Aims of Finance Function

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

Profit Maximization :

Profit maximization is a term which denotes the maximum profit to be earned by an organization in a given 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 into form of dividend to the share holders. Profit as the operational concept means profitability. Which is an indicator of economic efficiency of the enterprise.

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.

Merits of Profit Maximization :

Best criterion on Decision Making : The goal of profit maximization is regarded as the best criterion of decision making as it provides a sign to judge the economic performance of the enterprise. Barometer : Profitability is a barometer for measuring efficiency of a economic prosperity of a business enterprise. Efficient allocation of resources: It leads to efficient allocation of scarce resources as tend to be diverted to those uses which in terms of profitability are the most desirable.

Optimum Utilization : Optimum utilization of available resources is possible if the business enterprise objective is profit maximization . Maximum Social Welfare : It ensures maximum social 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.

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.

The term maximum is also ambiguous: The term maximum is also not clear. The concept of profit is also not clear. It is therefore, not possible to maximize what cannot be known. It ignores Time Value : The profit maximization objective fails to provide any idea regarding the timing of expected cash earnings. The choice of a more worthy project lies in the study of time value of future inflows of cash earnings. It ignores the fact that the rupee earned today is more valuable than, the rupee earned later.

Wealth Maximisation :

Wealth Maximisation appropriate objective of an enterprise when 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 .

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 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.

Criticism of Wealth Maximisation :

The wealth maximisation objectives has been criticized by certain financial theoriests mainly on following 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 the objective 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.

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 is computed 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.

Net Profit after tax & preference dividend

EPS =

--------------------------------------No. of Equity shares.

An overview of Managerial Finance Functions :

Financial management is emerged as a district field of study only in the early part of the 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.

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 the financial 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.

3. It laid heavy emphasis long term financing institutions, procedures used 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.

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.

3. Modern Phase :

It begin in the mid 1950s and 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. The following 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.

Portfolio analysis gives the idea for the allocation of a fixed sum of money among the available investment securities. Capital asset Pricing Model (CAPM) suggests that 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, but understanding the international dimension of corporate finance formed a very small part of it. Which is not sufficient in this era of globalization.

The Importance of Financial Management / Financial Decision :

Financial management indeed, the key to successful 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

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. In other 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-inprogress, closing stock Working capital.

2)Financing Decision :

Once the firm has taken the investment decision and committed itself to new investment, 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 finance new assets, but also concerned with the best overall mix of financing for the firm.

3)Dividend Decision :

This is the third financial decision which relates to dividend policy. Dividend is a part of profits that are available for distribution, 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 the ordinary 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.

Financial Management Process:

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Financial Control
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Financial Analysis
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Financial Planning

Financial Decision Making

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Financial Management Process:

Financial 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 particular financial problem, risk, limitation and an assessment of financial strength, weakness, and opportunities and threats (A financial SWOT Analysis)

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 as investing in new production facilities or the acquisition of another company and strategic financial decision. For Example : The decision to rise additional long term loans.

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 level of risk involved to enable the firms objectives to be achieved.

Financial Control: The final stage of the process involves the entire organization. This is to ensure that plans are properly implemented that progress is continuously reported to the management, and any deviations from the plans are clearly identified.

Time Value of Money :

Profit Maximization objective ignores the time value of money & doesnt considered the magnitude 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. They expect to get some future, either as dividend or increases share price when the shares are sold.

Most of the financial decisions, such as acquisition assets or procurement of funds affect firms cash flows in different time periods. If a firm acquires as assets today it will required at immediate cash outlay, but the benefit of this asset will be received in future. Similarly if funds are raised through borrowings for present needs, these will have to be returned in future as principle & interest.

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 adjustment for time otherwise it may take faulty decisions.

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 of money 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 at either 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 1 year. 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.

Reasons for Time Preference of Money:

The future is always uncertain and involves risk. An individual can never be certain of getting 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.

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.

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 to be received tomorrow or after a certain period of time. In an inflationary economy the money received today has more purchasing power than money to be received in future.

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 of uncertainty 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.

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

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 the waiting by way of ensuring more money in future. In this concept the interest earned the initial principal amount becomes a past of the principal of the end of the compounding period.

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

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 earned at the end of first year. This paying of interest is called compounding technique. The value of money after two years can be calculated as :

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

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

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.

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 banks may allow interest on quarterly basis or a company may allow compounding of interest twice a year on 30th June & 31st Dec every year.

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.

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 = V0 ( 1+ (i/m)) m x n = 10000 ( 1 + (0.12 / 4)) 4 x 3 = 10000 (1.03)12 = Rs. 14,260 /-

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 value of series of payments made at different time periods.
Vn = R1 ( 1 + i) n-1 + R2 ( 1+i) n-2 + ---- (Rn 1 ) (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

For Ex: Calculate the future value at the end of 5 years 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 2nd year R3 = Rs. 3000 at the end of 3rd year R4 = Rs. 2000 at the end of 4th year R5 = Rs. 1500 at the end of 5th year

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.

Compound an Value of Annuity :

An annuity is a series of equal payments lasting for some specified duration. The premium 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)

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 at the end of 4 years. Vn = 1000 ( 4.641) = Rs. 4641/-

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 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 Principle. The present value of money to be received on future date will be less because we have lost the opportunity of 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

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

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

Calculate the Present value of an annuity of Rs. 500 received annually for 4 years, when discounting factor is 10% years. Years Cashflow P.V.F @ 10% P.V.

1 500 0.909 454.50 2 500 0.827 413.50 3 500 0.751 375.50 4 500 0.683 341.50 Find out the P.V. of annuity of Rs. 5000 over 3 years when discounted at 5% ?

P.V. = R( D.F.) = 5000 x 2.773 = 13865. 5% of 3 Years = 2.773.