UNIT- I INTRODUCTION

In our present day economy, finance is defined as the provision of money at the time when it is required. Every enterprise, whether big, medium of small, needs finance to carry on its operations and to achieve its targets. In fact, finance is so indispensable today that it is rightly said to be the lifeblood of an enterprise. Without adequate finance, no enterprise can possibly accomplish its objectives. The subject of finance has been traditionally classified into two classes: (i) Public Finance; and (ii) Private Finance. Public finance deals with the requirements, receipts and disbursements of funds in the government institutions like states, local self-governments and central government. Private finance is concerned with requirements, receipts and disbursements of funds in case of an individual, a profit seeking business organisation and a non-profit organisation. Thus, private finance can be classified into: (i) Personal finance; (ii) Business finance; and (iii) Finance of non-profit organisations. Finance

Public Finance

Private Finance

Government Institutions State Governments Local Self-Governments organisation Central Government

-person finance -business finance -finance of non-profit

Personal finance deals with the analysis of principles and practices involved in managing one's own daily need of funds. The study of principles, practices, procedures, and problems concerning financial management of profit making organizations engaged in the field of industry, trade, and commerce is undertaken under the discipline of business finance. The finance of non-profit organisation is concerned with the practices, procedures and problem involved in financial management of charitable, religious, educational, social and the other similar organisations. CONCEPT OF BUSINESS FINANCE Literally speaking, the term 'business finance' connotes finance of business activities It is composed of two words (i) business, and (ii) finance Thus, it is essential to understand the meaning of the two words, business and finance, which is the starting point to develop the whole concept and meaning of the term business finance! " The word 'business' literally means a 'state of being busy'. All creative human activities relating to the production and distribution of goods and services for satisfying human wants are known as business. It also includes all those activities which indirectly help in production and exchange of goods, such as transport, insurance, banking and warehousing, etc. Broadly speaking, the term 'business' includes industry, trade and commerce. Finance may be defined as the provision of money at the time when it is required. Finance refers to the management of flows of money through an organisation. It concerns with .the application of skills in the manipulation, use and control of money. Different authorities have interpreted the term 'finance' differently. However, there are three main approaches to finance:

1. The first approach views finance as to providing of funds needed by a business on most suitable terms. This approach confines finance to the raising of funds and to the study of financial institutions and instrument from where funds can be procured. 2. The second approach relates finance to cash. 3. The third approach views finance as being concerned with raising of funds and their effective utilization. Having studied the meaning of the two terms business and finance; we can develop the meaning of the term 'business finance' as an activity or a process which is concerned with acquisition of funds, use of funds and distribution of profits by a business firm. Thus, business finance usually deals with financial planning, acquisition of funds, use and allocation of funds and financial controls. Business finance can further be sub-classified into three categories, viz; (i) sole-proprietary finance, (ii) partnership firm finance, and (iii) corporation or company finance. Business Finance

Sole-proprietary Finance

Partnership Firms Finance

Company or Corporation Finance

The above classification of business finance is based upon the three major forms of organisation for a business firm. In sole proprietorship form of organisation, a single individual promotes, finances, controls and manages the business enterprise. He also bears the whole risk of business. A partnership, on the other hand, is an association of two or more persons to carry on as co-owners a business and to share its profits and losses. It may come into existence either as a result of the expansion of sole-trade business or by an agreement between two or more persons. The liability of the partners is unlimited and they collectively share the risks of the business. A joint stock company or a corporation is an association of many persons who contribute money or money's worth to a common stock and employs it in some trade or business and who share profit and loss arising there from. In the words of Chief Justice Marshall, "a corporation is an artificial being, invisible, intangible and existing only in contemplation of the law. Being a mere creation of law, it possesses only the properties which the charter of its creation confers upon it either expressly or as incidental to its very existence". Corporation is a legal entity having limited liability, perpetual succession and a common seal. A corporation is regarded as something different from its owners The assets of the corporation are owned by it rather than its members, and a corporation's liabilities are the obligations of the corporation, not the not the owners or the members. FINANCE FUNCTION Finance function is the most important of all business functions. It remains # focus of all activities. It is not possible to substitute or eliminate this function because the business will dose down in the absence of finance. The need for money is continuous. It starts with the setting up of an enterprise and remains at all times. The development and expansion of business rather needs more commitment for funds. The funds will have to be raised from various sources. The sources will be selected in relation to the implications attached with them. The receiving of money is not enough, its utilization is more important. The money once received will have to be returned also. If its use is proper then its return will be easy otherwise it will create difficulties for repayment. The management should have an idea of using the money profitably. It may be easy to raise funds, but it may be difficult to repay them. the inflows and outflows of funds should be properly matched.

APPROACHES TO FINANCE FUNCTION A number of approaches are associated with finance function but for the sake of convenience, various roaches are divided into two broad categories: 1. The Traditional Approach 2. The Modern Approach 1. The Traditional Approach : The traditional approach to the finance function relates to the initial stages of its evolution during 1920s and 1930s when the term 'corporation finance' was used to describe what mown in the academic world today as the 'financial management'. According to this approach, the scope, of f finance function was confined to only procurement of funds needed by a business on most suitable terms. The utilization of funds was considered beyond the purview of finance function. It was felt that decisions regarding the application of funds are taken somewhere else in the organisation. However, institutions and rumen and for raising funds were considered to be apart of finance function. The scope of the finance function, evolved around the study of rapidly growing capital market institutions, instruments and practices involved in raising of external funds. The traditional approach to the scope and functions of finance has now n discarded as it suffers from many serious limitations: I. It is outsider-looking in approach that completely ignores internal decision making as to the proper utilisation of funds. II. The focus of traditional approach was on procurement of long-term funds. Thus, it ignored the important issue of working capital finance and management. III. The issue of allocation. Of funds, which is so important today is completely ignored. IV. It does not lay focus on day to day financial problems of an organisation. 2. The Modern Approach: The modern approach views finance function in broader sense. It includes both raising of funds as well as their effective utilisation under the purview of finance. The finance function does not stop only by finding out sources of raising enough funds; their proper utilisation is also to be considered. The cost of raising funds and the returns from their use should be compared. The funds raised should be able to give more returns than the costs involved in procuring them. The utilisation of funds requires decision making. Finance has to be considered as an integral part of overall management. So finance functions, according to this approach, covers financial planning, raising of funds, allocation of funds, financial control etc. The new approach is an analytical way of dealing with financial problems of a firm. The techniques of models, mathematical programming, simulations and financial engineering are used in financial management to solve complex problems of present day finance. The modem approach considers the three basic management decisions, i.e., investment decisions, financing decisions and dividend decisions within the scope of finance function. AIMS OF FINANCE FUNCTION The primary aim of finance function is to arrange as much funds for the business as are required from time to time. This function has the following aims: 1. Acquiring Sufficient Funds. The main aim of finance function is to assess the financial needs of an enterprise and then finding out suitable sources for raising them. The sources should be commensurate with the needs of the business. If funds are needed for longer periods then long-term sources like share capital, debentures, term loans may be explored. A concern with longer gestation period should rely more on owner's funds instead of interest-bearing securities because profits may not be there for some years. 2. Proper Utilisation of Funds. Though raising of funds is important but their effective utilisation is more important. The funds should be used in such a way that maximum benefit is derived from them. The returns from their use should be more than their cost. It should be ensured that funds do not remain idle at any point of time. The funds committed to various operations should be effectively utilised. Those projects should be preferred which are beneficial to the business.

3. Increasing Profitability. The planning and control of finance function aims at increasing profitability of the concern. It is true that money generates money. To increase profitability, sufficient funds will have to be invested. Finance function should be so planned that the concern neither suffers from inadequacy of funds nor wastes more funds than required. A proper control should also be exercised so that scarce resources are not frittered away on uneconomical operations. The cost of acquiring funds also influences profitability of the business. If the cost of raising funds is more, then profitability will go down. Finance function also requires matching of cost and returns from funds. 4. Maximizing Firm's Value. Finance function also aims at maximizing the value of the firm. It is generally said that a concern's value is linked with its profitability. Even though profitability influences a firm's value but it is not all. Besides profits, the type of sources used for raising funds, the cost of funds, the condition of money market, the demand for products are some other considerations which also influence a firm's value. SCOPE OR CONTENT OF FINANCE FUNCTION / FINANCIAL MANAGEMENT The main objective of financial management is to arrange sufficient finances for meeting short-term and long-term needs. These funds are procured at minimum costs so that profitability of the business is maximised. With these things in mind, a Financial Manager will have to concentrate on the following areas of finance function. 1. Estimating Financial Requirements. The first task of a financial manager is to estimate short-term and long-term financial requirements of his business. For this purpose, he will prepare a' financial plan. for present as well as for future. The amount required for purchasing fixed assets as well as needs of funds for working capital will have to be ascertained. The estimations should be based on sound financial principles so that neither there are inadequate, nor excess funds with the concern. The inadequacy of funds will adversely affect the day-to-day working of the concern whereas excess funds may tempt a management to indulge in extravagant spending or speculative activities 2. Deciding Capital Structure. The capital structure refers to the kind and proportion of different securities for raising funds. After deciding about the quantum of funds required it should be decided which type of securities should be raised. It may be wise to finance fixed assets through long-term debts. Even here if gestation period is longer, then share. Capital may be most suitable. Long-term funds should be employed to finance working capital also, if not wholly then partially. Entirely depending upon overdrafts and cash credits for meeting Working capital needs may not be suitable. A decision about various sources for funds should be linked to the cost of raising funds. If cost of raising funds is very high then such sources may not be useful for long. A decision about the kind of securities to be employed and the proportion in which these should be used is an important decision which influences the short-term1 and long-term financial planning of an enterprise. 3. Selecting a Source of Finance. After preparing a capital structure, an appropriate source of finance is selected. Various sources, from which finance may be raised, include: share capital, debentures, financial institutions, commercial banks, public deposits, etc. It finances are needed for short periods then banks, public deposits and financial institutions may be appropriate ; on the other hand, if long-term finances are required then share capital and debentures may be useful. If the concern does not want to tie down assets as securities then public deposits may be a suitable source. If management does not want to dilute ownership then debentures should be issued in preference to shares. The need, purpose, object and cost involved may be the factors influencing the selection of a suitable source of financing. 4. Selecting a Pattern of Investment. When funds have been procured then a decision about investment pattern is to be taken. The selection of an investment pattern is related to the use of funds. A decision will have to be taken as to which assets are to be purchased? The funds will have to be spent first on fixed assets and then an appropriate portion will be retained for working capital. Even in various categories of assets, a decision about the type of fixed or other assets will be essential/While selecting a plant and machinery, even different categories of them may be available. The decision-making techniques such as

Capital Budgeting, Opportunity Cost Analysis etc. may be applied in making decisions about capital expenditures. While spending on various assets, the principles of safety, profitability and liquidity should not be ignored. A balance should be struck even in these principles. One may not like to invest on a project which may be risky even though there may be more profits 5. Proper Cash Management. Cash management is also an important task of finance manager. He has to assess various cash needs at different times and then make arrangements for arranging cash. Cash may be required to (a) purchase raw materials, (b) make payments to creditors, (c) meet wage bills; (d) meet day-to-day expenses. The usual sources of cash may be: (a) cash sales, (b) collection of debts, (c) short-term arrangements with banks etc. The cash management should be such that neither there is a shortage of it and nor it is idle. Any shortage of cash will damage the creditworthiness of the enterprise. The idle cash with the business will mean that it is not properly used. It will be better if Cash Flow Statement is regularly prepared so that one is able to find out various sources and applications. If cash is spent on avoidable expenses then such spending may be curtailed. A proper idea on sources of cash inflow may also enable to assess the utility of various sources. Some sources may not be providing that much cash which we should have thought. All this information will help in efficient management of cash. 6. Implementing Financial Controls. An efficient system of financial management necessitates the use of various control devices. Financial control devices generally used are, (a) Return on investment, (7;) Budgetary Control, (c) Break-even Analysis. Cost Control, (e) Ratio Analysis (f) Cost and Internal Audit. Return on investment is the best control device to evaluate the performance of various financial policies. The higher this percentage better may be the financial performance. The use of various control techniques by the finance manager will help him in evaluating the performance in various areas and take corrective measures whenever needed. 7. Proper Use of Surpluses. The utilization of profits or surpluses is also an important factor in financial management. A judicious use of surpluses is essential for expansion and diversification plans and also in protecting the interests of shareholders. The ploughing back of profits is the best policy of further financing but it clashes with the interests of shareholders. A balance should be struck in using funds for paying dividend and retaining earnings for financing expansion plans, etc. The market value of shares will also be influenced by the declaration of dividend and expected profitability in future. A finance manager should consider the influence of various factors, such as: (a) trend of earnings of the enterprise, (b) expected earnings in future, (c) market value of shares, (d) need for funds for financing expansion, etc. A judicious policy for distributing surpluses will be essential for maintaining proper growth of the unit. OBJECTIVES OF FINANCIAL MANAGEMENT OR GOALS OF BUSINESS FINANCE Financial management is concerned with procurement and use of funds. Its main is to use business funds in such a way that the firm's value / earnings are maximised. There are various alternatives available for using business funds. Each alternative course has to be evaluated in detail. The pros and cons various decisions have to look into before making a final selection. The decisions will have to take into consideration the commercial strategy of the business. Financial management provides a framework tor selecting a proper course of action and deciding a viable commercial strategy. The main objective of a business is to maximse the owner s economic welfare. This objective can be achieved by: 1. Profit Maximization, and 2. Wealth Maximization 1. Profit Maximization. Profit earning is the main aim of every economic activity. Business being an economic institution must earn profit to cover its costs and provide funds for growth. No business can survive without earning profit. Profit is a measure of efficiency of a business enterprise. Profits also serve as a protection against risks which cannot be ensured. The accumulated profits enable a business to face risks like fall in prices, competition from other units, adverse government policies etc. Thus profit maximization is considered as the

main objective of business. The following arguments are advanced in favour of profit maximisation as the objective of business: I. When profit-earning is the aim of business then profit maximisation should be the obvious objective II. Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise, thus, profit maximisation is justified on the grounds of rationality! III. 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 survive under unfavorable situation, only if it has some past earnings to rely upon Therefore, business should try to earn more and more when situation is favorable. IV. Profits are the main sources of finance for the growth to a business, Should aim at maximisation of profits for enabling its growth and development. 1 V. Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit1 maximisation also maximizes socio-economic welfare. However, profit maximisation objective has been criticized on many grounds. A firm pursuing the, objective of profit maximisation starts exploiting workers and the consumers. Hence, it is immoral and lead to a number of corrupt practices. Further, it leads to colossal inequalities and lowers human values which are an essential part of an ideal social system. It is also argued that profit maximisation should be the objective the conditions to perfect competition and in the wake of imperfect competition today, it cannot be the legitimate objective of a firm. The concept of limited liability in the present day business has separated ownership and management. A company is financed by shareholders, creditors and financial institutions and is controlled by professional managers. Workers, customers, government and society are also concerned with it. So, one has to reconcile the conflicting interests of all these parties connected with the firm. Thus, profit maximisation as an objective of financial management has been considered inadequate. Even as an operational criterion for maximizing owner's economic welfare, profit maximisation has been rejected because of the following drawbacks: (i) The term 'profit' is vague and it cannot be precisely defined. It means different things for different people. Should we consider short-term profits or long-term profits? Does it mean total profits or earnings per share? Should we take profits before tax or after tax? Does it mean operating profit or profit available for --Cardholders? Further, it is possible that profits may increase but earnings per share decline. For example, if a company has presently 10,000 equity shares issued and earn a profit of Rs. 1, 00,000 the earnings per share Rs. 10. Now, if the company further issues 5,000 shares and makes a total profit of Rs. 1, 20,000, the total profits have increased by Rs. 20,000, but the earnings per share will decline to Rs. 8. "Even if, we take the meaning of profits as earnings per share and maximise the earnings per share, it does tot necessarily mean increase in the market value of shares and the owner's economic welfare. (ii) Profit maximisation objective ignores the time value of money and does not consider the magnitude and timing of earnings. It treats all earnings as equal though they occur in different periods, it ignores the fact that cash received today is more important than the same amount of cash received after, say, three years. The stockholders may prefer a regular return from investment even if it is smaller than the expected higher returns after a long period. (iii) It does not take into consideration the risk of the prospective earnings stream. Some projects are more risky than others. The earning streams will also be risky m the former than the latter. Two firms may 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. (iv)The effect of dividend policy on the market price of shares is also not considered in the objective of profit maximisation. In case, earnings per share is the only objective then an

enterprise may not think of raying dividend at all because retaining profits in the business or investing them in the market may satisfy this 2. Wealth Maximisation. Wealth maximisation is the appropriate objective of an enterprise. Financial theory asserts that wealth maximisation is the single substitute for a stockholder's utility. When the firm maximises the stockholders wealth the individual stockholder can use this wealth to maximize his individual utility. It means that by maximizing stockholder's wealth the firm is operating consistently towards maximising stockholder's utility. A stockholder's current wealth in the firm is the product of the number of shares owned, multiplied with the current stock price per share. Stockholders current wealth in a firm = (Number of share owned) (Current stock price per share) Symbolically, W = NP Given the number of shares that the stockholder owns, the higher the stock price per share the greater will be the stockholder's wealth. Thus, a firm should aim at maximising its current stock price. This objective helps in increasing the value of shares in the market. The shares market price serves as a performance index or report card of its progress. It also indicates how well management is doing on behalf of the shareholder. We can conclude that: Refers to refers to Maximum Utility > Maximum stockholder's wealth--> Maximum current stock price per share However, the maximisation of the market price of the shares should be in the long run! The long run implies a period which is long enough to reflect the normal market value of the shares irrespective of short-term fluctuations. While pursuing the objective of wealth maximisation, all efforts must be put in for maximising the current present value of any particular course of action. Every financial decision should be based on cost-benefit analysis. If the benefit is more than the cost, the decision will help in maximizing the wealth. On the other hand, if cost is more than the benefit the decision will not be serving the purpose of maximising wealth. Implications of Wealth Maximisation. There is a rationale in applying wealth maximising policy as an operating financial management policy. It serves the interests of suppliers of loaned capital, employees, management and society. Besides shareholders, there are shortterm and long-term suppliers of funds who have financial interests in the concern. Shortterm lenders are primarily interested in liquidity position so that they get their payments in time. The long-term lenders get a fixed rate of interest from the earnings and also have a priority over shareholders in return of their funds. Wealth maximisation objective not only serves shareholder's interests by increasing the value of holdings but ensures security to lenders also. The employees may also try to acquire share of company's wealth through bargaining etc. Their productivity and efficiency is the primary consideration in raising company's wealth. The survival of management for a longer period will be served if the interests of various groups are served properly. Management is the elected body of shareholders. The shareholders may not like to change a management if it is able to increase the value of their holdings. The efficient allocation of productive resources will be essential for raising the wealth of the company. The economic interest of society is served if various resources are put to economical and efficient use. Criticism of Wealth Maximisation. The wealth maximisation objective has been criticised by certain financial theorists mainly on following accounts: I. It is a prescriptive idea. The objective is not descriptive of what the firms actually do. II. The objective of wealth maximisation is not necessarily socially desirable.

There is some controversy as to whether the, objective is to maximise the stockholders wealth or the wealth of the firm which includes other financial claimholder such as debenture holder preferred stockholders, etc. IV. The objective of wealth maximisation may also face difficulties when and management are separated as is the case in most of the large corporate of organisations. When managers act as agents of the real owners (equity shareholders), there is a possibility for a conflict of interest between shareholders and the managerial interests. The manager may act in such manner which maximises the managerial utility but not the wealth of stockholders or the firm. In spite of all the criticism, we are of the opinion that wealth maximisation is the most appropriate objective of a firm and the side costs in the form of conflicts between the stockholders and debentureholders, firm and society and stockholder and manager can be minimized. Financial Management and Profit Maximisation The primary aim of a business is to maximise shareholders' wealth. This can be done by increasing the quantum of profits. Financial management helps in devising ways and exercising appropriate cost controls which utilimately help in increasing profitability. The following elements are involved in maximizing profits. (i) Increase in Revenues. For maximising its profits, a firm will have to increase revenue receipts. Revenues will go up only when sales increase. There should be all out efforts to increase the sales. All possible markets should be exploited so that demands for products increases. This should be followed by increasing production for meeting increased demand. In a competitive economy, profits can be increased either by raising the price of products or by increasing the volume of sales. The second alternative will be more appropriate. (ii) Controlling Costs. Another way of increasing profit is to control or reduce costs. This will increase the margin of profit per unit. The costs may be controlled by controlling material wastages, increasing labour efficiency, reducing overhead cost by increasing production etc. (iii) Minimising Risks. A business operates under a number of uncertainties. Business is done with an eye on future which itself is uncertain and difficult to predict. There are many risks, both business and financial. It is general said more the risk and more the gain. In spite of this, those financial decisions should be taken which will not involve more risks but at the same time may help in increasing profitability. A financial manager will have to balance the pros and cons of various decisions so that risk element is kept under control. FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT Financial management, at present, is not confined to raising and allocating funds. The study of financial institutions like stock exchange, capital market etc. is also emphasized because they influence underwriting of securities and corporate promotion. Company finance was considered to be the major domain of financial management. The scope of this subject has widened to cover capital structure, dividend policies, profit planning and control, depreciation policies, etc. The techniques of financial analysis like financial statements analysis, funds statements, ratio analysis etc. are also helpful in analyzing financial strength of the enterprise. Some of the functional areas covered in financial management are discussed as such: 1. Determining Financial Needs. A finance manager is supposed to meet financial needs of the enterprise. For this purpose, he should determine financial needs of the concern. Funds are needed to meet promotional expenses, fixed and working capital needs. The requirement of fixed assets is related to the type of industry. A manufacturing concern will require more investments in fixed assets than a trading concern. The working capital needs depend upon the scale of operations, larger the scale of operations, the higher will be the needs for working capital. A wrong assessment of financial needs may jeopardize the survival of a concern.

III.

2. Selecting the Sources of Funds. A number of sources may be available for raising funds. A concern may resort to issue of share capital and debentures. Financial institutions may be requested to provide long-term funds. The working capital needs may be met by getting cash credit or overdraft facilities from commercial banks. A finance manager has to be very careful and cautious in approaching different sources. The terms and conditions of banks may not be favourable to the concern. A small concern may find difficulties in raising funds for want of adequate securities or due to its reputation. The selection of a suitable source of funds will influence the profitability of the concern. This selection should be made with great caution. 3. Financial Analysis and Interpretation. The analysis and interpretation of financial statements is an important task of a finance manager. He is expected to know about the profitability, liquidity position, short-term and long-term financial position of the concern. For this purpose, a number of ratios have to be calculated. The interpretation of various ratios is also essential to reach certain conclusions. Financial analysis and interpretation has become an important area of financial management. 4. Cost-Volume-Profit Analysis. Cost-volume-profit analysis is an important tool of profit planning. It answers questions like, what is the behaviour of cost and volume. At what point of production a firm will be able to recover its costs? How much a firm should produce to earn a desired profit? To understand cost-volume profit relationship, one should know the behaviour of costs. The costs may be subdivided as: fixed costs, variable costs and semivariable costs. Fixed costs remain constant irrespective of changes in production. An increase or decrease in volume of production will not influence fixed costs. Variable costs, on the other hand, vary in direct proportion to change in production. Semi-variable costs remain constant for a period and then become variable for a short period. These costs change with the change in output but not in the same proportion. The first concern of a finance manager will be to recover all costs. He will aspire to achieve break-even point at the earliest. It is a point of no-profit no-loss. Any production beyond break-even point will bring profits to the concern. The volume of sales, to earn a desired profit can also be ascertained. This analysis is very helpful in deciding the volume of output or sales. The knowledge of cost-volume profit analysis is essential for taking important decisions about production and profits. 5. Capital Budgeting. Capital budgeting is the process of making investment decisions in capital expenditures. It is an expenditure the benefits of which are expected to be received over a period of time exceeding one year. It is an expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of years in future. Capital budgeting decisions are vital to any organisation. An unsound investment decision may prove to be fatal for the very existence of the concern. The crux of capital budgeting is the allocation of available resources to various proposals. The crucial factor which influences the capital budgeting decision is the profitability of the, prospective investment. , For making correct capital budgeting decisions, the knowledge of its techniques is essential. A number of methods like pay back period method, rate of return method, net present value method, internal rate of return method and profitability index method may be used for making capital budgeting decisions. 6. Working Capital Management. Working capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, working capital is essential to maintain the smooth running of business. No business can run successfully without an adequate amount of working capital. Working capital refers to that part of the firm's capital which is required for financing short-term or current assets such as cash, receivables and inventories It is essential to maintain a proper level of these assets. Finance manager is required to determine the quantum of such assets. Cash is required to meet day-to-day needs and purchase inventories etc. The scarcity of cash may adversely affect the reputation of a concern. The receivables management is related to the volume of production and sales. For increasing sales, there may be a need to give more credit facilities/rough sales may go up but the risk of bad debts and cost involved in it may have to

be weighted against the benefits. Inventory control is also an important factor in working capital management. The inadequacy of inventory may cause delays or stoppages of work. Excess inventory, on the other hand, may result in blocking of money in stocks, more costs in stock maintaining etc. Proper management of working capital is an important area of financial management. 7. Profit Planning and Control. Profit planning and control is an important responsibility of the financial manager. Profit maximisation is, generally, considered to be an important objective of a business-Profit is also used as a tool for evaluating the performance of management. Profit is determined by the volume of revenue and expenditure. Revenue may accrue from sales, investments in outside securities or income from other sources. The expenditures may include manufacturing costs, trading expenses, office and administrative expenses, selling and distribution expenses and financial costs. The excess of revenue over expenditure determines the amount of profit. Profit planning and control directly influence the declaration of dividend, creation of surpluses, taxation etc. Break-even analysis and cost-volume-profit relationship are some of the tools used in profit planning and control. 8. Dividend Policy. Dividend is the reward of the shareholders for investments made by them in the shares of the company. The investors are interested in earning the maximum return on their investments whereas management wants to retain profits for further financing. These contradictory aims will have to be reconciled in the interests of shareholders and the company. The company should distribute a reasonable amount as dividends to its members and retain the rest for its growth and survival. A dividend policy is influenced by a number of factors such as magnitude and trend of earnings, desire and type of shareholders, future requirements of the company, government's economic policy, taxation policy, etc. Dividend policy is an important area of financial management because the interests of the shareholders and the needs of the company are directly related to it. ORGANISATION OF THE FINANCE FUNCTION The finance function is very vital for every type of business enterprise. There is a need to set up a sound and efficient organisation to achieve its goals. However, organisation of finance function is not standardized one. It varies from enterprise to enterprise, depending upon its nature, size and other requirements. In a small concern, whose operations are simple and there is little delegation of authority no separate executive is appointed to handle finance function. It is the owner who performs all these functions himself. But in medium and large scale concerns, a separate department to organize all financial activities may be created at top level under the direct supervision of Board of Directors or a highly placed official. This function may be headed by a committee or a top management executive. All important financial decisions are taken by the committee or the executive but routine decisions are left to the lower levels of management. The finance function is centralized because of its importance. The financial decisions are crucial for the survival of the concern. Any bad decision on financial aspects will adversely affect the reputation of the concern. The centralisation of finance function will result in certain economies in raising funds, purchasing of fixed assets, etc. In large concerns, for organizing finance functions, the Controller and Treasurer are appointed. Financial controller performs the functions of planning and controlling, preparation of annual reports, capital budgeting, profit analysis, cost and inventory management, and accounting and payroll. The main functions of the treasurer include raising of additional funds, cash management, receivables management, audit of accounts, protecting funds and securities and maintaining relations with banks and other financial institutions, etc. The organisation of finance function may be diagrammatically shown as below: Board of Directors

Managing Director

Finance Committee

Vice President Production

Vice President Finance

Vice President Sales

Financial Controller

Treasurer

Planning Profit Analysis and control

Annual Report

Budgetin g

Accounting and Payroll

Additional Funds

Cash manageme nt

Receivables manageme nt

Audit

Relations with Banks & Financial Institutions

TIME VALUE OF MONEY We have observed in the previous chapter that profit maximisation objective ignores the time value of money and does not consider the magnitude and timing of earnings. It treats all earnings as equal though they occur in different periods. Thus, maximisation of shareholder's wealth is considered to be an appropriate objective of a firm. Given the objective of wealth maximisation, the firm should, while making financial, decisions, consider those things which are important to investors. Financial theory asserts that as the shareholders make a current sacrifice by investing their funds into the firm, they expect to get some future benefit, either as dividend or increased share price when the shares are sold or both. However, the expected benefit is a future one while the sacrifice is a current one. Hence, the investors expect a rate of return on their investment that compensates them the duration of the sacrifice deferral. This leads us to the study of the ratio of return of waiting or the time value of money. Most of the financial decisions, such as acquisition of assets or procurement of funds affect firm's cash flows in different time periods. If a firm acquires an asset today, it will require an immediate cash outlay, but the benefit of this asset will be received in future. Thus, it will have an affect on future cash flows over the life of the asset. Similarly, if funds are raised through borrowings for present needs, these will have to be returned in future as principal and interest. A firm may also raise additional funds through issue of share capital, but it will have to pay dividend on the share capital in future. While taking such financial decision, the firm will have to compare the total of cash inflows with the total cash outflows. The logical way is to recognize the time value of money and make appropriate adjustments for time otherwise it may take faulty decisions. The owner's utility will be maximised when net present worth is created from the financial decisions. CONCEPT OF TIME VALUE OF MONEY The simple concept to time value of money is that the value of the money received today is more than the value of same amount of money received after a certain period. In other

words, money received in the future is not as valuable as money received today. The sooner one receives money, the better it is. Taking the case of a rational human being, given the option to receive a fixed amount of money at either of the two time periods, he will prefer to receive it at the earliest. If you are given the choice of receiving Rs. 1000 today or after one year, you will definitely opt to receive today than after one year. This is because you value the current receipt of money higher than future receipt of money after one year. The phenomenon is referred to as time preference for money. Reasons for Time Preference of Money (i) The future is always uncertain and involves risk. An individual can never be certain if getting cash inflows in future and hence he will like to receive money today instead of waiting for the future. (ii) People generally prefer to use their money for satisfying their present needs in buying more food, or clothes or another car, than deferring them for future. The present needs are considered urgent as compared to future needs. Moreover, there may also be a fear in one's mind that he may not be able to use the money in future for fear of illness or death. (iii) Money has time value because of the opportunities available to invest money received at earlier dates at some interest or otherwise to enhance future earnings. For example, if you have Rs. 100 today, you can put it in your bank account and earn interest. After one year the interest would be Rs. 8 (taking rate of interest at 8% p.a.) and you would have Rs. 108 at the end of the year. So, if you have a choice between Rs. 100 today or after one year, it is the same as a choice between Rs. 108 next year and Rs. 100 next year." Any rational person would prefer the larger amount. TECHNIQUES OF TIME VALUE OF MONEY There are two techniques for adjusting the time value of money: (i) Compounding Technique (ii) Discounting or Present Value Technique. (i) COMPOUNDING TECHNIQUE The time preference for money encourages a person to receive the money at present instead of waiting for future. But he may like to wait if he is duly compensated for the waiting time by way of ensuring more money in future. For example, a person being offered Rs. 100 today may wait for a year if he is ensured of Rs. 110 at the end of one year (taking his preference for an interest of 10% p.a.) The cash flow of Rs. 100 at present or Rs. 110 after one year will be the same for this person. The future value at the end of period I can be calculated by a simple formula given below: V1=VO (1+ i) where, V1 = Future value at the period 1 Vo = Value of money at time 0, i.e. original sum of money i = Interest rate. Taking the example given above, V1 =100(1+ 10) = Rs. 110. In the example given above, we have only considered the future value after one period .But we may need to calculate future values over longer periods. For example, what will be the value of Rs. 100 after two years at 10 % p.a. rate of interest if neither the principal sum of Rs. 100 nor interest is withdrawn at the end of one year? The answer to this question lies in understanding that the second year's interest will be paid on both original principal and the interest earned at the end of first year. This paying of interest is called compounding. The value of money after 2 years can be calculated as: V2 = V1<l + i) = 110(1+10) = Rs. 121.

Similarly, the value of Rs. 100 after 3 years shall be: V3 = V2 (1 + i) = 121(1+ .10) = Rs. 133.10 and in the same manner we could calculate the time value of money after any number of years. We can generalize that the future value of a current sum of money at period n is : Vn =Vo(l + i)n So, after 10 years the value of Rs. 100 at 10% rate of interest shall be: V10=100(l + .10)10 = 100 (1.10)10 = Rs. 259.4 Compound Factors Tables We have noted above that as n becomes large, the calculation of (1 + i)" becomes difficult. Such calculations can be made with the help of Compound Factor Tables given at the end of this book. For clear understanding, a portion of the table is reproduced below: Compound Factor Table Period (n) Percent (i) 2 1............ 2............ 3............. 4............ 5............ 6............. 7............ 8............ 9............ 10............ 1.020 1.040 1.061 1.082 1.104 1.126 1.149 1.172 1.195 1.219 4 1.040 1.082 1.125 1.170 1.217 1.265 1.316 1.369 1.423 1.480 6 1.060 1.124 1.191 1.262 1.338 1.419 1.504 1.594 1.689 1.791 8 1.080 1.166 1.260 1.360 1,469 1.587 1.714 1.851 1.999 2.159 10 1.100 1.210 1.331 1.464 1.611 1.772 1.949 2.144 2.358 2.594

For a more complete set of compound factors see Table A at the end of the book. Using the compound Factor Tables, the future value of money can be calculated as below: V =Vo(CFi) (where CF; n is compound factor at (i) percent and n periods.) or V10=V0 (2.594) = Rs. 259.4 Doubling Period Compound Factor Tables can be easily used to calculate the doubling period, i.e. the length of period which an amount is going to take to double at a certain given rate of interest. For example, we find from Table that it takes about 7 years to double the amount at 10 per cent and about 6 years at 12 per cent rate of interest. Doubling period can also be calculated by adopting the following Rules of Thumb: 1. Rule of 72 Doubling Period = Interest 2. Rule of 69 Doubling Period = 0.35 + Interest 72 Rate of

69 Rate of

Multiple Compounding Periods So far we have considered only the compounding of interest annually. But in many cases, interest may have to be compounded more than once a year. For example, banks may allow interest on quarterly basis; or a company may allow compounding of interest twice a year on 30th June and 31 st December every year. The future value of money in such cases can be calculated as below: where, Vn = Future Value of money after n years Vo = Value of money at time O, i.e. original sum of money, i = Interest rate m = Number of times (Frequency) of compounding per year. Effective Rate of Interest In Case of Multi-Period Compounding We have noticed above that amount grows faster in case of multi-period compounding, i.e. when frequency of interest compounding is more than once a year. It is so because the actual rate of interest realised, called effective rate in case of multi-period compounding is more than the aparent annual rate of interest called nominal rate. To illustrate, we can take a simple example of the future value of Rs. 100 at the end of one year at 10% rate of interest calculated (i) annually and (ii) on half yearly basis. In case of yearly compounding, Rs. 100 shall grow to Rs. 110 at the end of the year. But if compounding is made half-yearly, it will grow as below: At the end of first six months to Rs. 105, i.e. 100+ 5% of Rs. 100. At the end next six months to Rs. 110.25, i.e. 105+ 5% of Rs. 105. Hence the total interest realised in case of half yearly compounding is Rs. 5 + 5.25, i.e. Rs. 10.25 or we can say that effective rate of interest is 10.25% while the nominal rate is 10%. Effective rate of interest in case of multi-period compounding can also be calculated with the use of following formula: Where; EIR = Effective rate of interest i = Nominal rate of interest m = Frequency of compounding per year Future Value of a Series of Payments So far we have considered only the future value of a single payment made at time zero. But in many instances, we may be interested to know the future value of a series of payments made at different time periods. This can be calculated as below: Vn = R1 (1 + i)n-1 + R2 (1 + i)n-2.... (Rn-1) (1 +i) + Rn where, Vn = Future value at period n R1 = Payment after period 1 R2 = Payment made after period 2 Rn = Payment made after period n i = Rate of interest.

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, for example, are 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 an annuity due. Since the payments are equal in an annuity R1 = R2= R3......Rn = R. The future value of an annuity can be calculated as below: Vn = (R) (1 + i) n-1 + (R) (1 + i)-2 +......(R) (1 + i) 1 + R = (R) [(1 + i)-1 + (1 + i)-2 +...... (1 + i)'+ 1] Annuity Compound Factor Tables Compound value of an annuity can also be calculated with the help of Annuity Compound Factor Tables given at the end of the book. A portion of the Annuity Compound Factor Tables is given below for ready use: Annuity Compound Factor Table Period (n) 2 1.000 2.020 3.060 4.122 5.204 6.308 7.434 8.583 9.755 10.950 4 1.000 2.040 3.122 4.246 5.416 6.633 7.898 9.214 10.583 12.006 Percent (i) 6 1.000 2.060 3.184 4.375 5.637 6.975 8.394 9.897 11.491 13.181 8 1.000 2.080 3.246 4.506 5.867 7.336 8.923 10.637 12.488 14.487 10 1.000 2.100 3.310 4.641 6.105 7.716 9.487 11.436 13.579 15.937

1............ 2............ 3............ 4............ 5............ 6............ 7............ 8............ 9............ 10............

For a more complete set of annuity compound factors see Table B at the end of the book. Making use of the annuity compound factor tables, we can calculate the future value of an annuity as: Vn (R) (ACFi-n) Compound Value of an Annuity Due When the cash flows occur at the beginning of each period the annuity is called an annuity due. The future value of an annuity due can be calculated as below: V = (R) (l+i)n + (R) (1+i)-1 +..................(R) (1+i)1 = R [ (1+i) n - 1 / i ] (1+i) Making use of the annuity compound factor tables, we can calculate the future value of an annuity due as: Vn =(R) (ACFi,n) (1+i) DISCOUNTING OR PRESENT VALUE TECHNIQUE Present value is the 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. In compound or future value approach the money invested today appreciates because the compound interest is added to the principal. The present value of money to be received on future date will be less because we have lost the opportunity of investing it at some interest. Thus, the present value of money to be received in future will always be less. It is for this reason that the present value technique is called discounting.

Suppose, for example, you have an opportunity to buy a debenture today and you will get back Rs. 1,000 after one year. What will you be willing to pay for the debenture today if your time preference for money is 10 percent per annum? We can calculate the present value of Rs. 1,000 to be received after one year at 10% time preference rate as below: Vn = Vo(l+i) (where Vn = Future value n period and Vo = Present value or, Vo = Vn / (1 + i) = 1000 / 1.10 =Rs. 909 The concept of present value can be represented on time scale as shown below: Present value Time Scale (i = 10 percent per annum) 0 1 year Rs. 909 Rs.1, 000 Present Value or Discount Factor Tables We have observed in compounding technique that as n becomes large, the calculation of (1 + i)"becomes difficult. To calculate the present values in such cases we can make use of Present value or Discount Factor Tables given at the end of this book. A portion of the table is reproduced below for ready use: Discount Factor Table Present Value Tables Period (n) Percent (i) 2 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 4 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 6 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592 0.558 8 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 10 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

1............ 2............ 3............ 4............ 5............ 6............ 7............ 8 9............ 10............

For more a more complete set of discount factors see Table C at end of the book. The discount factor for (i) percent interest and n periods is DF i,n which is equal to 1 / (1 + i)n DF i, n= 1/(1+)n Present value (V) = Future Value (Vn ) x DF. Present Value of a Series of Payments So far, we have considered only present value of a single payment to be received or paid after a certain period. But in many instances we may have to calculate present value of several sums of money, each occurring m. different point of time. If series of payments is represented by R1,. R2, R3,. etc., the present value of such a series of payment will be: Present Value of an Annuity An annuity is a series of equal payments lasting for some specified period. If the amount of payment is R, the present value of an annuity can be calculated as: n V0 =R [ 1/ (1+i) t] 1=i Using the Annuity Discount Factor Tables, The present value of annuity can be calculated by multiplying the annuity payment with the annuity discount factor. Vo=(R) (ADF i,n)

Present Value of an Annuity Due The Present value of an annuity due, i.e. if the cash flows occur at the beginning of each year can be calculated by using the Present Value Tables as below: Vo = (R)(ADF i,n)(1 +i) Present Value of an Infinite Life Annuity The present value of an infinite (a) life annuity can be calculated as: Vo= (R) (ADF i,a) or, Vo = R/i This is because as the length of time of the annuity increases, the discount factors increase, but when the length of time gets very long, this increase in the annuity factor slows down. And as it becomes infinitely long the annuity discount factor reaches the upper limit, i.e. Present Value of an Annuity Growing at a Constant Rate When cash flows grow at a compound rate, we will have to calculate the series of cash flows first and then the present value of the series of payments as demonstrated in the following illustration.