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Scope/Goal/Objectives - Finance
2. Objectives:
While profit maximization is one of the main objectives the other important
objective is to increase the shareholder’s value. In short the key objective of a
company is to maximize the value of the company based on
(i)Proper planning (ii) prudent and timely financing/investing decisions (iii) effective
monitoring and control
To achieve the objectives, the finance manager should take careful decisions of
(i) Arranging for finance (ii) Liquidity Management (iii) Using good investment
opportunities (iv) arrange for payment of dividends
Source of funds:
Equity capital, is the share capital raised through issuance of shares and the
owners of such shares are considered part owners of the company.
Debt: Public invest in companies through capital market on long term basis, by
means of debentures. In this case, the investor not only invests in the company but
also lends money against security or without security. The debenture holders are
creditors of the company.
Source of funds – Bank loans – Short term and Long term (fund based)
A finance manager’s responsibility is not only to raise capital funds (equity/debt) but
also to arrange for loan (borrowed) funds from banks and Financial Institutions and
investing public in company deposits/bonds.
The combination of various options, would reflect in the efficient financing decision.
Investment decision:
The decision to the acquisition of assets is based on various factors. Assets are
classified as financial assets such as shares, debentures, bonds, and real assets are
the immovable properties like land, building, plant, machinery, etc.,
Financial decisions of a company results in sourcing out the best possible mix of
financial options to manage the company’s affairs, investment in project is dealt by
the Capital Budgeting which is based on the concept “Net Present Value” (NPV) of
the assets.
Further the investment decisions deals with issues relating to mergers, acquisition,
restructuring to achieve economy of scale in operation and also to increase the
market share
Dividend decision:
While the cost of equity capital is the payment of dividend, as it is a pay out, it is a
financing decision. However, the dividend decision is a trade off between paying
reasonable dividend (to the shareholders) and retaining the balance profit as a
retained earnings or Reserve.
Wealth/Value/Profit maximization :
(b) Companies are more social conscious as regards Corporate Social Responsibility
re: external economic environment.
If the EPS (earning per share) in simple terms = total profits/total o/s shares.
If the company earned Rs 10,00,000.00 and the total o/s is 1,00,000 shares, the
EPS
opportunities:
Investment in A
---------------------------------------------------------------------------------------------------------
Year 1 2 3 9 10
EPS 10 10 10 10 10
---------------------------------------------------------------------------------------------------------
Investment in B
---------------------------------------------------------------------------------------------------------
Year 1 2 3 9 10
EPS 0 12 12 12 12
---------------------------------------------------------------------------------------------------------
Investing in A would give higher return in the I year (EPS of Rs.10 against an EPS
of ( 0) In case of B, for the remaining 9 years it gives higher EPS. The better
alternative (if other things being equal ) would be option B
Capital Budgeting
Generation
Planning
Analysing
Selection
Execution
Review
Project generation: The generation of project/s may take place any or all ot the
following:
Planning: The planning phase of a firm’s capital budgeting deals with the
investment
Analysis: There are many aspects that require a proper analysis. Some of the
important aspects to be covered are: financial, technical, marketing, economic
and environmental analysis. For example the financial analysis (cash flows and
funds flows) assists the financial manager to take decision on estimated
benefits/costs.
The other method, i.e., discounting method consists of (i) Net Present Value
(NPV) (ii)Internal Rate of Return (IRR) and (iii) Benefit Cost Ratio (BCR)
(a) comparison of estimates and actual (b) serves as a guide for future projects
(b) assists in taking corrective steps and also decision making in future projects.
Capital budgeting, which involves a large outlay of funds and a longer period.
The commitments for large outlay of funds would result either in profit or loss
and benefits or drawbacks. Hence the capital budget discussions are crucial for a
firm.
Cash flows: The significance of cash flows both inflows and outflows are
important factors. The cash inflows from an investment are the effect of
incremental changes in after tax in operating cash flows. The cash outflows are
the cost of investment less salvage value received on an old machine.
Investment Proposals:
Return on Investment: This is the average annual cash inflow divided by the
original capital outlay. Both pay back and ROI are examples of non discounted
cash flows.
Net Present Value (NPV): The present value of future returns discounted at the
cost of capital minus cost of investment.
Internal Rate of Return(IRR): The interest that = the present value of future cash
flow to the investment outlay. NPV and IRR are discounted cash flows
If Rs11,000 is reinvested in the same fixed deposit at the end of 2nd year will be
= Rs 12,100 (Rs,11,000+interest of Rs 11,000 (@10% p.a.)
The equation:
A= P(1+i)n where
i = Rate of interest
n = Number of Years
= 10,000 x 1.21
= 12,100
(ii)Discounting: This method is used to find out the present value of Rs1 received
The equation:
P = A/(1+i)n
i = Rate of interest
n = Number of Years
If Rahesh expected to receive Rs10,000 after two years for an investment made
@10%, what amount should Rahesh invest today.
P= A/(1+i)n
= 10,000/(1+0.10)2
= 10,000/1.21
= Rs 8,264.46
Working capital is defined as the difference between current assets and current
liabilities. Working capital is frequently used to measure a company’s ability to
manage the current obligations. A high level of working capital indicates
significant liquidity. WC is calculated as current assets – current liabilities.
Bank > Cash > Raw Materials > Semi finished goods > Finished goods > Credit
Sale > Bills receivables > Cash > Bank
(iv) Bank borrowings: One of the important source of WC is the bank loan
availed against hypothecation/pledge of movable assets (inventories)
WC is basically the investment in current assets like raw materials, semi finished
goods,finished goods, sundry debtors,etc.,
WC consists of pre sales financing also known as inventory financing and post sales
financing also called as receivables financing. The non fund based financing also
constitute a portion of overall WC financing.
Inventory finance is also known as pre sales finance and the receivables finance
is called as
To grant the working capital finance, the company or corporate needs to have a
line of credit with the lending banker. The lending banker will grant the finance
based on certain evaluation of the firm, based mainly on the performance of the
company.
Capital Budgeting:
Capital
Budgeting
Non
Discounting
Discounting
Methods
Methods
Cash inflow
1st year 40,000 80,000 200,000
2nd year 60,000 100,000 300,000
3rd year 50,000 120,000
Project X:Cash inflow for three years is Rs.150,000 is = investment and hence will
be recoved at the end of three years.
Project Y: Cash in flow for 3 years is 300,000. It has covered the investment of
Rs.250,000 between 2 and 3rd year. Since the cash flow for the 3rd year is Rs 10,000
per month , the short fall of 70,000 (Investment Rs.250,000-180,000 (2 years cash
inlow) = 70,000, is payable at the end of 7 months.
Return on Investment(ROI): This is the average annual cash inflow divided by the
original capital outlay. Both pay back and ROI are examples of non discounted cash
flows.
ROI method is used as a decision making tool by prescribing minimum ROI. This is
an average rate of return calculated by expressing average profit as percentage of
average capital employed as investment.
Here profit is considered, as profit after depreciation charges but before taxation
and of course dividends.
1 15,000
2 12,500
3 25,000
4 30,000
5 20,000
Assuming the capital employed is Rs 200,000, then the average capital employed =
200,000/2=Rs100,000
Average annual profit 102,500/5 = 20,500
Net Present Value (NPV): The present value of future returns discounted at the cost
of capital minus cost of investment.
Internal Rate of Return(IRR): The interest that = the present value of future cash
flow to the investment outlay. NPV and IRR are discounted cash flows
Finance is a set of tools that helps FM (Finance Manager) to answer the following
questions…
Firms:
Commercial Function:
Trading functions:
• Decides how to pay for these projects (debt vs. equity) and what firm’s mix of
debt and equity should be
Also ensures that is there the firm has enough cash to meet its obligations and
invest in profitable projects
3. Cost Management
4. Preparing Budgets
5. Preparing Forecasts
6. Tax Planning
9. Determine how the assets (LHS of balance sheet) will be financed (RHS of
balance sheet)
Growth and increased market share are only desirable to the extent
that current (or future) sales are profitable
While managers may be content to just keep their jobs, investors will
prefer to earn higher returns elsewhere
Wealth maximization does not preclude the firm from being socially
responsible.
Assume we view the firm as producing both private and social goods.
Default Risk
Political Risk
Economic Risk
Business Risk
Fund Raising
Investment Decision
Dividend Decision
Minimizing risk