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Aims of Finance Function
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The primary aim of Finance function is to
arrange as much as funds for the business as
are required from time to time. This function
has the following aims.
Acquiring sufficient funds
Proper Utilization of Funds
Increasing Profitability
Maximizing firms value
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Profit Maximization :
Profit maximization is a term which denotes the
maximum profit to be earned by an organization in agiven time period. The profit maximization goal
implies that the investment, financing and dividend
policy decision of the enterprise should be oriented
to profit maximization. The term profit can be used in two senses first
as the owner oriented concept, second as the
operational concept. Profit as the owner concept
refers to the amount of net profit which goes intoform of dividend to the share holders. Profit as the
operational concept means profitability. Which is an
indicator of economic efficiency of the enterprise.
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Profitability maximization implies that
the enterprise should select assets.
Project and decisions, that are profitable
and reject the non profitable ones. It is
in this sense the term profit
maximization is used in financial
management.
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Merits of Profit Maximization :
Best criterion on Decision Making: The goal
of profit maximization is regarded as the bestcriterion of decision making as it provides asign to judge the economic performance of theenterprise.
Barometer : Profitability is a barometer formeasuring efficiency of a economic prosperityof a business enterprise.
Efficient allocation of resources: It leads to
efficient allocation of scarce resources as tendto be diverted to those uses which in terms ofprofitability are the most desirable.
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Optimum Utilization : Optimum utilization of
available resources is possible if the business
enterprise objective is profit maximization .
Maximum Social Welfare : It ensures maximumsocial welfare in the form of maximum dividend to
share holders, timely payment to creditors, higher
wages, better quality & lower prices, more
employment opportunities to the society &maximization of capital to the owners.
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However, the profit maximization objective suffers from several drawbacks
which are as follows :
Time factor ignored:The term profit does
not speak anything about the period of profit
whether it is short term or long term profit.
It is Vague :The term profit is very vague.It is not clear in what exact sense the term
profit is used. Whether it is profit after tax or
profit before tax.
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The term maximum is also ambiguous:The term maximum is also not clear. The
concept of profit is also not clear. It istherefore, not possible to maximize whatcannot be known.
It ignores Time Value : The profit
maximization objective fails to provide anyidea regarding the timing of expected cashearnings. The choice of a more worthyproject lies in the study of time value of
future inflows of cash earnings. It ignoresthe fact that the rupee earned today is morevaluable than, the rupee earned later.
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Wealth Maximisation :
Wealth Maximisation appropriate objective of an enterprisewhen the firm maximizes the stock holders wealth, the
individual stock holders can use this wealth to maximize
his individual utility. It means that by maximizing share
holders wealth the firm is operating consistently towards
maximizing share holders utility. Every financial decision
should be based on the 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
design will not be sensing the purpose of maximizing
wealth .
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It serves the interests of suppliers of loaned
capital, employee, management & society
besides shareholders there are short term &long term suppliers of funds who have
financial interests in the concern. Short term
lenders are primarily interested in liquidityposition. 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.
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Criticism of Wealth Maximisation :The wealth maximisation objectives has been
criticized by certain financial theoriests mainly onfollowing accounts :
1. It is a perspective idea.
2. The objective is not descriptive at what the firms
actually do.
3. The objective of wealth maximization is not
necessarily socially desirable.
4. There is some contraversy as to whether theobjective is to maximise share holders wealth or
wealth of the firm which includes other financial
claim holders such as debenture holders. Preferred
stock holders etc.
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EPS Maximisation (Earnings per Share) :
Besides the profit maximization and wealth maximization to
objectives firms also try to ensure a fair return to share holders.
The EPS is one of the important measures of economic
performance of a corporate entity. The flow of capital to the
company under the present imperfect capital market conditions
would be made on the evaluation of EPS.
A higher EPS means better capital productivity. EPS is one of the
most important ratios which measure the net profit earned per
share. EPS is one of the major factors effecting the dividend policy
of the firm and the market prices of a company. A steady growth in
EPS year after year indicates a good track of Profitability. EPS iscomputed by dividing the net profit and dividend to Preference
share holders. This avoids confusion and indicates the Profit
available to the ordinary share holders on a per share basis.
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Net Profit after tax & preference dividend
EPS = --------------------------------------- No. of Equity shares.
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An overview of Managerial Finance Functions :
Financial management is emerged as a
district field of study only in the early part ofthe century. As a result of consolidation
movement & formation of large enterprise. Its
evaluation may be divided into 3 phrases.They are :
1. The Traditional phase
2. The Transitional phase
3. The Modern phase.
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1. The Traditional Phase :
This phase has lasted for about 4 decades. Its first
expression was shown in the work of Arthur S.Dewing in his book titled thefinancial policy of the
corporation in 1920s. In this phase the focus of
financial management was on the following
aspects. 1. It treats the entire subject of finance from the
outsiders point of view rather than the financial
decision makes in the firm.
2. The sequence of treatment was on certain
episodic events like formation, issuing of capital,
major expansion, merger, reorganisation &
liquidation during the life cycle of an enterprise.
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3. It laid heavy emphasis long term
financing institutions, proceduresused in capital markets. It lacks
emphasis on the problems of working
capital management.
Traditional phase was only
outsiders looking approach over
emphasis on episodic events & lack
of importance to day-to-day problems.
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2. The Transitional Phase : It begin in the early 1940s and
continued through the early 1950s.The nature of financial management
in this phase is almost similar to the
earlier phase, but more important is
given to the day to day problems
faced by the finance managers.
Capital budgeting techniques were
developed in this phase.
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3. Modern Phase : It begin in the mid 1950sand has shown development
with combination of ideas from economic statistic has
led the financial management is to be more analytical
and quantitative. The main issue of the phase is
rational matching of funds to their user which leads to
the maximization of share holders wealth. Thefollowing are the area of advancements in this phase.
The study says that cost of capital and capital structure
are independent in nature. Dividend policy suggest that
there is the effect of dividend policy on the value of
the firm. This phase has also seen one of the first
applications of linear programming.
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Portfolio analysis gives the idea for the allocation of a
fixed sum of money among the available investment
securities. Capital asset Pricing Model (CAPM) suggeststhat some of the risks in investments can be neutralized
by holding a diversified portfolio of securities.
Financial engineering that involves the design,
development and implementation of innovative financial
instrument and formulation of creative optional solutions
to problems in finance. Even though the above mentioned
developed areas of finance is remarkable, butunderstanding the international dimension of corporate
finance formed a very small part of it. Which is not
sufficient in this era of globalization.
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The Importance of Financial Management /
Financial Decision :
Financial management indeed, the key tosuccessful business operation without proper
administration effective utilisation of finance. No
business enterprise can utilise its potential for
growth expansion.
The discussion on financial management can be
divided into 3 major decisions: Investment Decision
Financing Decision
Dividend Decision
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1)Investment Decision : It is most important than other two decisions.
It begins with determination of the total
amount of assets need to be held by firm. Inother words it relay to the selection of assets
that a firm will invest funds. The required
assets follow two groups.
Long term assets :P&M, Land & Buildings
..etc.- Capital Budgeting Short term assets : raw material, work-in-
progress, closing stockWorking capital.
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2)Financing Decision :
Once the firm has taken the investment
decision and committed itself to newinvestment, it must decide the best means of
financing these commitments. Since firms
regularly make new investments, the needs for
financing and financial decisions are ongoing.
Hence a firm will be continuously planning for
new financial needs. The financing decisions is
not only concerned with how best to financenew assets, but also concerned with the best
overall mix of financing for the firm.
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3)Dividend Decision :
This is the third financial decision which relates to dividend
policy. Dividend is a part of profits that are available fordistribution, to equity share holders for payment of dividend
should be analyzed in relation to the financial decision of a
firm. There are two options available in dealing with the net
profits of a firm i.e., distribution of profits as dividend to theordinary shareholders, where there is no need of retention of
earnings or they can be retained in the firm, it self it they
required for financing business activity. But distribution of
dividends or retaining should be determined interms of its
impact on the shareholders wealth. The financial manager
should determine optimum dividend policy which maximises
market value of the firm.
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Financial Management Process:
Information
Financial
Control
Financial
Analysis
Financial
Planning
Financial
Decision Making
Information
Information
Information
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Financial Management Process:
Financia l Analysis: This is the Preliminary
diagnostic stage and will include: A financial
analysis and review to determine the current
financial performance & conditions of the
business; & an identification of any particularfinancial problem, risk, limitation and an
assessment of financial strength, weakness, and
opportunities and threats (A financial SWOT
Analysis)
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Financial Decision Making: Based on the
finding of the review stage financial decisions
and choices are made. These are likely to
include strategic investment decisions such asinvesting in new production facilities or the
acquisition of another company and strategic
financial decision. For Example : The decision
to rise additional long term loans.
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Financial Planning: The essence of
financial planning is to ensure that the
right amount of funds is available at the
right time and at the right cost for the levelof risk involved to enable the firms
objectives to be achieved.
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Financial Contro l: The final stage of the
process involves the entire organization.
This is to ensure that plans are properly
implemented that progress is continuouslyreported to the management, and any
deviations from the plans are clearly
identified.
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Time Value of Money : Profit Maximization objective ignores the time
value of money & doesnt considered themagnitude and timing of money. It treats all
earnings as equal through they occur in different
periods. Thus, the wealth maximization of share
holders wealth is considered to be an
appropriate objective of a firm. Financial assets
that have share holders make a current sacrifice
by investing their funds into the firm. Theyexpect to get some future, either as dividend or
increases share price when the shares are sold.
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Most of the financial decisions, such as
acquisition assets or procurement of funds affect
firms cash flows in different time periods. If afirm acquires as assets today it will required at
immediate cash outlay, but the benefit of this
asset will be received in future. Similarly if fundsare raised through borrowings for present needs,
these will have to be returned in future as
principle & interest.
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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 andmake appropriate adjustment for time
otherwise it may take faulty decisions.
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Concept of Time Value of Money:
The simple concept of time value of money is that the value of
money received today is more than the value of same amount ofmoney received after a certain period.
In other words money received in future is not as valuable
money the better it is. Taking the case of a rational human
being, given the option to receive a fixed amount of money ateither off the two time periods, he will prefer to receive it at the
earliest.
If you are given the choice of receiving Rs 100/- today or after
1 year. You will definitely opt to receive today than after 1year.
This is because value the current receipt of money is higher
than future receipt of money after one year. The phenomenon is
referred to as time preference for money.
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Reasons for Time Preference of Money:
The future is always uncertain and involves
risk. An individual can never be certain ofgetting cash inflows in future and hence he
will like to receive money instead of waiting
for the future. People generally prefer to use their money
for satisfying their present needs in buying
more food, clothes or another. Moreover their
may also be a fear is once mind that he may
not able to use the money in future for fear of
illness or death.
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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.
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Factors contributing to the Time Value of
Money :
Individuals generally prefer current
consumption than future consumption
A investors can profitably employ a rupee
received today, to give him a higher value tobe received tomorrow or after a certain period
of time.
In an inflationary economy the moneyreceived today has more purchasing power
than money to be received in future.
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A bird in Hand is worth than two in the
bush; this statement implies that people
consider a rupee today worth more than a
rupee in the future. This is because ofuncertainty connected with the future.
Time value of money or Time preference of
money is one of the central ideas in Finance.It becomes most important and is vital
consideration in decision making.
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Techniques of Time Value of Money:
There are two techniques for adjusting the time
value of money :
1. Compounding technique
2. Discounting or Present Value concept
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1. Compounding Technique:
The time preference for money encourages
the person to receive money of present
instead of waiting for future. But he may like
to wait if he is duly compensated for thewaiting by way of ensuring more money in
future.
In this concept the interest earned the initialprincipal amount becomes a past of the
principal of the end of the compounding
period.
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V1= V0(1+i)
Where as V1= Future value of the period first
year
Vo= Value of money at time Zero or Original
sum of Money
I = Interest Rate
F l b i ff d R 100 t d
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For example a person being offered Rs. 100 today may
wait for a year if he is ensured of Rupees Rs. 100 at the
end of One year (taking the preference interest 10% per
annum) In the example given above we have only considered the
future value after one period. But we may need to
calculate future value over longer periods. For example
what will be value of Rs. 100 after two years at 10% P.A.Rate of interest if neither the principle sum of Rs. 100 nor
interest is withdrawn at the end of 1 year. The answer to
this question lies in understanding the second year interest
will be paid on both original principal and interest earnedat the end of first year. This paying of interest is called
compounding technique. The value of money after two
years can be calculated as :
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V1= 100 (1+i)
V2= V1(1+i) = 100 (1+0.10) = 110
Vn= Vo(1+i)n
Calculate the compounding interest for 10
years for the value of 100 @ 10% interest.
V10= 100 (1+0.10)10
= 100 (1.10)10
= 100 (1.10)10 = 259.4
D bli P i d
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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 of a certain given rate of interest.Doubling period can also be calculated by adopting the
following rules of Thumb
Rule of 72:
72
DP = -----------------------
Rate of Interest
Rule of 69 :
69
DP = 0.35 + ---------------------
Rate of Interest
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Example : If you deposit Rs. 5000 @ 6% Rate of Interest,
in how many years will this amount double work out this
problem by using the rule of 72 & rule of 69.
72
Rule of 72 = ---------------- = 12 years.
(6 / 100 )
69
Rule of 69 = 0.35 + --------
6
= 0.35 +11.50
= 11.85 years.
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Multiple Compounding Periods:
So far we have considered only the
compounding of interest actually. But in many
cases interest may have to be compounded
more than once a year for example banksmay allow interest on quarterly basis or a
company may allow compounding of interest
twice a year on 30th June & 31st Dec every
year.
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The future value of money in such
cases can be calculated as below : i
Vn= V0( 1 + ------ )m X n
m
Where as Vn = Future value of money after n
years
V0 = Value of money at time zero (or) Original
sum of money
I =interest rate
M= number of times of compounding per year.
C l l t th di l f R 10 000 t th d
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Calculate the compounding value of Rs. 10,000 at the end
3 years at 12 % rate of interest when interest is calculated
on a) Yearly basis b) Quarterly basis
A) Yearly basis interest is computed as Vn= V0( 1+i)
n
= 10000 (1+0.12)3
= 10000 (1.12)3
= 10000 X 1.405
= Rs. 14,050 /-
B) Quarterly basis :
Vn= V
0( 1+ (i/m)) m x n
= 10000 ( 1 + (0.12 / 4)) 4 x 3
= 10000 (1.03)12
= Rs. 14,260 /-
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Future Value of a Series of Payments : In previous models we have considered the future value
of a single payment made at time Zero. But in many
instances we may be interested to know the future valueof series of payments made at different time periods.
Vn = R1 ( 1 + i) n-1 + R2 ( 1+i) n-2 + ---- (Rn1 ) (1+i) + Rn
Where as Vn = future value of the period n R1 = Payment after period one
R2 = Payment after period two
Rn = Payment after period n
I = Interest rate
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For Ex: Calculate the future value at the end of 5years of the following series of payments of 10%
R.O.I. R1= Rs. 1000 at the end of Ist year
R2= Rs. 2000 at the end of 2ndyear
R3= Rs. 3000 at the end of 3rdyear
R4= Rs. 2000 at the end of 4thyear
R5 = Rs. 1500 at the end of 5thyear
Vn =1000 (1+0.10)5-1+ 2000 (1+0.10)5-2+ 3000 (1+0.10)5-3+ 2000 (1+0.10)5-4+ 1500
= 1000 (1.10)4+ 2000 (1+0.10)3+ 3000(1+0.10)2+ 2000(1+0.10)1+1500
= 1000 x 1.464 + 2000 (1.331) + 3000 (1.210) + 2000 (1.10) +1500
= 11456.
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Compound an Value of Annuity : An annuity is a series of equal payments
lasting for some specified duration. Thepremium payments of life Insurance company
is the best example for annuity. When the
cash flows occur at the end of cash period
the annuity is called a regular annuity or
deferred annuity. If the cash flows occur at
the beginning of each year the annuity is
called an annuity due. Vn= R(Annuity Compound Factor I, n)
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Mr. A deposit Rs. 1000 at the end of every
year for 4 years and the deposit earns a
compound interest at the rate of 10% P.a.
Determine how much money he will have atthe end of 4 years.
Vn= 1000 ( 4.641)
= Rs. 4641/-
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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
of some future period, present value showswhat the value is today of some future sum of
money.
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In compound or future value approach the money invested
today appreciates because the compound interest is added to
the Principle. The present value of money to be received on
future date will be less because we have lost the opportunityof investing it yet some interest. Thus the present value of
money to be received in future will always be less. It is for
this reason the present value technique is called
Discounting. Vn
V0= --------
1 + I
Where Vn= Future Value
V0= Present Value
I = Interest Rate
E l If M X d i R 100 f
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Example : If Mr. X depositor, expects to get Rs. 100 after one
year@ 10%. Calculate Present Value of Money ?
Vn
V0= ------ 1 + I
100
= ------------
1 + 0.10
= 90.90
Present Value of Money for n Periods Vn
V0= ---------
( 1+i)n
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Present Value of a Series of Cash flows:
C1 C2 C3 Cn
P.V. = ----- + ------- + ------ + ---- + ------
(1+i)1 (1+i)2 (1+i)3 (1+i)n
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P.V. = R( D.F.)
= 5000 x 2.773
= 13865.
5% of 3 Years = 2.773.