the better investment decision based on the following factors: (a) Inflation ~ It is the continuous rise of the price level. The money in your pocket has more purchasing power today than in five years after that, Therefore, an appropriate investment can only maintain or increase the value of your mon (b) Risk the futur your risk by investing it right now (c) Investment Opportunity — There are many ways and options in which you can invest your money However, you lose the opportunity if you wait to invest your money. Any delay will lose the value of your money over time, uncertain so you may lose ome or all of your money in the future, but you can reduce13. Explain the compounding & discounting technique in relation to time value of money? [BHALOTIA] [9883034569] [40%] ‘Time Value of Money says that the worth of a unit of money is going to be changed in future. Put simply, the value of one rupee today will be decreased in future, The whole concept is about the present value and future value of money. There are two methods used for ascertaining the worth of money at different points of time, namely, compounding and discounting. Compounding method is used to know the future value of present money. Conversely, discounting is a way to compute the present value of future money Compounding is helpful to know the future values, of the cash flow, at the end of the particular period, at a definite rate. Contrary to this, Discounting is used to determine the present value of the future cash flow, at a certain interest rate, Here, in this article, we've described the differences between compounding and discounting, Techniques of compounding ‘The “time value of money” describes the effects of compounding. An amount invested today has more value than the same amount invested at a later date because it can utilize the power of compounding. Compounding is the process by which interest is earned on interest, When a principal amount is invested, interest is eamed on the principal during the first period or year. In the second period or year, interest is earned on the original principal plus the interest camed in the first period, Over time, this reinvestment process can help an account grow significantly. Technique of discounting: ‘The present value of a sum of money to be received at a future date is determined by discounting the future value at the interest rate that the money could eam over the period. This process is known as Discounting. ‘The present value interest factor declines as the interest rate rises and as the length of time increases. Differencs en_ compoundin: Discounting: BASIS FOR companion ‘COMPOUNDING DISCOUNTING Meaning The method used to determinethe __ | The method used to determine the future value of present investment is | present value of future cash flows is known as Compounding. known as Discounting. [Concept If we invest some money today, what _| What should be the amount we will be the amount we get at a future | need to invest today, to get a specific date. amount in future, lUse of Compound interest rate. Discount rate Known Present Value Future Value Factor Future Value Factor or Compounding | Present Value Factor or Discounting Factor Factor Formula FV=PV(1 +n" PVEFV/(1+ A"14, Briefly explain how the role in the financial dec’ n making. [2022 H] [RKB] [50%] OR Discuss the relationship between Risk and Return. [2021H old] ‘The risk and retum constitute the framework for taking investment decision. It has generally been found that there is a direct relationship between risk and return. An investment proposal involving low risk has low return while a proposal involving higher risk has higher return. risk-return relationship model RELATIVE COMFORT ZONE HIGH Low Risk Low Retum | High Return | High Retum RISK Low Low HIGH RETURN Following is the main type of relationship of risk and return. 1. Direct Relationship between Risk and Return (A) High Risk - High Return According to this type of relationship, if investor will take more risk, he will get more reward. § million, it means his risk of loss is million dollar @B) Low Risk - Low Return Iti also direct relationship between risk and return, If investor decreases investment, It means, he is, decreasing his risk of loss, at that time, his return will also decrease. 2. Negative Relationship between Risk and Return (A) High Risk Low Return : Sometime, investor increases investment amount for getting high return but with increasing return, he faces low return because it is nature of that project. There is no benefit to increase investment in such project. Suppose, there are 1,00,000 lotteries in which you will earn the prize of You have bought 50% of total lotteries. But, if you buy 75% of lotteries. Prize will same but at increasing of risk, your return will decrease. (B) Low Risk High Return ‘There are some projects, if you invest low amount, you can eam high return, For example, Govt. of India need money. Because, govt, needs this money in emergency and Govt. is giving high return on small investment. If you get this opportunity and invest your money, you will get high return on your small risk of loss of money. he investedUnit 2: Sources of Capital & Cost of Capital: [Optional theory or No theory] 15. What are the various sources of long term finance of limited company? Explain merits and demerits of any three of them. [2013 Pass] [BHALOTIA] [9883034569] [10%] ‘Sources of Long-term Finance of a Business (A) Share capital or Equity share (B) Preference shares (C) Retained earning (D) Debentures’Bonds of different types (©) Loans from financial institutions (A) Share capital or Equity share Equity Share Capital isa basic source of finance for any firm. It represents the ownership interest in the company ‘The characteristics of equity Share Capital are a direct consequence of its position in the company’s control, income and assets. Equity Share Capital does not have any maturity and there is no compulsion to pay dividend. ‘The Equity Share Capital provides funds, more or less, on a permanent basis. It also works as a base for ereating the debt and loan capacity of the firm. The advantages and limitations of Equity Share Capital may be summarized as follows’ Advantages of Equity Share Financing: (a) Itis a permanent source of funds. (b) The new Equity Share Capital increases the corporate flexibility for the point of view of capital structure planning (c) Equity Share Capital does not involve any mandatory payments to shareholders, (d) It may be possible to make further issue of share capital by using a right offering. In general, selling right shares involves no change in the relationship between ownership and control. Limitations of Equity Share Financ (2) Cost of eapital is the highest of all sources. (b) Equity Share Capital has a burden of Corporate Dividend Tax on the company (c) New issue of Equity Capital may reduce the EPS. (B) Preference shar. The Preference Share Capital is also owner’s capital but has a maturity period. In India, the preference shares must be redeemed within a maximum period of 20 years from the date of issue, The rate of dividend payable on preference shares is also fixed. As against the equity share capital, the preference shares have two references: (i) Preference With respect fo payment of div Advantage (a) The preference shares carry limited voting right though they are a part of the capital. (b) The cost of capital of preference shares is less than that of equity shares. (c) The preference share financing may also provide a hedge against inflation. (@) A company does not face liquidation or other legal proceedings if it fails to pay the preference dividendsDisadvantages (a) The cost of capital of preference shares is higher than cost of debt. (b) Non-payment of dividend may adversely affect the value of the firm. (©) The compulsory redemption of preference shares after 20 years will entail a substantial eash outflow from the company (C) Retained earnings Long-term funds may also be provided by accumulating the profits of the company and by ploughing them back into business, Such funds belong to the ordinary shareholders and increase the net worth of the company. A. public limited company must plough back a reasonable amount of profit every year keeping in view the legal requirements in this regard and its own expansion plans. Such funds also entail almost no risk. Further, control of present owners is also not diluted by retaining profits. (D) Debentures or Bonds: As compared with preference shares, debentures provide a more convenient mode of long- term funds. The cost of capital raised through debentures is quite low since the interest payable on debentures can be charged as expense before tax. From the investors’ point of view, debentures offer a more attractive prospect than the preference shares since interest on debentures is payable whether or not the company makes profits Advantages (a) The cost of debentures is much lower than the cost of preference or equity capital as the interest is tax- deductible, Also, investors consider debenture investment safer than equity or preferred investment and, hence, may require a lower return on debenture investment. (b) Debenture financing does not result in dilution of control (©) Ina period of rising prices, debenture issue is advantageous. The fixed monetary outgo decreases in real terms as the price level increases, Disadvantages (a) Debenture interest and capital repayment are obligatory payments. (b) The protective covenants associated with a debenture issue may be restrictive, (©) Debenture financing enhances the finaneial risk associated with the firm. (@) Since debentures need to be paid during maturity, a large amount of eash outflow is needed at that time. {E) Loans from Financial Institutions: In India specialised institutions provide long- term financial assistance to industry. Thus, the Industrial Finance Corporation of India, the State Financial Corporations, the Life Insurance Corporation of India, the National ‘Small Industries Corporation Limited, the Industrial Credit and Investment Corporation, the Industrial Development Bank of India, and the Industrial Reconstruction Corporation of India provide term loans to companies,16. What are the various sources of short term finance of limited company? Discuss [BHALOTIA] [9883034569] [20%] ‘Sources of Short-term Finance of a Business (A) Trade credit It represents credit granted by suppliers of goods, ete., as an incident of sale. The usual duration of such eredit is 15 to 90 days. It generates automatically in the course of business and is common to almost all business operations. It can be in the form of an ‘open account’ or ‘bills payable’. Trade credit is preferred as a source of finance because it is without any explicit cost and till a business is a going concern it keeps on rotating. Another very important characteristic of trade credit is that it enhances automatically with the inerease in the volume of business (B) Accrued Expenses and Deferred Income: Acorued expenses represent liabilities which a company has to pay for the services which it has already received ‘Such expenses arise out of the day to day activities of the company and hence represent a spontaneous source of finance. Deferred income, on the other hand, reflects the amount of funds received by a company in liew of goods and to be provided in the future, Since these receipts increase a company’ liquidity, they are also considered to be an important source of spontaneous finance. (© Ads Manufacturers and contractors engaged in producing or constructing costly goods involving considerable length of manufacturing or construction time usually demand advance money from their customers at the time of accepting their orders for executing their contracts or supplying the goods. This is a cost free source of finance and really useful (D) Commercial Pap: A Commercial Paper is an unsecured money market instrument issued in the form of a promissory note. The Reserve Bank of India introduced the commercial paper scheme in the year 1989 with a view to enabling highly rated corporate borrowers to diversify their sources of short term borrowings and to provide an additional instrument to investors. Subsequently, in addition to the Corporate, Primary Dealers and All India Financial Institutions have also been allowed to issue Commercial Pape Commercial Papers can be issued for maturities between 15 days and a maximum up to one year from the date of issue. These can be issued in denominations of Rs 5 lakh or multiples thereof. All eligible issuers are required to get the eredit rating (©) Bank Advances: Bank advances are in the form of loan, overdraft, cash credit and bills purchased/discounted ete. Banks do not sanction advances on a Jong term basis beyond a small proportion of their demand and time liabilities. Advances are granted against tangible securities such as goods, shares, government promissory notes, Bills ete. In very rare ceases, clean advances may also be allowed,17. What is the weighted average cost of capital? What weights do you take into consideration for computation of weighted average cost of capital? Which of them do you recommend most? Why? [BHALOTIA] [9883034569] [20%] The weighted Average Cost of Capital can be computed by using the “Book Value” or the ‘Market value” as weights. If there is a difference between market value and book value weights, the weighted average cost of capital would also differ. Thi value is used. ighted average cost is usually higher than it would be if the book The Market values weights are sometimes preferred to the book value weights due to following reasons a, Market value represents the true expectations of the investors as they presumably reflect economic b, Market value weights are not influenced by the arbitrary accounting policy of the firm. ©. It considers price level changes and, therefore, reflects current cost of capital. Because of this market value weights for calculating the cost of capital is theoretically more appealing But it suffers from the following limitations a, Market value weights are operationally inconvenient as market values undergo frequent fluctuations. This will affect the overall cost of capital and, in tum decision criterion for investment. b, Market values of all sources of capital are not readily available, ©. Use of market values tends to shift a greater importance towards the larger amounts of equity fun particularly when additional financing is undertaken ‘When the shares are not listed in any stock exchange, the use of market value weights is impossible and Demerits of ma Due to above limitations, it is desirable to use the book value weights. This method has the following advantages: a, Book value weights are easily Otreadily available from published accounts, b. The capital structure targets are usually set in terms of book values. c. To evaluate the riskiness of the company, the book value debt-equity ratios are analyzed by the investors. 4. It is easier to evaluate the performance of a financial manager in producing funds comparing on the basis of book values, ¢. When the shares of the company are not listed in any stock exchange the use of book value weights is the only alternative. However, the book value weights system suffers from the following limitations: a, Itdoes not truly reflect the economic values. b. Book values weights may be based on arbitrary accounting policies followed to calculate retained earnings and value of assets, ‘The book value weights system is not consistent with the definition of the overall cost of capital, which is defined as the minimum rate of return required to maintain the company’s market value 4. Theoretically, it is very difficult to justify the use of book value weights. Selection of appropriate weights by using both the altematives - book value and market values is an important aspect to calculate weighted average cost of capital. Both have their own commendable features. Market value weights are operationally inconvenient as compared to book value weights. However, market values weights are theoretically consistent and sound, and therefore a better indicator of firm’s cost of capital, provided market value of various sources of capital are readily available and they seems to be stable.