UNIT-I FOUNDATIONS OF FINANCE

FINANCIAL MANAGEMENT
Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and
utilization of funds of the enterprise. It means applying general management principles to financial resources of the
enterprise.
Financial management is the process of planning funds, organizing available funds and controlling financial activities to
achieve the goal of an organization. It includes three important decisions which are investment decisions, financing decision
and dividend decision for a specified period of time. Investment decision includes working capital decision and capital
budgeting decision. Financing decision involves identifying sources of financing, determining the duration and cost of
financing and managing investment return.

OBJECTIVES OF FINANCIAL MANAGEMENT

The financial management is generally concerned with procurement, allocation and control of financial resources of a
concern. The objectives can be
 To ensure regular and adequate supply of funds to the concern.
 To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the
share, expectations of the shareholders.
 To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way
at least cost.
 To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be
achieved.
 To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is
maintained between debt and equity capital.

FUNCTIONS OF FINANCIAL MANAGEMENT

1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of
the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations
have to be made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the capital structure have to be decided.
This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a
company is possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many choices like
 Issue of shares and debentures
 Loans to be taken from banks and financial institutions
 Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period of financing.
4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on
investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done in two ways:
 Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.
 Retained profits - The volume has to be decided which will depend upon expansional, innovational, diversification
plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for
many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting
current liabilities, maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise
control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit
control, etc.
FINANCE FUNCTIONS
1. Investment Decision One of the most important finance functions is to intelligently allocate capital to long term
assets. This activity is also known as capital budgeting. It is important to allocate capital in those long term assets so
as to get maximum yield in future. Following are the two aspects of investment decision a. Evaluation of new
investment in terms of profitability b. Comparison of cut off rate against new investment and prevailing investment.
Since the future is uncertain therefore there are difficulties in calculation of expected return. Along with uncertainty
comes the risk factor which has to be taken into consideration. This risk factor plays a very significant role in
calculating the expected return of the prospective investment. Therefore while considering investment proposal it is
important to take into consideration both expected return and the risk involved. Investment decision not only involves
allocating capital to long term assets but also involves decisions of using funds which are obtained by selling those
assets which become less profitable and less productive. It wise decisions to decompose depreciated assets which are
not adding value and utilize those funds in securing other beneficial assets. An opportunity cost of capital needs to be
calculating while dissolving such assets. The correct cut off rate is calculated by using this opportunity cost of the
required rate of return (RRR)
2. Financial Decision Financial decision is yet another important function which a financial manger must perform. It is
important to make wise decisions about when, where and how should a business acquire funds. Funds can be
acquired through many ways and channels. Broadly speaking a correct ratio of an equity and debt has to be
maintained. This mix of equity capital and debt is known as a firm’s capital structure. A firm tends to benefit most
when the market value of a company’s share maximizes this not only is a sign of growth for the firm but also
maximizes shareholders wealth. On the other hand the use of debt affects the risk and return of a shareholder. It is
more risky though it may increase the return on equity funds. A sound financial structure is said to be one which aims
at maximizing shareholders return with minimum risk. In such a scenario the market value of the firm will maximize
and hence an optimum capital structure would be achieved. Other than equity and debt there are several other tools
which are used in deciding a firm capital structure.
3. Dividend Decision Earning profit or a positive return is a common aim of all the businesses. But the key function a
financial manger performs in case of profitability is to decide whether to distribute all the profits to the shareholder or
retain all the profits or distribute part of the profits to the shareholder and retain the other half in the business. It’s the
financial manager’s responsibility to decide a optimum dividend policy which maximizes the market value of the
firm. Hence an optimum dividend payout ratio is calculated. It is a common practice to pay regular dividends in case
of profitability. Another way is to issue bonus shares to existing shareholders.
4. Liquidity Decision It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s
profitability, liquidity and risk all are associated with the investment in current assets. In order to maintain a tradeoff
between profitability and liquidity it is important to invest sufficient funds in current assets. But since current assets
do not earn anything for business therefore a proper calculation must be done before investing in current assets.

ORGANIZATION OF THE FINANCE FUNCTIONS

Today, finance function has obtained the status of a science and an art. As finance function has far reaching significance in
overall management process, structural organization for further function becomes an outcome of an important organization
problem. The ultimate responsibility of carrying out the finance function lies with the top management. However,
organization of finance function differs from company to company depending on their respective requirements. In many
organizations one can note different layers among the finance executives such as Assistant Manager (Finance), Deputy
Manager (Finance) and General Manager (Finance). The designations given to the executives are different. They are
 Chief Finance Officer (CFO)
 Vice-President (Finance)
 Financial Controller
 General Manager (Finance)
 Finance Officers
Finance, being an important portfolio, the finance functions is entrusted to top management. The Board of Directors, who are
at the helm of affairs, normally constitutes a ‘Finance Committee’ to review and formulate financial policies. Two more
officers, namely ‘treasurer’ and ‘controller’ – may be appointed under the direct supervision of CFO to assist him/her. In
larger companies with modern management, there may be Vice-President or Director of finance, usually with both controller
and treasurer. The organization of finance function is portrayed below:
It is evident from the above that Board of Directors is the supreme body under whose supervision and control Managing
Director, Production Director, Personnel Director, Financial Director, Marketing Director perform their respective duties and
functions. Further while auditing credit management, retirement benefits and cost control banking, insurance, investment
function under treasurer, planning and budgeting, inventory management, tax administration, performance evaluation and
accounting functions are under the supervision of controller.
Meaning of Controller and Treasurer
The terms ‘controller’ and ‘treasurer’ are in fact used in USA. This pattern is not popular in Indian corporate sector.
Practically, the controller / financial controller in India carried out the functions of a Chief Accountant or Finance Officer of
an organization. Financial controller who has been a person of executive rank does not control the finance, but monitors
whether funds so augmented are properly utilized. The function of the treasurer of an organization is to raise funds and
manage funds. The treasures functions include forecasting the financial requirements, administering the flow of cash,
managing credit, flotation of securities, maintaining relations with financial institutions and protecting funds and securities.
The controller’s functions include providing information to formulate accounting and costing policies, preparation of
financial reports, direction of internal auditing, budgeting, inventory control payment of taxes, etc. According to Prof. I.M.
Pandey, while the controller’s functions concentrate the asset side of the balance sheet, the treasurer’s functions relate to the
liability side.
OBJECTIVES OF FINANCIAL MANAGEMENT

Wealth Maximization
 Wealth Maximization is the ability of the company to increase the value for the stakeholders of the company, mainly
through an increase in the market price of the company’s share over time. The value depends on several tangible and
intangible factors like sales, quality of products or services, etc.
 It is mainly achieved throughout the long-term as it requires the company to attain a leadership position, which
translates to a larger market share and higher share price, ultimately benefiting all the stakeholders.
 To be more specific, the universally accepted goal of a business entity has been to increase the wealth for the
shareholders of the company as they are the actual owners of the company who have invested their capital, given
the risk inherent in the business of the company with expectations of high returns.
 Wealth maximization is a long-term objective that gradually happens and hence, the management is always ready to
pay for the discretionary expenses, including research and maintenance.
 For effective wealth maximization, the companies normally choose to reduce the prices and have a strong backup in
the form of market share.
 A wealth-oriented firm is focused on making expenses keeping in mind the long-term sales objectives. It believes that
such expenditure will help increase the value of the business.
 Companies aiming to maximize wealth focus on risk mitigation measures to avoid risk of losses in future.
Profit Maximization
 Profit Maximization is the ability of the company to operate efficiently to produce maximum output with limited
input or to produce the same output using much lesser input. So, it becomes the most crucial goal of the company to
survive and grow in the current cut-throat competitive landscape of the business environment.
 Given this form of financial management, companies mainly have a short-term perspective when it comes to earning
profits, which is very much limited to the current financial year.
 If we get into the details, profit is actually what remains out of the total revenue after paying for all the expenses and
taxes for the financial year. Now to increase profit, companies can either increase their revenue or minimize their cost
structure. It may need some analysis of the input-output levels to diagnose the company’s operating efficiency and
identify the key improvement areas where processes could be tweaked or changed in their entirety to earn larger
profits.
 When it is about maximizing profits for a business, companies aim to make instant profits. Hence, they choose not to
pay for discretionary expenses, which include advertising costs, research and maintenance expenditure, etc.
 Unlike wealth maximization, profit maximization favors the choice of increasing product prices to keep the margins
as high as possible. Hence, the companies do so to ensure more and more instant profit making.
 Businesses aiming to maximize profits have a focus on managing their existing level of sales efficiently and
productively. In short, they emphasize short-term sales goals for profits, which sometimes hampers their long-term
goals.
  To show they are earning profits, companies choose to minimize expenditure, which makes them unprepared for the
hedges required at a later stage.

Basis Wealth Maximization Profit Maximization

It is defined as managing financial It is defined as the management of

Definition resources to increase the value of the financial resources to increase the
company’s stakeholders. company’s profit.

Focuses on increasing the value of the Focuses on increasing the profit of the
Focus
company’s stakeholders in the long term. company in the short term.

It does not consider the risks and

It considers the risks and uncertainty
Risk uncertainty inherent in the company’s
inherent in the company’s business model.
business model.

It helps achieve a larger value of a It helps achieve efficiency in the

Usage company’s worth, which may reflect in the company’s day-to-day operations to
company’s increased market share. make the business profitable.

RISK RETURN TRADE OFF

Financial decisions incur different degree of risk. Your decision to invest your money in government bonds has less risk as
interest rate is known and the risk of default is very less. On the other hand, you would incur more risk if you decide to invest
your money in shares, as return is not certain. However, you can expect a lower return from government bond and higher
from shares. Risk and expected return move in tandem; the greater the risk, the greater the expected return.

Financial decisions of the firm are guided by the risk-return trade off. These decisions are interrelated and jointly affect the
market value of its shares by influencing return and risk of the firm. The relationship between return and risk can be simply
expressed as follows:
Return = Risk-free rate + Risk premium
Risk-free rate is a rate obtainable from a default-risk free government security. An investor assuming risk from her
investment requires a risk premium above the risk-free rate. Risk-free rate is a compensation for time and risk premium
leading to higher required return on that action. A proper balance between return and risk should be maintained to maximize
the market value of a firm’s shares. Such balance is called risk-return trade-off, and every financial decision involves this
trade-off. It also gives an overview of the functions of financial management.

The financial manager, in a bid to maximize shareholder’s wealth, should strive to maximize returns in relation to the given
risk; he or she should seek courses of actions that avoid unnecessary risks. To ensure maximum return, funds flowing in and
out of the firm should be constantly monitored to assure that they are safeguarded and properly utilized. The financial
reporting system must be designed to provide timely and accurate picture of the firm’s activities.

RISK AND RETURN OF A PORTFOLIO

One of the ideal measures to reduce risk while simultaneously maximizing revenue is by diversifying the investment
portfolio. Investors can choose multiple investments that offer different returns accordingly.
There are different investment options: stocks, bonds, commodities, mutual funds, etc. Stocks usually carry high chance of
failure but can give good returns. On the other hand, government bonds can carry low to zero risk but offer low profits.
There are many benefits of diversifying an investment portfolio. Investors can choose to invest in stocks with high risk and
compensate for the risk by investing in bonds. Bonds usually give assured returns, although it is low. They can also invest in
mutual funds for a longer period with moderate risk.
In studying the risk and return concept, some financial experts suggest investing in different industries or markets. Because
different sectors prosper and fall at different times. For example, during the onset of the COVID-19 pandemic, many internet
and e-commerce companies flourished, whereas automobile companies didn’t do well. So, taking different investment stands
can help investors in the long run.

TIME VALUE OF MONEY

 The time value of money means that a sum of money is worth more now than the same sum of money in the future.
 The principle of the time value of money means that it can grow only through investing so a delayed investment is a
lost opportunity.
 The formula for computing the time value of money considers the amount of money, its future value, the amount it
can earn, and the time frame.
 For savings accounts, the number of compounding periods is an important determinant as well.
 Inflation has a negative impact on the time value of money because your purchasing power decreases as prices rise.
TECHNIQUES IN TIME VALUE OF MONEY
1. Discounting and Present Value Discounting involves determining the present value (PV) of a future sum of money. This
technique is used when you want to find out the current value of a future cash flow or investment.
2. Compounding and Future Value Compounding is the process where interest is calculated on the initial principal and also
on the accumulated interest of previous periods. This technique is used to find out the future value (FV) of an investment or
savings over time.
3. Annuities An annuity is a series of equal payments made at regular intervals over a fixed period of time. There are two
main types of annuities:
 Ordinary Annuity: Payments are made at the end of each period.
 Annuity Due: Payments are made at the beginning of each period.

4. Perpetuities A perpetuity is an annuity that continues indefinitely.

5. Sinking Fund A sinking fund in the context of time value of money refers to a fund set aside by a company or individual
to repay debt or replace assets at the end of their useful life. The primary purpose of a sinking fund is to ensure that there are
enough funds available when a specific financial obligation or expense comes due.
6. Annuity Due An annuity due is a type of annuity where payments are made at the beginning of each period, rather than at
the end. This means that the first payment is made immediately or at the beginning of the first period, and subsequent
payments continue at the beginning of each subsequent period.

SHARE AND BONDS

Shares (Stocks):
Definition: A share represents ownership in a company. When you buy shares of a company's stock, you become a
shareholder and own a portion of that company.
Features:
1. Ownership: Buying shares means owning a part of the company, which gives you voting rights and a share in the
company's profits through dividends.
2. Potential for Growth: Share prices can increase, allowing you to sell your shares at a higher price than what you
paid for them, resulting in capital gains.
3. Dividends: Some companies pay dividends to shareholders, which are a portion of the company's profits.
4. Risk: Shares are generally considered riskier than bonds because their prices can be volatile. If the company
performs poorly, the share prices can drop.
5. Liquidity: Shares of publicly traded companies can usually be easily bought or sold on stock exchanges.
Bonds:
Definition: A bond is a debt instrument issued by governments, municipalities, or corporations to raise capital. When you
buy a bond, you are essentially lending money to the issuer in exchange for periodic interest payments and the return of the
bond’s face value when it matures.
Features:
1. Fixed Income: Bonds typically pay a fixed interest rate, known as the coupon rate, which is paid periodically (e.g.,
annually, semi-annually).
2. Maturity Date: Bonds have a maturity date at which the issuer repays the bond’s face value to the bondholder.
Bonds can have short-term (less than 5 years), medium-term (5-10 years), or long-term (more than 10 years)
maturities.
3. Safety: Bonds are generally considered less risky than shares because bondholders are creditors and have a higher
claim on the issuer’s assets than shareholders in the event of bankruptcy.
4. Income Stream: Bonds can provide a steady income stream through interest payments, making them attractive to
investors seeking regular income.
 5. Liquidity: The liquidity of bonds can vary. Government bonds and bonds issued by well-established corporations are
typically more liquid than bonds issued by smaller entities or with lower credit ratings.
Key Differences:
1. Ownership vs. Debt: Shares represent ownership in a company, while bonds represent a debt obligation.
2. Return Potential: Shares offer the potential for higher returns through capital appreciation and dividends, while
bonds provide a fixed income through interest payments.
3. Risk: Shares are generally riskier than bonds due to their price volatility, whereas bonds are considered safer but
offer lower potential returns.
4. Purpose: Shares are typically bought with the expectation of capital appreciation and dividend income, while bonds
are often purchased for income generation and capital preservation.
Both shares and bonds can be part of a diversified investment portfolio, allowing investors to balance risk and return based on
their financial goals, time horizon, and risk tolerance.

VALUATION OF SHARES (STOCKS)

1. Fundamental Analysis:
 Earnings Multiplier Approach: This involves calculating the Price-to-Earnings (P/E) ratio, which compares the
company's current share price to its earnings per share (EPS).
P/E Ratio=Market Price per ShareEarnings per Share (EPS)P/E Ratio=Earnings per Share (EPS)Market Price per Share
 Discounted Cash Flow (DCF) Analysis: This method estimates the present value of the company's future cash
flows, discounted back to their value in today's terms.
 Book Value: It's the value of a company's assets minus its liabilities, divided by the number of outstanding shares.
 Dividend Discount Model (DDM): This focuses on valuing a stock based on the present value of its expected future
dividends.
2. Technical Analysis: This approach uses historical price and volume data to forecast future price movements. It includes
chart patterns, indicators, and other statistical measures.
3. Comparable Company Analysis (CCA): Here, the valuation is based on the valuation multiples (like P/E, P/BV) of
similar companies in the same industry.

VALUATION OF BONDS
1. Discounted Cash Flow (DCF) Analysis: For bonds, this involves discounting the bond's future cash flows (coupon
payments and return of principal) back to their present value using the bond's yield to maturity (YTM).
2. Yield to Maturity (YTM): It's the internal rate of return (IRR) of a bond, considering all future cash flows including
coupons and return of principal.
3. Current Yield: It's the annual coupon payment of the bond divided by its current market price.
Current Yield=Annual Coupon PaymentCurrent Market PriceCurrent Yield=Current Market PriceAnnual Coupon Payment
4. Comparable Bond Yields: Similar to CCA for stocks, bonds can be valued by comparing their yields to similar bonds in
the market.
5. Credit Risk Assessment: Bonds from different issuers might carry different levels of credit risk. Bonds from issuers with
higher credit ratings might have lower yields compared to riskier bonds.
6. Duration and Convexity: These are measures of a bond's sensitivity to interest rate changes. They help in understanding
how bond prices will change with changes in interest rates.