BUSINESS FINANCE

Business Finance:
Nature and Scope
Business finance refers to the process of managing funds and financial resources within an
organization to achieve its financial objectives.
It involves making decisions regarding the acquisition, utilization, and management of funds in
order to maximize shareholder value. The scope of business finance encompasses various
areas such as financial planning, investment decisions, financing decisions, dividend decisions,
and capital budgeting.

Finance Function
The finance function within a business is responsible for managing the financial resources of
the organization. It involves activities such as financial planning, budgeting, financial analysis,
capital budgeting, investment decisions, and financial control. The primary objective of the
finance function is to ensure the availability of adequate funds and their efficient utilization to
achieve the company's financial goals.

Investment Decisions
Investment decisions are crucial to a company's success. These decisions involve allocating
funds to different investment opportunities, such as acquiring new assets, expanding
operations, or investing in research and development. The objective is to maximize the returns
on investment while considering the associated risks. Some common investment evaluation
techniques include net present value (NPV), internal rate of return (IRR), payback period, and
profitability index.
 Financing Decisions
Financing decisions involve determining the capital structure of the company and deciding on
the sources of funds to finance its operations. The goal is to ensure the availability of funds at
the lowest cost while maintaining an optimal capital structure. Financing decisions consider
factors such as debt-equity ratio, cost of capital, risk, and financial leverage. Common sources of
financing include equity financing, debt financing, and retained earnings.

Dividend Decisions
Dividend decisions pertain to the distribution of profits to shareholders. These decisions involve
determining the portion of earnings to be distributed as dividends and the portion to be
retained for reinvestment. Factors influencing dividend decisions include the company's
profitability, cash flow position, growth opportunities, and shareholder expectations. Dividend
policy can impact the company's stock price and the perception of investors.

Capital Budgeting: Meaning, Nature, and Importance

Capital budgeting refers to the process of evaluating and selecting long-term investment
projects that involve substantial financial commitments. It involves assessing the profitability,
feasibility, and risk associated with potential investment opportunities.
Capital budgeting decisions have long-term implications and require careful analysis to ensure
the effective allocation of resources.
The importance of capital budgeting lies in its ability to contribute to the company's growth,
profitability, and long-term sustainability.
Evaluation Criteria for Investment Decisions
Investment decisions are evaluated based on several criteria to assess their potential profitability and
feasibility. The major evaluation criteria include:
1. Net Present Value (NPV): NPV calculates the present value of future cash flows generated by
an investment, considering the time value of money. If the NPV is positive, the investment is
considered acceptable.

2. Internal Rate of Return (IRR): IRR is the discount rate at which the NPV of an investment becomes
zero. It represents the expected rate of return on the investment. If the IRR is higher than the required rate
of return, the investment is considered viable.

3. Payback Period: Payback period is the time required to recover the initial investment through
cash inflows. Investments with shorter payback periods are generally preferred as they provide
faster returns.

4. Profitability Index: The profitability index (PI) measures the ratio of the present value of cash
inflows to the present value of cash outflows. A PI greater than 1 indicates a profitable
investment.

5. Risk Analysis: Investments should be evaluated in terms of their risk profile. Risk analysis involves
assessing factors such as market conditions, competition, regulatory environment, and project-specific risks.

6. Sensitivity Analysis: Sensitivity analysis examines the impact of changes in key variables (e.g.,
sales volume, costs, interest rates) on the project's financial outcomes. It helps identify the
project's sensitivity to different scenarios.
Cost of Capital:
The cost of capital refers to the minimum rate of return that a company must earn on its investments to
maintain or increase the value of its stock. It represents the cost of financing or obtaining funds for a
business through various sources such as debt, preference shares, equity shares, and retained earnings.

Importance of Cost of Capital:

1. Capital budgeting: The cost of capital is used as a benchmark to evaluate the feasibility of investment
projects. It helps determine whether the expected returns from a project are higher than the cost of capital.

2. Financing decisions: The cost of capital assists in making financing decisions by comparing the cost of
different sources of funding. It helps in determining the optimal capital structure for the company.

3. Performance evaluation: The cost of capital is used to assess the performance of various divisions or
projects within a company. It serves as a standard for evaluating the profitability of investments and
determining the value added by different business units.

4. Setting hurdle rates: The cost of capital helps in setting hurdle rates for different business units or
divisions. These rates act as benchmarks for assessing the viability of new projects and determining the
minimum required returns.

5. Investor expectations: Investors consider the cost of capital while evaluating the attractiveness of a
company's stock. If the company fails to generate returns higher than the cost of capital, it may indicate poor
financial performance.
Calculation of Cost of Debt:
The cost of debt represents the cost of borrowing funds from lenders or issuing bonds. It can
be calculated using the following formula:
Cost of Debt = Interest Expense / Average Debt

Where:
- Interest Expense: Annual interest payments on outstanding debt.
- Average Debt: Average outstanding debt over a specific period.

Calculation of Cost of Preference Shares:

The cost of preference shares is the rate of return required by preference shareholders. It can
be calculated using the following formula:
Cost of Preference Shares = Dividend on Preference Shares / Net Proceeds from Preference
Shares

Where:
- Dividend on Preference Shares: Annual dividend paid to preference shareholders.
- Net Proceeds from Preference Shares: Proceeds received from issuing preference shares
(excluding flotation costs).
Calculation of Cost of Equity Shares:
The cost of equity shares represents the return required by equity shareholders. It can be
calculated using various methods such as the dividend discount model (DDM) or the capital
asset pricing model (CAPM).
One common approach is the CAPM, which can be calculated using the following formula:
Cost of Equity Shares = Risk-Free Rate + Beta * Equity Risk Premium

Where:
- Risk-Free Rate: The rate of return on a risk-free investment, such as government bonds.
- Beta: Measure of the systematic risk associated with the company's stock.
- Equity Risk Premium: The additional return required by investors for taking on the risk of
investing in equities.

Calculation of Cost of Retained Earnings:

The cost of retained earnings is the opportunity cost of using internal funds for investments
instead of distributing them to shareholders. It is usually considered the same as the cost of
equity shares.

Combined (Weighted) Cost of Capital:

The combined cost of capital is the weighted average cost of various sources of capital (debt,
preference shares, equity shares, and retained earnings) based on their proportional
contribution to the total capital structure of the company. It can be calculated using the
following formula:
Combined Cost of Capital = (Weight of Debt × Cost of Debt) + (Weight of Preference Shares ×
Cost of Preference Shares) + (Weight of Equity Shares × Cost of Equity Shares) + (Weight of
Retained Earnings × Cost of Retained Earnings)

Where:
- Weight of Debt, Preference Shares, Equity Shares, and Retained Earnings: Proportional weights
assigned to each source of capital based on their respective market values or book values.

Capitalization:
Capitalization refers to the total value of a company's outstanding shares of stock. It represents
the sum of a company's long-term debt, equity shares, preference shares, and retained
earnings.

Overcapitalization:
Overcapitalization occurs when a company has raised more capital than is justified by its
earnings capacity and asset base. It implies that the company's capital structure is imbalanced,
with excessive capital relative to its profitability and operational requirements.
Overcapitalization can lead to reduced profitability, inefficiency, and lower returns for
shareholders.
Dividend Policies:
Dividend policies refer to the decisions made by a company regarding the distribution of profits
to its shareholders in the form of dividends. There are several issues and considerations
associated with dividend policies, including:

1. Dividend Stability: Companies need to decide whether to maintain a stable dividend payout
over time or vary the dividend amounts based on the company's performance and available
funds.

2. Dividend Yield: Companies must determine the desired level of dividend yield, which is the
ratio of dividends per share to the stock price. This decision depends on factors such as market
conditions and investor expectations.

3. Dividend Payment Methods: Companies can choose between various methods of dividend
payments, including cash dividends, stock dividends (issuing additional shares to existing
shareholders), or stock repurchases.

4. Dividend Reinvestment: Companies can allow shareholders to reinvest their dividends back
into the company's stock, typically through a dividend reinvestment plan (DRIP). This can provide
additional capital for the company and benefit shareholders.
Dividend Models:
There are several dividend models used by companies to determine the appropriate level of
dividend payments.

Two commonly used models are:

1. Dividend Discount Model (DDM): The DDM calculates the intrinsic value of a company's
stock by discounting the expected future dividends.
The formula for the DDM is as follows:
Stock Price = Dividend per Share / (Required Rate of Return - Dividend Growth Rate)

2. Gordon Growth Model: The Gordon Growth Model is a variation of the DDM that assumes
a constant dividend growth rate. The formula for the Gordon Growth Model is as follows:
Stock Price = Dividend per Share / (Required Rate of Return - Dividend Growth Rate)
Sources of Funds:
Companies require funds to finance their operations and growth. The sources of funds can be
broadly categorized into long-term funds and short-term funds.

Long-Term Funds:
Long-term funds are obtained for a period exceeding one year. They are typically used to
finance long-term investments and capital expenditures. Common sources of long-term funds
include:
1. Equity Capital: Funds raised through the issuance of common or preferred stock.

2. Debt Financing: Funds raised by issuing long-term debt instruments such as bonds or
obtaining loans from financial institutions.

Short-Term Funds:
Short-term funds are obtained for a period of up to one year. They are used to meet the
company's short-term obligations and finance day-to-day operations. Common sources of short-
term funds include:
1. Trade Credit: Credit extended by suppliers to finance purchases of goods and services.

2. Bank Loans: Short-term loans obtained from banks to meet working capital needs.

3. Commercial Paper: Short-term unsecured promissory notes issued by companies to raise

funds from the market.

Nature, Significance, and Determinants of Working Capital:

Working capital refers to the funds required to finance the company's day-to-day operations,
such as inventory, accounts receivable, and operating expenses. The nature, significance, and
determinants of working capital include:
1. Nature of Working Capital: Working capital is a cyclical concept as it fluctuates with the
business cycle. It is also a quantitative measure of a company's liquidity and short-term financial
health.

2. Significance of Working Capital: Adequate working capital is crucial for smooth operations,
meeting short-term obligations, and taking advantage of business opportunities. Insufficient
working capital can lead to liquidity problems and hinder growth.

3. Determinants of Working Capital: Several factors influence the working capital requirements
of a company, including:

a. Nature of the industry: Different industries have varying working capital needs. For example,
manufacturing companies generally require more working capital due to inventory
requirements.
b. Business cycle: Companies need to manage working capital according to the fluctuations in
the business cycle to ensure sufficient liquidity during downturns.
c. Seasonality: Seasonal businesses may require additional working capital to meet higher
demands during peak seasons.
d. Efficiency of operations: Effective inventory management, accounts receivable collection,
and payables management can significantly impact working capital requirements.
e. Sales growth: Rapidly growing companies may need to increase their working capital to
support higher sales volumes.
Time Value of Money (TVM):
The time value of money is a financial concept that states that money received or paid today is
worth more than the same amount in the future due to the potential to earn interest or
investment returns over time.
TVM is crucial in financial decision-making and is used in various calculations, such as present
value, future value, and annuity calculations.
- Present Value (PV): It represents the current worth of a future sum of money,
discounted at a specific rate of interest. The formula for present value is:
PV = FV / (1 + r)^n
where PV is the present value, FV is the future value, r is the interest rate, and n is the number
of periods.

- Future Value (FV): It represents the value of an investment or sum of money at a specific
future date, taking into account compound interest. The formula for future value is:
FV = PV * (1 + r)^n
where FV is the future value, PV is the present value, r is the interest rate, and n is the number
of periods.

- Annuities: An annuity is a series of equal cash flows received or paid at regular intervals
over a specified period. There are two types of annuities: ordinary annuity (cash flows occur at
the end of each period) and annuity due (cash flows occur at the beginning of each period). The
formulas for calculating the present value and future value of annuities are variations of the
present value and future value formulas mentioned above.
Simple and Compound Interest in Business Finance:
- Simple Interest: Simple interest is calculated only on the principal amount (original investment or loan). It
does not take into account any interest earned or accrued over time. The formula for simple interest is:
SI = P * r * t
where SI is the simple interest, P is the principal amount, r is the interest rate, and t is the time period.

- Compound Interest: Compound interest takes into account both the principal amount and the interest
earned or accrued over time. It is calculated based on the initial principal and any accumulated interest. The
formula for compound interest is:
CI = P * (1 + r/n)^(n*t) - P
where CI is the compound interest, P is the principal amount, r is the annual interest rate, n is the number
of compounding periods per year, and t is the time period.
Compound interest is more commonly used in business finance because it reflects the compounding effect of
interest over time, leading to greater growth of investments or higher costs of borrowing.

Capital Market:
The capital market is a segment of the financial market where long-term debt and equity instruments are
traded. It consists of two primary components: the new issue market and the secondary market.
(A) New Issue Market: The new issue market, also known as the primary market, is where companies raise
fresh capital by issuing new securities to investors. It includes Initial Public Offerings (IPOs), where a
company offers its shares to the public for the first time, and rights issues, where existing shareholders are
given the opportunity to purchase additional shares at a discounted price.

(B) Secondary Market: The secondary market is where previously issued securities, such as stocks and
bonds, are bought and sold among investors. It provides liquidity to investors by allowing them to trade
securities after the initial issuance. The secondary market is facilitated by stock exchanges such as the
Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) in India.
The functions of the stock exchanges include:
- Providing a platform for trading: Stock exchanges provide a centralized marketplace where
buyers and sellers can trade securities. They match buy and sell orders and ensure fair and
transparent transactions.

- Price determination: Stock exchanges facilitate price discovery by allowing investors to bid and
offer prices for securities. Through supply and demand dynamics, the prices of securities are
determined in the market.

- Liquidity provision: Stock exchanges enhance market liquidity by providing a platform for
investors to buy or sell securities at any time. This liquidity allows investors to convert their
investments into cash quickly.

- Listing and compliance: Stock exchanges have listing requirements that companies must meet
to be listed on the exchange. These requirements ensure that listed companies comply with
certain standards of financial reporting and corporate governance.

Money Market: Indian Money Markets - Composition and Structure:

The Indian money market refers to the market where short-term borrowing and lending of funds
take place. It consists of various participants, instruments, and institutions.
The composition of the Indian money market includes:
- Reserve Bank of India (RBI): The central bank of India regulates and supervises the money
market. It formulates and implements monetary policies to control money supply and interest
rates.

- Commercial Banks: Commercial banks are the major players in the money market. They
borrow and lend funds in the interbank market, provide loans to businesses, and accept
deposits from individuals and organizations.

- Non-Banking Financial Companies (NBFCs): NBFCs are financial institutions that provide
financial services similar to banks but do not hold a banking license. They participate in the
money market by providing short-term loans and accepting deposits.

- Mutual Funds: Mutual funds pool money from investors and invest in various money market
instruments. They provide individuals and institutions with access to the money market and
offer relatively low-risk investment options.
- Treasury Bills (T-Bills): T-Bills are short-term debt instruments issued by the government to
meet its short-term funding requirements. They are highly liquid and serve as a benchmark for
short-term interest rates.

- Commercial Paper (CP): CP is an unsecured promissory note issued by corporations to raise

short-term funds directly from the money market. It is typically issued by creditworthy
companies and provides higher yields compared to T-Bills.

- Certificates of Deposit (CDs): CDs are negotiable money market instruments issued by banks
and financial institutions to raise funds for a specified period. They offer fixed interest rates and
are often used by investors looking for safe and short-term investments.
The Indian money market provides a platform for efficient allocation of short-term funds and
plays a crucial role in managing liquidity in the economy.