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Corporate Finance and Policy
Unit 1 A Introduction of the module, need and Importance of financial management, Financial Functions , Financial Decisions, Objectives & Scope of Financial Management B Operating environment, Risk and Uncertainty, Measurement of Risk, Relationship between Risk and Return. C Time Value of Money, Valuation concepts. Techniques, Practical applications of Compounding and Present Value Techniques.
Meaning of 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.
Scope/Elements
Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in current assets is also a part of investment decisions called as working capital decisions.
Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby.
Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two:
Dividend for shareholders- Dividend and the rate of it has to be decided.
Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise.
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
- 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.
- 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.
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.
- 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.
- Disposal of surplus: The net profits decisions 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.
- 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.
The government is always around to collect taxes. Financial management must plan to pay its taxes on a timely basis.
Financial management is an important skill of every small business owner or manager. Every decision that an owner makes has a financial impact on the company, and he has to make these decisions within the total context of the company's operations.
Role of a Financial Manager
Financial activities of a firm is one of the most important and complex activities of a firm. Therefore in order to take care of these activities a financial manager performs all the requisite financial activities.
A financial manager is a person who takes care of all the important financial functions of an organization. The person in charge should maintain a far sightedness in order to ensure that the funds are utilized in the most efficient manner. His actions directly affect the Profitability, growth and goodwill of the firm.
Following are the main functions of a Financial Manager:
Raising of Funds
In order to meet the obligation of the business it is important to have enough cash and liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a financial manager to decide the ratio between debt and equity. It is important to maintain a good balance between equity and debt.
Allocation of Funds
Once the funds are raised through different channels the next important function is to allocate the funds. The funds should be allocated in such a manner that they are optimally used. In order to allocate funds in the best possible manner the following point must be considered
The size of the firm and its growth capability
Status of assets whether they are long-term or short-term
Mode by which the funds are raised
These financial decisions directly and indirectly influence other managerial activities. Hence formation of a good asset mix and proper allocation of funds is one of the most important activity
Profit Planning
Profit earning is one of the prime functions of any business organization. Profit earning is important for survival and sustenance of any organization. Profit planning refers to proper usage of the profit generated by the firm.
Profit arises due to many factors such as pricing, industry competition, state of the economy, mechanism of demand and supply, cost and output. A healthy mix of variable and fixed factors of production can lead to an increase in the profitability of the firm.
Fixed costs are incurred by the use of fixed factors of production such as land and machinery. In order to maintain a tandem it is important to continuously value the depreciation cost of fixed cost of production. An opportunity cost must be calculated in order to replace those factors of production which has gone thrown wear and tear. If this is not noted then these fixed cost can cause huge fluctuations in profit.
Understanding Capital Markets
Shares of a company are traded on stock exchange and there is a continuous sale and purchase of securities. Hence a clear understanding of capital market is an important function of a financial manager. When securities are traded on stock market there involves a huge amount of risk involved. Therefore a financial manger understands and calculates the risk involved in this trading of shares and debentures.
Its on the discretion of a financial manager as to how to distribute the profits. Many investors do not like the firm to distribute the profits amongst share holders as dividend instead invest in the business itself to enhance growth. The practices of a financial manager directly impact the operation in capital market.
Profit Maximization and Wealth Maximization: Meaning and Difference
Financial Management
The firm’s investment and financing decision are unavoidable and continuous. In order to make them rational, the firm must have a goal. Two financial objectives predominate amongst many objectives. These are:
- Profit maximization
- Shareholders’ Wealth Maximization (SWM)
Profit Maximization refers to the rupee income while wealth maximization refers to the maximization of the market value of the firm’s shares. Although profit maximization has been traditionally considered as the main objective of the firm, it has faced criticism. Wealth maximization is regarded as operationally and managerially the better objective.
1. Profit Maximization
profitability maximization with a view to using resources to yield economic values higher than the joint values of inputs required is a useful goal.
Wealth Maximization:
Shareholders’ wealth maximization means maximizing the net present value of a course of action to shareholders. Net Present Value (NPV) of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in negative NPV destroys shareholders’ wealth and is, therefore undesirable. Between mutually exclusive projects, the one with the highest NPV should be adopted.
NPVs of a firm’s projects are additive in nature. That is NPV(A) NPV(B) = NPV(A B)
The objective of Shareholders Wealth Maximization (SWM) considers timing and risk of expected benefits. Benefits are measured in terms of cash flows. One should understand that in investment and financing decisions, it is the flow of cash that is important, not the accounting profits. SWM as an objective of financial management is appropriate and operationally feasible criterion to choose among the alternative financial actions.
Maximizing the shareholders’ economic welfare is equivalent to maximizing the utility of their consumption over time. The wealth created by a company through its actions is reflected in the market value of the company’s shares. Therefore, this principle implies that the fundamental objective of a firm is to maximize the market value of its shares. The market price, which represents the value of a company’s shares, reflects shareholders’ perception about the quality of the company’s financial decisions. Thus, the market price serves as the company’s performance indicator.
In such a case, the financial manager must know or at least assume the factors that influence the market price of shares. Innumerable factors influence the price of a share and these factors change frequently. Moreover, the factors vary across companies. Thus, it is challenging for the manager to determine these factors.
Differences between Profit Maximization and Wealth Maximization:
- The process through which the company is capable of increasing is earning capacity is known as Profit Maximization. On the other hand, the ability of the company in increasing the value of its stock in the market is known as wealth maximization.
- Profit maximization is a short term objective of the firm while long term objective is Wealth Maximization.
- Profit Maximization ignores risk and uncertainty. Unlike Wealth Maximization, which considers both?
- Profit Maximization avoids time value of money, but Wealth Maximization recognizes it.
- Profit Maximization is necessary for the survival and growth of the enterprise. Conversely, Wealth Maximization accelerates the growth rate of the enterprise and aims at attaining maximum market share of the economy
Types of risk
In finance, different types of risk can be classified under two main groups, viz.,
- Systematic risk.
- Unsystematic risk.
The meaning of systematic and unsystematic risk in finance:
- Systematic risk is uncontrollable by an organization and macro in nature.
- Unsystematic risk is controllable by an organization and micro in nature.
A. Systematic Risk
Systematic risk is due to the influence of external factors on an organization. Such factors are normally uncontrollable from an organization's point of view.
It is a macro in nature as it affects a large number of organizations operating under a similar stream or same domain. It cannot be planned by the organization.
The types of systematic risk are depicted and listed below.
- Price risk arises due to the possibility that the price of the shares, commodity, investment, etc. may decline or fall in the future.
- Reinvestment rate risk results from fact that the interest or dividend earned from an investment can't be reinvested with the same rate of return as it was acquiring earlier. 2. Market risk
Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or securities. That is, it arises due to rise or fall in the trading price of listed shares or securities in the stock market.
The types of market risk are depicted and listed below.
- Absolute risk,
- Relative risk,
- Directional risk,
- Non-directional risk,
- Basis risk and
- Volatility risk.
The meaning of different types of market risk is as follows:
- Absolute risk is without any content. For e.g., if a coin is tossed, there is fifty percentage chance of getting a head and vice-versa.
- Relative risk is the assessment or evaluation of risk at different levels of business functions. For e.g. a relative-risk from a foreign exchange fluctuation may be higher if the maximum sales accounted by an organization are of export sales.
- Directional risks are those risks where the loss arises from an exposure to the particular assets of a market. For e.g. an investor holding some shares experience a loss when the market price of those shares falls down.
- Non-Directional risk arises where the method of trading is not consistently followed by the trader. For e.g. the dealer will buy and sell the share simultaneously to mitigate the risk
- Basis risk is due to the possibility of loss arising from imperfectly matched risks. For e.g. the risks which are in offsetting positions in two related but non-identical markets.
- Volatility risk is of a change in the price of securities as a result of changes in the volatility of a risk-factor. For e.g. it applies to the portfolios of derivative instruments, where the volatility of its underlying is a major influence of prices. 3. Purchasing power or inflationary risk
Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates) from the fact that it affects a purchasing power adversely. It is not desirable to invest in securities during an inflationary period.
The types of power or inflationary risk are depicted and listed below.
- Demand inflation risk and
- Cost inflation risk.
The meaning of demand and cost inflation risk is as follows:
- Demand inflation risk arises due to increase in price, which result from an excess of demand over supply. It occurs when supply fails to cope with the demand and hence cannot expand anymore. In other words, demand inflation occurs when production factors are under maximum utilization.
- Asset liquidity risk and
- Funding liquidity risk.
The meaning of asset and funding liquidity risk is as follows:
- Asset liquidity risk is due to losses arising from an inability to sell or pledge assets at, or near, their carrying value when needed. For e.g. assets sold at a lesser value than their book value.
- Funding liquidity risk exists for not having an access to the sufficient-funds to make a payment on time. For e.g. when commitments made to customers are not fulfilled as discussed in the SLA (service level agreements). 2. Financial or credit risk
Financial risk is also known as credit risk. It arises due to change in the capital structure of the organization. The capital structure mainly comprises of three ways by which funds are sourced for the projects. These are as follows:
- Owned funds. For e.g. share capital.
- Borrowed funds. For e.g. loan funds.
- Retained earnings. For e.g. reserve and surplus.
The types of financial or credit risk are depicted and listed below.
- Exchange rate risk,
- Recovery rate risk,
- Credit event risk,
- Non-Directional risk,
- Sovereign risk and
- Settlement risk.
The meaning of types of financial or credit risk is as follows:
- Exchange rate risk is also called as exposure rate risk. It is a form of financial risk that arises from a potential change seen in the exchange rate of one country's currency in relation to another country's currency and vice-versa. For e.g. investors or businesses face it either when they have assets or operations across national borders, or if they have loans or borrowings in a foreign currency.
- Recovery rate risk is an often neglected aspect of a credit-risk analysis. The recovery rate is normally needed to be evaluated. For e.g. the expected recovery rate of the funds tendered (given) as a loan to the customers by banks, non-banking financial companies (NBFC), etc.
- Sovereign risk is associated with the government. Here, a government is unable to meet its loan obligations, reneging (to break a promise) on loans it guarantees, etc.
- Settlement risk exists when counterparty does not deliver a security or its value in cash as per the agreement of trade or business. 3. Operational risk
Operational risks are the business process risks failing due to human errors. This risk will change from industry to industry. It occurs due to breakdowns in the internal procedures, people, policies and systems.
What do you understand by Time value of Money? Illustrate with formula the future value of money in lump sum.
There is no reason for any rational person to delay taking an amount owed to him or her. More than financial principles, this is basic instinct. The money you have in hand at the moment is worth more than the same amount you ‘may’ get in future. One reason for this is inflation and another is possible earning capacity. The fundamental code of finance maintains that, given money can generate interest; the value of a certain sum is more if you receive it sooner. This is why it is called as the present value.
Basically, the time value of money validates that it is more beneficial to have cash now than later. Say, if you invest a Rs. 100 today – the returns will be more compared to the same investment made 2 months from now. Moreover, there is always a risk that the borrower might delay even more or not pay at all in the future.
FV = PV x [ 1 + (I/ N) ] (N*T) Where, FV is Future value of money, PV is Present value of money, I is the interest rate, N is the number of compounding periods annually and T is the number of years in the tenure.
For instance, if you invest Rs. 1 lakh for 5 years at 10% interest, the future value of this one lakh will be Rs. 161,051 as per the formula. This formula can help you to analyze different investments over different time periods, enabling you to make optimal and informed financial decisions.
Double Your Money: The Rule of 72
The Rule of 72 is a quick and simple technique for estimating one of two things:
- the time it takes for a single amount of money to double with a known interest rate, or
- the rate of interest you need to earn for an amount to double within a known time period.
The rule states that an investment or a cost will double when:
[Investment Rate per year as a percent ] x [Number of Years] = 72.
Effective interest rates and nominal interest rates
Nominal interest rate is also defined as a stated interest rate. This interest works according to the simple interest and does not take into account the compounding periods. Effective interest rate is the one which caters the compounding periods during a payment plan. It is used to compare the annual interest between loans with different compounding periods like week, month, year etc.
In general stated or nominal interest rate is less than the effective one. And the later depicts the true picture of financial payments. The nominal interest rate is the periodic interest rate times the number of periods per year.
For example, a nominal annual interest rate of 12% based on monthly compounding means a 1% interest rate per month (compounded). A nominal interest rate for compounding periods less than a year is always lower than the equivalent rate with annual compounding (this immediately follows from elementary algebraic manipulations of the formula for compound interest). Note that a nominal rate without the compounding frequency is not fully defined: for any interest rate, the effective interest rate cannot be specified without knowing the compounding frequency and the rate.
