Basic Finance Functions for a company to make decision

Unit - I
Finance Function PPT

1. Syllabus
CORPORATE FINANCE
The students need Discounting Table and Annuity tables for the examination.
CourseObjective:TounderstandthebasicdecisionstakenbyafinancemanagerinaCorporate.FMhelpsinunderstandingtheuseof
resourcesefficiently,effectivelyandeconomically.
CourseOutcome:Studentswillbeabletounderstanda)Goalsoffinancialfunctionb)Investmentcriteriaanddecisionprocessc)capital
structureandDividendDecisionsd)AssetLiabilitymanagement
UNIT-I:TheFinanceFunction:NatureandScope;Evolutionoffinancefunction–Itsnewroleinthecontemporary
scenario–Goalsoffinancefunction–maximizingvs.satisfying;Profitvs.Wealthvs.Welfare;theAgencyrelationshipand
costs;Risk-Returntradeoff;ConceptofTimeValueofMoney–FutureValueandPresentvalue.
UNIT-II:TheInvestmentDecision:Investmentdecisionprocess-Projectgeneration,projectevaluation,projectselection
andprojectImplementation.DevelopingCashFlow;DataforNewProjects;CapitalBudgetingTechniques–Traditionaland
DCFmethods.TheNPVvs.IRRDebate;Approachesforreconciliation.Capitalbudgetingdecisionunderconditionsofrisk
anduncertainty.CostOfCapital:Conceptandmeasurementofcostofcapital,Debtvs.Equity,costofequity,preference
shares,equitycapitalandretainedearnings,weightedaveragecostofcapitalandmarginalcostofcapital.Importanceof
costofcapitalincapitalbudgetingdecisions.

2. UNIT-III:CapitalStructureandDividendDecisions:Capitalstructurevs.financialstructure-Capitalization,financial
leverage,operatingleverageandcompositeleverage.EBIT-EPSAnalysis,IndifferencePoint/Breakevenanalysisof
financialleverage,CapitalstructureTheories–TheModiglianiMillerTheory,NI,NOITheoryandTraditionalTheory–A
criticalappraisal.
DividendDecisions:Dividendsandvalueofthefirm-Relevanceofdividends,theMMhypothesis,Factorsdetermining
DividendPolicy-dividendsandvaluationofthefirm-thebasicmodels–formsofdividend.Declarationandpaymentof
dividends.Bonusshares,Rightsissue,share-splits,Majorformsofdividends–CashandBonusshares.Dividendsand
valuation;MajortheoriescenteredontheworksofGordon,WalterandLintner.Abriefdiscussionondividendpoliciesof
Indiancompanies.
UNIT-IV:WorkingCapitalManagementandFinance:WorkingCapitalManagement:Componentsofworkingcapital,
grossvs.networkingcapital,determinantsofworkingcapitalneeds,theoperatingcycleapproach.Planningofworking
capital,FinancingofworkingcapitalthroughBankfinanceandTradeCredit,regulationofbankfinance.
UNIT-V:ManagementofCurrentAssets:Managementofcash–Basicstrategiesforcashmanagement,cash
planning,cashbudget,cashmanagementtechniques/processes.Marketablesecurities:characteristics,selection
criterion,Managementofreceivables-Creditpolicy,creditevaluationofindividualaccounts,monitoringreceivables,
Managementofinventory-Inventorymanagementprocess,Inventorycontrolsystems,analysisofinvestmentin
inventory.

3. Suggested Readings:
•IMPandey,FinancialManagement,11e,VikasPublications,2015.
•M.YKhan,PKJain,FinancialManagement-TextandProblems,TMH,
2015.
•JamesCVanHorne,SanjayDhamija,FinancialManagementand
Policy,PearsonEducation,NewDelhi.
•EugeneF.BrighamMichaelC.Ehrhardt,FinancialManagement,
CengageLearning,12e,2012.
•ArindamBanerjee,FinancialManagement,OxfordPublications,2016.
•RajeshKothari,FinancialManagementAcontemporaryApproach,
Sagepublications,2017.

4. Unit –I
Finance Funtion
Done by
K Arjun Goud
Assistant Professor

5. Finance Function
•Thefinancefunctionreferstopracticesandactivitiesdirectedto
managebusinessfinances.Thefunctionsareorientedtowardacquiring
andmanagingfinancialresourcestogenerateprofit.Thefinancial
resourcesandinformationoptimizedbythesefunctionscontributeto
theproductivityofotherbusinessfunctions,planning,anddecision-
makingactivities.
•Amongvariousfunctionsofbusiness,financialfunctionsareoneof
themostsignificantfunctions.Itisallthebusinessactivities.This
functionofabusinesscannotbeignored,substitutedorthelackof
financemayprovetobedisastrousforabusinessenterpriseandmay
leadtoitsclosure.Thedemandforfinanceisongoingand
uninterruptedduringtheentirelifetimeofacompany.

6. Definition
•AccordingtoHowardandUpton,“Financemaybedefinedasthat
administrativeareaorsetofadministrativefunctionsinan
organisationwhichrelateswiththearrangementofeachandcreditso
thattheorganisationmayhavethemeanstocarryouttheobjectivesas
satisfactorilyaspossible”.
•AsperF.W.Paish,“Financemaybedefinedasthepositionofmoney
atthetimeitiswanted”.
•AccordingtoJohnJ.Hampton,“Thetermfinancecanbedefinedas
themanagementoftheflowsofmoneythroughanorganisation,
whetheritwillbeacorporation,school,bankorgovernmentagency”.

7. Types of Finance Function
•Investment Decision
•Financing Decision
•Dividend Decision
•Liquidity Decision

8. Nature of Finance Function
Afewsalientfeaturesofthefinancefunctionarementionedbelow:
•1)TheFinancefunctionismostlyintegratedandcentralizedineverybusiness
organization,asitbringsforthcostadvantagestothecompany.
•2)Irrespectiveofsize,nature,andlegalstatus,everyorganizationhasafinance
function,asitputsacrosscertainamountofcontrolonotheractivitiesand
functionsoftheorganization.
•3)Financefunctionshelpinmanagerialdecisionmaking,throughtheanalysisand
interpretationoffinancialdata.
•4)Thefinancefunctionisinterrelatedtootherprimaryfunctionsofbusinessas
well,suchashumanresources,marketing,productionplanning,etc.These
functionsareverymuchdependentonfinanceandareaffectedbyexternalfactors
oftheenvironment.
•5)Financeanditsrelatedactivitiesplayaverysignificantroleinthelong-term
survivalandgrowthoftheorganization.
•6)Basically,“ValuationofaFirm”isoneoftheimportantaspectsofthefinance
function.

9. Scope of Finance Function
•Estimating Financial Requirements
•Deciding Capital Structure
•Selected a Source of Finance
•Selecting a Pattern of Investment
•Proper Cash Management
•Proper Uses of Surpluses
•Implementing Financial Controls

10. Evolution of Financial Function
•The evolution of financial management may be divided into three
broad phases:
•i) The traditional phase (1920 –40)
•ii) The transitional phase (1940-50)
•iii) The modern phase. (From 1950)

11. Traditional Phase
•Inthetraditionalphasethefocusoffinancialmanagementwason
certaineventswhichrequiredfundse.g.,majorexpansion,merger,
reorganizationetc.
•Thetraditionalphasewasalsocharacterizedbyheavyemphasison
legalandproceduralaspectsasatthatpointoftimethefunctioningof
companieswasregulatedbyaplethoraoflegislation.
•Anotherstrikingcharacteristicofthetraditionalphasewasthat,a
financialmanagementwasdesignedandpracticedfromtheoutsiders
pointofviewmainlythoseofinvestmentbankers,lenders,regulatory
agenciesandotheroutsideinterests.

12. Transition Phase
•Duringthetransitionalphasethenatureoffinancialmanagementwasthesamebut
moreemphasiswaslaidonproblemsfacedbyfinancemanagersintheareasof
fundanalysisplanningandcontrol.
Themodernphaseischaracterisedbytheapplicationofeconomictheoriesandthe
applicationofquantitativemethodsofanalysis.Thedistinctivefeaturesofthe
modernphaseare:
•Changesinmacroeconomicsituationthathasbroadenedthescopeoffinancial
management.Thecorefocusishowontherationalmatchingoffundstotheiruses
inthelightofthedecisioncriteria.
•Theadvancesinmathematicsandstatisticshavebeenappliedtofinancial
managementspeciallyintheareasoffinancialmodeling,demandforecastingand
riskanalysis.
Modern Phase

13. NewRoleofFinanceFunctioninthe
ContemporaryScenario
•ContinuousFocusonMarginsandEnsurethattheorganisationstays
committedtovaluecreating
•Workacrossthefunctional,dividethecompanyandexhibitleadershipskills
•Understandwhat’sdrivingthenumbersandprovideoperationinsights,
includingasenseofexternalmarketissuesandinternaloperatingtrends,
andbecomekeystrategyplayer
•Awareandusethehighlyinnovativefinancialinstruments
•Knowtheemergenceofcapitalmarketascentralstageforraisingmoney
•Addingmorevaluetothebusinessthroughinnovationsinimpactinghuman
capital

14. Importance of Finance Function
•Success of Promotion Depends on Financial Administration
•Smooth Running of an Enterprise
•Financial Administration Co-ordinates Various Functional Activities
•Focal Point of Decision Making
•Determinant of Business Success
•Measure of Performance
•Determination of Fixed Assets
•Determination of Current Assets
•Determination of Capital Structure

15. Objectives of Finance Function
•ensureadequateandregularsupplyoffundstothebusiness,
•provideafairrateofreturntothesuppliersofcapital,
•ensureefficientutilizationofcapitalaccordingtotheprinciplesof
profitability,liquidityandsafety,
•deviseadefinitesystemforinternalinvestmentandfinancing,
•minimizecostofcapitalbydevelopingasoundandeconomical
combinationofcorporatesecurities,
•co-ordinatetheactivitiesofthefinancedepartmentwiththeactivities
ofotherdepartmentsoftheorganization.

16. Goals of Finance Decisions
•Profit Maximization
•Wealth Maximization

17. Profit Maximization
•Thebasicobjectiveofeverybusinessenterpriseisthewelfareofits
owners.Itcanbeachievedbythemaximisationofprofits.
•Therefore,accordingtothiscriterion,thefinancialdecisions
(investment,financinganddividend)ofafirmshouldbeorientedto
themaximisationofprofits(i.e.selectthoseassets,projectsand
decisionswhichareprofitableandrejectthosewhicharenot
profitable).
•Inotherwords,actionsthatincreaseprofitsarebeundertakenand
thosethatdecreaseprofitsaretobeavoided.

18. Profitmaximizationasanobjectiveoffinancial
managementcanbejustifiedonthefollowinggrounds:
•1) Rational
•2) Test of Business Performance
•3) Main Source of Inspiration
•4) Maximum Social Welfare
•5) Basis of Decision-Making

19. Drawbacks of Profit Maximization Concept
•1) It is vague
•2) It ignores time value of money
•3) It ignores risks
•4) It ignores social responsibility

20. Wealth Maximization
•Theobjectiveofprofitmaximization,asdiscussedabove,isnotonly
vagueandambiguous,butitalsoignoresthetwobasiccriteriaof
financialmanagementi.e.
•riskand
•timevalueofmoney.
•Therefore,wealthmaximisationistakenasthebasicobjectiveof
financialmanagement,ratherthanprofitmaximisation.
•Itisalsoknownas‘ValueMaximisation’or‘NetPresentValue
Maximisation’.
•AccordingtoEzraSolomanofStanfordUniversity,theultimateobjective
offinancialmanagementshouldbethemaximisationofwealth.
•Prof.IrwinFriendhasalsosupportedthisview.

21. Contdd..
•WealthMaximisationmeanstomaximizethenet
presentvalue(orwealth)(NPV)ofacourseofaction.
•ItNPVisthedifferencebetweenthegrosspresent
valueofthebenefitsofthatactionandtheamountof
investmentrequiredtoachievethosebenefits.
•Thegrosspresentvalueofacourseofactionis
calculatedbydiscountingorcapitalisingitsbenefitsat
aratewhichreflectstheirtimingsanduncertainty

22. MaximisingVsSatisfying
•Theobjectiveofmanagementhasbeendeemed
tobeprimarilyoneofmaximisingshareholders
wealth.Howeeverinpracticeadistinctionmust
bemadebetweenmaximisingandsatisfying
•Maximising–Seekingthebestpossibleoutcome
•Satisfying–Findingamerelyadequateoutcome

23. Profit Vs Wealth Maximization Vs Welfare Maximization
Profit Maximization Wealth Maximization Welfare Maximization
Profits are earned maximised, so that
firm can over-come future risk which
are uncertain
Wealth is maximized, so that wealth of
share-holders can be maximized
Welfare Maximization is done with the
help of micro economic techniques to
examine a locative distribution
Profit Maximization is a yard stick for
calculating efficiency and economic
prosperity of the concern
In Wealth Maximization Stockholders
current wealth is evaluated in order to
maximize the value of shares in the
market
In Welfare Maximization social
welfare is evaluated by calculating
economic activities of Individuals in
the Society
Profit is measured in terms of
efficiency of the firm
Wealth is measured in terms of market
price of shares
Welfare can be measured in two ways,
either by pare to efficiency or in units
or in Rs
Profit Maximization involves problem
of Uncertainty because profits are
uncertain
Wealth maximization involves
problems related to maximizing
shareholders wealth or wealth of the
firms
Welfare Maximization involves
problem of combining the utilities of
different people

24. Agency Relationship
•Whenfirmsaresmalltheyusuallyfunctionassoleproprietorshipfirmsor
partnershipfirmswhereowner/partnersmakethedecisions.
•Asthevolumeandcomplexityofbusinessincreasesthesoleproprietorship
partnershipfirmsconvertthemselvesintopubliclimitedcompaniesorjointstock
companies.
•Withincreasedgeographicalspreadandothercomplexitiesoftenitisnotpossible
forownerstolookafteralltheaspectsofthebusiness.
•Thedecisionmakingpowerisdelegatedtothemanagers(agents).
•Anagentisapersonwhoactsfor,andexertspoweronbehalfofanotherpersonor
groupofpersons.
•Theperson(orgroupofpersons)whomtheagentrepresentsisreferredtoasthe
principal.
•Therelationshipbetweentheagentandtheprincipalisanagencyrelationship.
•Thereisanagencyrelationshipbetweenthemanagersandshareholdersofa
company.

25. ProblemsRelatedwithAgencyRelationship
•Inanagencyrelationshiptheagentischargedwiththeresponsibilityofactingforthe
principalandinthebestinterestoftheprincipal.But,itispossiblethattheagentmayact
inafashionwhichserveshis/herownself-interestratherthanthatoftheprincipal.
•Inrecentyearswehavewitnessednumerouscorporatefraudsi.e.Enron,Xerox,etc.,
wheretheagentshadmisappropriatedtheauthorityvestedinthembytheprincipal.
•Theproblemsassociatedwithagencyrelationshipcanmanifestitselfinmanyways.
•Themostcommonbeingthemisuseofpowerandauthoritybythemanagers,which
includesfinancialmisappropriation,usingthefundsofthecompanyforthepersonalself
(fringebenefits)etc.
•Incasetherewardandcompensationsarebasedoncertainparameters,forexamplesales;
managersmayindulgeinpracticeswhichwouldyieldresultintheshortrunbutprove
detrimentalinthelongrun,i.e.,overstockingthevariousintermediariesinthesupply
chain,offeringhugediscounts,dumpingofgoodsintheterritoryofanothermanageretc.
•Anotherfacetofthisproblemis,wheremanagersputalittleefforttowardsexpandingand
exploringthemarketfornewbusiness.
•Inanutshelltheproblemswithagencyrelationshipisthatthemanagersactinafashion
whichservestheirowninterestratherthanthatoftheshareholders.

26. CostsoftheAgencyRelationship
•Inordertominimizethepotentialforconflictbetweentheprincipal’sinterest
andtheagent’sinterestcertaincostsaretobeincurredbytheprincipalaswell
astheagentandthecumulativeeffectofthesecostsisreferredtoastheagency
costs.
•Agencycostsareofthreetypes:monitoringcosts,bondingcostsandresidual
cost.
•MonitoringCosts
•Thesearethecostsincurredbytheprincipaltomonitorandlimittheactionsoftheagent.In
companiestheshareholdersmayrequirethemanagerstoperiodicallyreportontheiractivitiesvia
auditedfinancialstatements.Thecostofresourcesspentonpreparingthesestatementsis
monitoringcost.Anotherexampleistheimplicitcostincurredwhentheprincipallimitsthe
decisionmakingpoweroftheagent;bydoingso,theprincipalmaymissprofitableinvestment
opportunities.Theforegoneprofitisthemonitoringcost.
•BondingCosts
•Thesearethecostsincurredbytheagentstoassuretheprincipalthattheywillactinthebest
interestoftheprincipal.
•ResidualCosts
•Residualcostsistheremainingcostsaftertakingintoconsiderationoftheabovecosts(i.e.,
monitoringcosts,bondingcosts).

27. Risk and Return Trade off
•Risk-returntrade-offmeansthatwithanincreaseinthe
potentialreturn,theriskalsoincreases.Every
individualinvestsinthestockmarketbyfollowinga
strategytoachieveshort-termorlong-terminvestment
goals.Earningprofitscomeswithasetofrisks,which
everyinvestorhastofactorintotheirstrategy.
•Aspermostinvestors,riskexposuredirectlyaffects
theprofitpotentialforeveryinvestmentinstrument.
Theybelievethatwithhigherriskcomesopportunities
forhigherprofits.Letusunderstandwhatisarisk-
returntrade-off.

28. Uses of Risk and Return Trade off
•Measuring Singular Risk in Context
•Risk –Return Trade –off at the Portfolio Level
Calculation of Risk –Return Trade off
•Alpha
•Beta
•Sharpe Ratio
•Standard Deviation

29. Time value of Money
•Thetimevalueofmoneyistheconceptthatthesumofthe
moneyisnowworthmorethanthesamesumwillbeata
futuredateduetoitsearningpotentialintheinterval.
•Timevalueofmoneyisbasedonasimpleprinciplethata
rupeereceivedtodayhasagreatervaluethanarupeereceived
infuture.
•Thetimevalueofmoneyisacrucialconceptbecauseifan
individualinvestsasumofmoneyitcangrowoveraperiod
oftime.Investinginasavingsaccountisanevenbetteridea
toearncompoundinterest.

30. Formula of the Time value of Money
•Where:
•PV = present value of money
•FV= future value of money
•I = Rate of interest or current yield on similar investment
•T = No of years
•N = No of compounding period of interest each year
FV =PV x (1 + i/n)
n x t
PV =. FV
. (1 + i/n)
n x t

31. PresentValue
•Presentvalueisthevalueofmoneyyouheld
today.Italsopresentsthevalueofthesumof
allfuturecashflowfromaninvestment.The
futurecashflowisdiscountedatadiscountrate.
Alowerdiscountratesuggestsahigherpresent
valueofthefuturecashflowandviceversa.
FutureValue
•Futurevalueisthevalueofaninvestmentatthe
endoftheinvestmentduration.Usually,itis
expectedthatfuturevalueshouldbegreater
thanthatofpresentvaluebecauseitgrowsover
timeandearnsinterest.So,forexample,you
candeterminethefuturevalueforround-sum
investmentsandrecurringinvestmentslike
SIPs.

32. Importance of Time Value of Money(TVM)
•Thetimevalueofmoneyisimportantbecauseithelpsinvestorsandpeopletosavemore
forretirementanddeterminehowtogetthemostoutoftheirdollars.Thisconceptis
fundamentaltofinancialliteracyandappliestoyoursavings,purchasingpower,and
investment.
•Thetimevalueofmoneyhelpsinvestorsmakethebestinvestmentdecisions,knowingthe
futurereturnstheyshouldexpectfromwhattheyinvest.
•Themoneyalsolosesitsvalueovertime,duetoinflationaffectingthebuyingpowerof
thepublic.
•Thefutureisalwaysunclear.Therefore,thebestfinancialdecisionscanbetakenwiththe
timevalueofmoney.
•TVMisanimportantareathatoneshouldknowifyouareassociatedwiththefield
offinanceespeciallywhenyouaredealingwithloans,capitalbudgeting,investment
analysis,andotherfinance-relateddecisions.Itisafundamentalbuildingblockonwhich
theentirefinanceisbuiltupon.
•Infinancialdecisions,thetimevalueofmoneyholdsgreatimportance.Itisthemost
crucialprincipleinfinanceandeconomicsnowbecauseallinvestmentdecisionsand
otherfinancialdecisionsaremadesolelyonthebasisofwhatandhowmuchtheywillget
inreturnfromsuchdecisions.

33. Five Components of the Time Value of Money
Five components of the time value of money are.
•Rate of interest
•Time period(n)
•Present value PV
•Future value FV
•installments(PMT)
Interest Rate(i)
•Interest rate is the rate of return received during the lifetime of an investment.
Time Period (n)
•It refers to the number of time periods for which we want to calculate a sum’s present or future value. These time periods can be annual,
semi-annually, weekly, monthly, quarterly, etc.
Present Value. (PV)
•We obtain the amount by applying a discounting rate on the future value of any cash flow.
Future Value (FV)
•We obtain the amount of money by applying a compounding rate on the present value of any cash flow.
Installments(PMT)
•Installments represent the payments to be paid periodically or received during each period. Therefore, the value is positive when payments
are received and becomes negative when payments are made.

34. Base for Time value of Money