Basic Finance Functions for a company to make decision

Syllabus
CORPORATE FINANCE
The students need Discounting Table and Annuity tables for the examination.
Course Objective: To understand the basic decisions taken by a finance manager in a Corporate. FM helps in understanding the use of
resources efficiently, effectively and economically.
Course Outcome: Students will be able to understand a) Goals of financial function b) Investment criteria and decision process c) capital
structure and Dividend Decisions d) Asset Liability management
UNIT- I: The Finance Function: Nature and Scope; Evolution of finance function – Its new role in the contemporary
scenario –Goals of finance function – maximizing vs. satisfying; Profit vs. Wealth vs. Welfare; the Agency relationship and
costs; Risk-Return trade off; Concept of Time Value of Money – Future Value and Present value.
UNIT - II: The Investment Decision: Investment decision process- Project generation, project evaluation, project selection
and project Implementation. Developing Cash Flow; Data for New Projects; Capital Budgeting Techniques –Traditional and
DCF methods. The NPV vs. IRR Debate; Approaches for reconciliation. Capital budgeting decision under conditions of risk
and uncertainty. Cost Of Capital: Concept and measurement of cost of capital, Debt vs. Equity, cost of equity, preference
shares, equity capital and retained earnings, weighted average cost of capital and marginal cost of capital. Importance of
cost of capital in capital budgeting decisions.

UNIT- III: Capital Structure and Dividend Decisions: Capital structure vs. financial structure - Capitalization, financial
leverage, operating leverage and composite leverage. EBIT-EPS Analysis, Indifference Point/Break even analysis of
financial leverage, Capital structure Theories –The Modigliani Miller Theory, NI, NOI Theory and Traditional Theory –A
critical appraisal.
Dividend Decisions: Dividends and value of the firm - Relevance of dividends, the MM hypothesis, Factors determining
Dividend Policy - dividends and valuation of the firm - the basic models – forms of dividend. Declaration and payment of
dividends. Bonus shares, Rights issue, share-splits, Major forms of dividends – Cash and Bonus shares. Dividends and
valuation; Major theories centered on the works of Gordon, Walter and Lintner. A brief discussion on dividend policies of
Indian companies.
UNIT- IV: Working Capital Management and Finance: Working Capital Management: Components of working capital,
gross vs. net working capital, determinants of working capital needs, the operating cycle approach. Planning of working
capital, Financing of working capital through Bank finance and Trade Credit, regulation of bank finance.
UNIT - V: Management of Current Assets: Management of cash – Basic strategies for cash management, cash
planning, cash budget, cash management techniques/processes. Marketable securities: characteristics, selection
criterion, Management of receivables- Credit policy, credit evaluation of individual accounts, monitoring receivables,
Management of inventory- Inventory management process, Inventory control systems, analysis of investment in
inventory.

Suggested Readings:
•I M Pandey, Financial Management, 11 e, Vikas Publications , 2015.
•M.Y Khan, P K Jain, Financial Management-Text and Problems, TMH,
2015.
•James C Van Horne, Sanjay Dhamija, Financial Management and
Policy, Pearson Education, New Delhi.
•Eugene F.Brigham Michael C. Ehrhardt, Financial Management,
Cengage Learning, 12e, 2012.
•Arindam Banerjee, Financial Management, Oxford Publications, 2016.
•Rajesh Kothari, Financial Management A contemporary Approach,
Sage publications, 2017.

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

Finance Function
• The finance function refers to practices and activities directed to
manage business finances. The functions are oriented toward acquiring
and managing financial resources to generate profit. The financial
resources and information optimized by these functions contribute to
the productivity of other business functions, planning, and decision-
making activities.
• Among various functions of business, financial functions are one of
the most significant functions. It is all the business activities. This
function of a business cannot be ignored, substituted or the lack of
finance may prove to be disastrous for a business enterprise and may
lead to its closure. The demand for finance is ongoing and
uninterrupted during the entire lifetime of a company.

Definition
• According to Howard and Upton, “Finance may be defined as that
administrative area or set of administrative functions in an
organisation which relates with the arrangement of each and credit so
that the organisation may have the means to carry out the objectives as
satisfactorily as possible”.
• As per F.W. Paish, “Finance may be defined as the position of money
at the time it is wanted”.
• According to John J. Hampton, “The term finance can be defined as
the management of the flows of money through an organisation,
whether it will be a corporation, school, bank or government agency”.

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

Nature of Finance Function
A few salient features of the finance function are mentioned below:
• 1) The Finance function is mostly integrated and centralized in every business
organization, as it brings forth cost advantages to the company.
• 2) Irrespective of size, nature, and legal status, every organization has a finance
function, as it puts across certain amount of control on other activities and
functions of the organization.
• 3) Finance functions help in managerial decision making, through the analysis and
interpretation of financial data.
• 4) The finance function is interrelated to other primary functions of business as
well, such as human resources, marketing, production planning, etc. These
functions are very much dependent on finance and are affected by external factors
of the environment.
• 5) Finance and its related activities play a very significant role in the long-term
survival and growth of the organization.
• 6) Basically, “Valuation of a Firm” is one of the important aspects of the finance
function.

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

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)

Traditional Phase
• In the traditional phase the focus of financial management was on
certain events which required funds e.g., major expansion, merger,
reorganization etc.
• The traditional phase was also characterized by heavy emphasis on
legal and procedural aspects as at that point of time the functioning of
companies was regulated by a plethora of legislation.
• Another striking characteristic of the traditional phase was that, a
financial management was designed and practiced from the outsiders
point of view mainly those of investment bankers, lenders, regulatory
agencies and other outside interests.

Transition Phase
• During the transitional phase the nature of financial management was the same but
more emphasis was laid on problems faced by finance managers in the areas of
fund analysis planning and control.
The modern phase is characterised by the application of economic theories and the
application of quantitative methods of analysis. The distinctive features of the
modern phase are:
• Changes in macro economic situation that has broadened the scope of financial
management. The core focus is how on the rational matching of funds to their uses
in the light of the decision criteria.
• The advances in mathematics and statistics have been applied to financial
management specially in the areas of financial modeling, demand forecasting and
risk analysis.
Modern Phase

New Role of Finance Function in the
Contemporary Scenario
• Continuous Focus on Margins and Ensure that the organisation stays
committed to value creating
• Work across the functional, divide the company and exhibit leadership skills
• Understand what’s driving the numbers and provide operation insights,
including a sense of external market issues and internal operating trends,
and become key strategy player
• Aware and use the highly innovative financial instruments
• Know the emergence of capital market as central stage for raising money
• Adding more value to the business through innovations in impacting human
capital

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

Objectives of Finance Function
• ensure adequate and regular supply of funds to the business,
• provide a fair rate of return to the suppliers of capital,
• ensure efficient utilization of capital according to the principles of
profitability, liquidity and safety,
• devise a definite system for internal investment and financing,
• minimize cost of capital by developing a sound and economical
combination of corporate securities,
• co-ordinate the activities of the finance department with the activities
of other departments of the organization.

Goals of Finance Decisions
• Profit Maximization
• Wealth Maximization

Profit Maximization
• The basic objective of every business enterprise is the welfare of its
owners. It can be achieved by the maximisation of profits.
• Therefore, according to this criterion, the financial decisions
(investment, financing and dividend) of a firm should be oriented to
the maximisation of profits (i.e. select those assets, projects and
decisions which are profitable and reject those which are not
profitable).
• In other words, actions that increase profits are be undertaken and
those that decrease profits are to be avoided.

Profit maximization as an objective of financial
management can be justified on the following grounds:
• 1) Rational
• 2) Test of Business Performance
• 3) Main Source of Inspiration
• 4) Maximum Social Welfare
• 5) Basis of Decision-Making

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

Wealth Maximization
• The objective of profit maximization, as discussed above, is not only
vague and ambiguous, but it also ignores the two basic criteria of
financial management i.e.
• risk and
• time value of money.
• Therefore, wealth maximisation is taken as the basic objective of
financial management, rather than profit maximisation.
• It is also known as ‘Value Maximisation’ or ‘Net Present Value
Maximisation’.
• According to Ezra Soloman of Stanford University, the ultimate objective
of financial management should be the maximisation of wealth.
• Prof. Irwin Friend has also supported this view.

Contdd..
• Wealth Maximisation means to maximize the net
present value (or wealth) (NPV) of a course of action.
• It NPV is the difference between the gross present
value of the benefits of that action and the amount of
investment required to achieve those benefits.
• The gross present value of a course of action is
calculated by discounting or capitalising its benefits at
a rate which reflects their timings and uncertainty

Maximising Vs Satisfying
•The objective of management has been deemed
to be primarily one of maximising shareholders
wealth. Howeever in practice a distinction must
be made between maximising and satisfying
•Maximising – Seeking the best possible outcome
•Satisfying – Finding a merely adequate outcome

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

Agency Relationship
• When firms are small they usually function as sole proprietorship firms or
partnership firms where owner/partners make the decisions.
• As the volume and complexity of business increases the sole proprietorship
partnership firms convert themselves into public limited companies or joint stock
companies.
• With increased geographical spread and other complexities often it is not possible
for owners to look after all the aspects of the business.
• The decision making power is delegated to the managers (agents).
• An agent is a person who acts for, and exerts power on behalf of another person or
group of persons.
• The person (or group of persons) whom the agent represents is referred to as the
principal.
• The relationship between the agent and the principal is an agency relationship.
• There is an agency relationship between the managers and shareholders of a
company.

Problems Related with Agency Relationship
• In an agency relationship the agent is charged with the responsibility of acting for the
principal and in the best interest of the principal. But, it is possible that the agent may act
in a fashion which serves his/her own self-interest rather than that of the principal.
• In recent years we have witnessed numerous corporate frauds i.e. Enron, Xerox, etc.,
where the agents had misappropriated the authority vested in them by the principal.
• The problems associated with agency relationship can manifest itself in many ways.
• The most common being the misuse of power and authority by the managers, which
includes financial misappropriation, using the funds of the company for the personal self
(fringe benefits) etc.
• In case the reward and compensations are based on certain parameters, for example sales;
managers may indulge in practices which would yield result in the short run but prove
detrimental in the long run, i.e., overstocking the various intermediaries in the supply
chain, offering huge discounts, dumping of goods in the territory of another manager etc.
• Another facet of this problem is, where managers put a little effort towards expanding and
exploring the market for new business.
• In a nutshell the problems with agency relationship is that the managers act in a fashion
which serves their own interest rather than that of the shareholders.

Costs of the Agency Relationship
• In order to minimize the potential for conflict between the principal’s interest
and the agent’s interest certain costs are to be incurred by the principal as well
as the agent and the cumulative effect of these costs is referred to as the agency
costs.
• Agency costs are of three types: monitoring costs, bonding costs and residual
cost.
• Monitoring Costs
• These are the costs incurred by the principal to monitor and limit the actions of the agent. In
companies the shareholders may require the managers to periodically report on their activities via
audited financial statements. The cost of resources spent on preparing these statements is
monitoring cost. Another example is the implicit cost incurred when the principal limits the
decision making power of the agent; by doing so, the principal may miss profitable investment
opportunities. The foregone profit is the monitoring cost.
• Bonding Costs
• These are the costs incurred by the agents to assure the principal that they will act in the best
interest of the principal.
• Residual Costs
• Residual costs is the remaining costs after taking into consideration of the above costs (i.e.,
monitoring costs, bonding costs).

Risk and Return Trade off
• Risk-return trade-off means that with an increase in the
potential return, the risk also increases. Every
individual invests in the stock market by following a
strategy to achieve short-term or long-term investment
goals. Earning profits comes with a set of risks, which
every investor has to factor into their strategy.
• As per most investors, risk exposure directly affects
the profit potential for every investment instrument.
They believe that with higher risk comes opportunities
for higher profits. Let us understand what is a risk-
return trade-off.

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

Time value of Money
• The time value of money is the concept that the sum of the
money is now worth more than the same sum will be at a
future date due to its earning potential in the interval.
• Time value of money is based on a simple principle that a
rupee received today has a greater value than a rupee received
in future.
• The time value of money is a crucial concept because if an
individual invests a sum of money it can grow over a period
of time. Investing in a savings account is an even better idea
to earn compound interest.

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

Present Value
• Present value is the value of money you held
today. It also presents the value of the sum of
all future cash flow from an investment. The
future cash flow is discounted at a discount rate.
A lower discount rate suggests a higher present
value of the future cash flow and vice versa.
Future Value
• Future value is the value of an investment at the
end of the investment duration. Usually, it is
expected that future value should be greater
than that of present value because it grows over
time and earns interest. So, for example, you
can determine the future value for round-sum
investments and recurring investments like
SIPs.

Importance of Time Value of Money(TVM)
• The time value of money is important because it helps investors and people to save more
for retirement and determine how to get the most out of their dollars. This concept is
fundamental to financial literacy and applies to your savings, purchasing power, and
investment.
• The time value of money helps investors make the best investment decisions, knowing the
future returns they should expect from what they invest.
• The money also loses its value over time, due to inflation affecting the buying power of
the public.
• The future is always unclear. Therefore, the best financial decisions can be taken with the
time value of money.
• TVM is an important area that one should know if you are associated with the field
of finance especially when you are dealing with loans, capital budgeting, investment
analysis, and other finance-related decisions. It is a fundamental building block on which
the entire finance is built upon.
• In financial decisions, the time value of money holds great importance. It is the most
crucial principle in finance and economics now because all investment decisions and
other financial decisions are made solely on the basis of what and how much they will get
in return from such decisions.

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.

Basic Finance Functions for a company to make decision

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