CHAPT

NATURE OF FINANCIAL MANAGEMENT

ER 1
 LEARNING OBJECTIVES
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 1.1 Nature, scope and objectives of financial management

 1.2 Time value of money
 1.3 Concept of Risk and Return (including Capital Asset
Pricing Model)
 1.4 Valuation of securities – Bonds & Equities
 Important Business
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Activities
 Production
 Marketing
 Finance
 Real And Financial
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Assets
 Real Assets: Can be Tangible or Intangible
 Tangible real assets are physical assets that include
plant, machinery, office, factory, furniture and
building.
 Intangible real assets include technical know-how,
technological collaborations, patents and copyrights.
 Financial Assets are also called securities, are
financial papers or instruments such as shares and
bonds or debentures.
 Equity and Borrowed
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Funds
 Shares represent ownership rights of their holders.
Shareholders are owners of the company. Shares
can of two types:
 Equity Shares
 Preference Shares
 Loans, Bonds or Debts: represent liability of the
firm towards outsiders. Lenders are not owners of
the company. These provide interest tax shield.
 Equity and Preference
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Shares
 Equity Shares are also known as ordinary shares.
 Do not have fixed rate of dividend.
 There is no legal obligation to pay dividends to equity
shareholders.
 PreferenceShares have preference for dividend
payment over ordinary shareholders.
 They get fixed rate of dividends.
 They also have preference of repayment at the time of
liquidation.
 Finance and
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Management Functions
 All business activities involve acquisition and use
of funds.
 Finance function makes money available to meet
the costs of production and marketing operations.
 Financial policies are devised to fit production and
marketing decisions of a firm in practice.
 Finance Functions
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Finance functions or decisions can be divided as

follows 
 Long-term financial decisions
• Long-term asset-mix or investment decision or capital
budgeting decisions.
• Capital-mix or financing decision or capital structure and
leverage decisions.
• Profit allocation or dividend decision
 Short-term financial decisions
• Short-term asset-mix or liquidity decision or working
capital management.
 Financial Procedures
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and Systems
 For effective finance function some routine functions have to
be performed. Some of these are:
 Supervision receipts and payments and safeguarding of cash
balances
 Custody and safeguarding of securities, insurance policies
and other valuable papers
 Taking care of the mechanical details of new outside
financing
 Record keeping and reporting
 Finance Manager’s Role
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 Raising of Funds
 Allocation of Funds
 Profit Planning
 Understanding Capital Markets
 Financial Goals
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 Profit
maximization (profit after tax)
 Maximizing earnings per share
 Wealth maximization
 Risk-return Trade-off
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 Financial decisions of the firm are guided by the

risk-return trade-off.
 The return and risk relationship:
Return = Risk-free rate + Risk
premium
 Risk-free rate is a compensation for time and risk
premium for risk.
 Risk Return Trade-off
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Risk and expected return move in tandem; the greater the risk, the greater
the expected return.
 Overview of Financial
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Management
 Time Preference for
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Money
 Time preference for money is an individual’s
preference for possession of a given amount of
money now, rather than the same amount at some
future time.
 Three reasons may be attributed to the individual’s
time preference for money:
  risk
  preference for consumption
  investment opportunities
 Required Rate of Return
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 The time preference for money is generally

expressed by an interest rate. This rate will be
positive even in the absence of any risk. It may be
therefore called the risk-free rate.
 An investor requires compensation for assuming
risk, which is called risk premium.
 The investor’s required rate of return is:
Risk-free rate + Risk premium.
 Required Rate of Return
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 Would an investor want Rs. 100 today or after one year?

 Cash flows occurring in different time periods are not comparable.
 It is necessary to adjust cash flows for their differences in timing and risk.
 Example : If preference rate =10 percent
 An investor can invest if Rs. 100 if he is offered Rs 110 after one year.
 Rs 110 is the future value of Rs 100 today at 10% interest rate.
 Also, Rs 100 today is the present value of Rs 110 after a year at 10% interest
rate.
 If the investor gets less than Rs. 110 then he will not invest. Anything
above Rs. 110 is favourable.
 Time Value Adjustment
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 Two most common methods of adjusting cash

flows for time value of money:
 Compounding—the process of calculating future values
of cash flows and
 Discounting—the process of calculating present values of
cash flows.
 Future Value
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 Compounding is the process of finding the future values of

cash flows by applying the concept of compound interest.
 Compound interest is the interest that is received on the
original amount (principal) as well as on any interest earned
but not withdrawn during earlier periods.
 Simple interest is the interest that is calculated only on the
original amount (principal), and thus, no compounding of
interest takes place.
 Future Value
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 Future Value
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In Microsoft Excel: Use FV function.

FV(rate,nper,pmt,pv,type)

Where: rate= interest rate. nper= n periods,

pmt= annuity value, pv= present value, type=
1 for beginning of the period and 0 for end for
end of period.
 Future Value: Example
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 Sinking Fund
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Example