Sem 1 BBA. IMBA UNIT 1 FIN AC. NATURE. SCOPE. TVM PDF

SCHOOL OF MANAGEMENT IMBA/BBA(Hons.) Semester: I SUBJECT:INTRODUCTION TO FINANCIAL MANAGEMENT UNIT 1: Compiled By: Dr. Niki Sharma 1 Nature and Scope Meaning, Scope Objective Importance...

SCHOOL OF MANAGEMENT IMBA/BBA(Hons.) Semester: I SUBJECT:INTRODUCTION TO FINANCIAL MANAGEMENT UNIT 1: Compiled By: Dr. Niki Sharma 1 Nature and Scope Meaning, Scope Objective Importance Finance Function (Traditional Vs Modern) Function of Financial Manager Time Value of Money Introduction Factors affecting time value of money Compound value, Present Value Practical Application 2 Contents Introduction to Financial Management.................................................................................. 4 Introduction..................................................................................................................... 4 Meaning, Scope of Financial Management....................................................................... 4 OBJECTIVES OF FINANCIAL MANAGEMENT :....................................................... 5 Importance of Financial Management.............................................................................. 7 Finance Function (Traditional Vs Modern)...................................................................... 9 Function of Financial Manager...................................................................................... 10 Time Value of Money......................................................................................................... 11 Introduction................................................................................................................... 11 Factors affecting time value of money........................................................................... 13 Techniques of time value of Money............................................................................... 14 Practical Sums.................................................................................................................... 15 THEORY QUESTIONS...................................................................................................... 17 MULTIPLE CHOICE QUESTIONS (MCQ'S).................................................................... 17 3 Introduction to Financial Management Introduction If we observe any business organization, small or big, we find people doing different activities in it. These people are carrying out various activities like: Managing the activities related to manufacturing of goods or providing services, Managing the people involved in various works of the organization, Selling different products that are manufactured or the services being offered by the organization, or Arranging and making available required financial resources for carrying out the activities of the firm. All these activities are managed by a couple of people in a small business organization, and by differently specialized people in large organizations. In big organizations, these activities are divided into different functional departments, called, the production department, human resource department, marketing department, and finance department. In other words, different people involved in large business organizations have been divided and classified into different groups and perform different functions of management. Finance is the lifeblood of any business and one of common denominator required for all the varied business activities. It must be sufficient to meet the requirements of the company. One needs outstanding financial management skills to start or run a successful firm. Every business concern must keep a sufficient amount of cash in hand to ensure smooth operations and to run the business to meet the company's objectives. We cannot overlook the utility of funds at any moment or in any circumstance. Thereafter, the finance department is one of the most crucial components of every corporation. As a result, it is necessary to understand what financial management is and why it is vital. The activities of every aspect of a business have an impact on the performance of the business and must be evaluated and controlled. Meaning, Scope of Financial Management In simple words, financial management means raising of adequate funds at the minimum cost and using them effectively in business. In other words, financial management is concerned with the financial problems of the business organisation. It is concerned with the problems of 4 raising finance to establish, expand and modernise business unit, the problems of providing fixed and working capital, the problem of distribution of income etc. Some of notable definitions of financial management are as follows: (i) Hoagland says 'Financial management is concerned mainly with such matters as, how a business corporation raises its finance and how it makes use of it'. (ii) According to Soloman "Financial Management is concerned with the efficient use of an important economic resource, namely, Capital Funds.". (iii) Phillippatus has given a more detailed definition. According to him, "Financial management is concerned with the managerial decisions that result into the acquisition and financing of long term and short term credits for the firm. As such it deals with the situations that require selection of specific assets (or combination of assets), the selection of specific liability (or combination of liabilities) as well as the problem of size and growth of an enterprise. The analysis of these decisions are based on the expected inflows and outflows of funds and their effects upon managerial objectives." Thus, financial management does not stop at procuring the required finance. It has also to see that it is effectively utilised in business. It is concerned with maintaining adequate funds on hand to meet the expenses of both revenue and capital nature. It has to manage the finances in such a way that the goal of business, say, profit maximisation, is realised. Objectives of Financial Management : The firm has to take investment and financing decisions on a continuous basis. To make optimum and wise decisions, a clear understanding of the objectives is a must. There are two widely-discussed approaches regarding objectives of financial management. (A) Profit Maximisation Approach (B) Wealth Maximisation Approach The objective is used in the sense of a goal or decision criterion for the decisions involved in financial management. (A) Profit Maximisation Approach: Economists believe for a long time that earning maximum profit is the sole aim of any business organisation, because that will lead to optimum allocation of resources also. Actions 5 that increase the firm's profits are undertaken and those that decrease profit are avoided. Thus, from the perspective of economic theory, profit maximisation is simply a criterion of economic efficiency. As Soloman and Pringle have put it "There is also broad agreement that under perfect competition, where all prices accurately reflect true values and consumers are well informed, profit maximising behaviour by firms leads to an efficient allocation of resources and maximum social welfare". The rationale behind profit maximisation objective is simple. A business firm is a profit seeking organisation. Profit is a test of economic efficiency. It is assumed to lead to efficient allocation of resources. It ensures maximum social welfare. Limitations of Profit Maximisation Objective: (1) The Concept of profit is vague: The definition of the term profit is vague and ambiguous. Does it refer to gross profit or profit after tax? Total profit or profit per share? Profit is interpreted by different persons in different ways. (2) It ignores time value of money: 'The fact that a rupee received today is of more value than a rupee received later. This concept is ignored leading to mistakes in decision making. (3) It ignores risk: 'The future benefits may possess different degrees of certainty. The more certain the expected return, the higher is its value or conversely the more uncertain is the expected return, the lower is its value." This concept is also totally ignored. It ranks the two proposals involving different degrees of risk equally. (4) Soloman and Pringle stated, "a system based on private ownership and profit maximisation might be efficient, but it leads to serious inequality of income and wealth among different groups. Of course, the counter argument is that society as a whole is clearly better off, as it leads to optimum allocation of society's resources." (B) Wealth Maximisation or Net Worth Maximisation: It means maximisation of net worth of the shareholders. It is also known as Maximisation Approach. When a financial decision is to be taken to invest money in some project, the 6 project must be so selected that the present value of cash flow received from it exceeds the present value of cash outflow to be invested. Thus net present worth of a course of action is the difference between the present value of all cash inflows and the present value of all cash outflows. A course of action means some action taken in which funds are invested e.g. a new machine is installed to replace manual labour. This is a course of action or a project in which money is invested. If the project gives more cash flow than cash invested, then it can be said that it increases net worth of shareholders. It increases value of shares of the company. As Prof. I. M. Pandey has written, "The wealth maximisation principle implies that the fundamental objective of a firm should be to maximise the market value of its shares. The value of the company's shares is represented by their market price, which in turn, is a reflection of the firm's financial decisions. The market price serves as the firm's performance indicator." A decision which maximises net present worth also maximises shareholders' wealth. A decision which results into negative net present worth will reduce shareholders' wealth and so such decisions are not to be accepted. This objective of maximisation of shareholders' wealth also takes care of all the three limitations of profit maximisation objective. (i) It is clear: Since cash flows and not profits are taken for finding out net present worth, there is no confusion in using the term cash flow, as it is in case of profit. (ii) It considers time value of money by discounting appropriately the future cashflows. Here present value of cash inflows and present value of cash outflows are taken into account. (iii) It considers risk element for evaluation : The future cash flows are discounted by a rate higher or lower depending upon the uncertainty associated with it. Hence Net Present Value of cash flows with more uncertainty will automatically be reduced when discounting is done at rate higher or lower according to the degree of risk involved. Importance of Financial Management Needless to say that without adequate finance, no business can succeed. It is easy to imagine the plight of the management which due to insufficiency of finance cannot make payment for raw materials and wages on time. It is not possible to avail of the opportunities if adequate 7 finance is not available. The significance of financial management will be clear from the following discussion: (1) Success of Promotion: The success or otherwise of a company can be guessed on the basis of its financial plan. If the plan is defective, it will fail to provide sufficient funds to meet the requirements of both fixed and working capital. Undue optimism of the framers of financial plan will lead to overcapitalisation. A larger amount of finance than can be absorbed in business will result into low profit and low rate of return on capital invested. In that case, the business is bound to fail. (2) Smooth Running of the Enterprise: Finance is required at each stage of an enterprise. Working capital is required for meeting day to day expenses. A defective financial plan can put the business in jeopardy. Funds are needed to purchase machines and materials, to pay wages and salaries, and even for sales activities. Money is required for advertisement, for payment of salaries of sales force and also for various selling and distribution expenses. The management will be constantly worrying. if the financial planning is defective. (3) Finance for Expansion: Finance is required for schemes of modernisation, expansion and development of the existing enterprises. How to meet this requirement is one of the major problems of the financial management. A prudent financial planning will provide the finance required for this purpose from retained profits of the enterprise and, if need be, from outside sources at a reasonable cost. (4) Cash Planning: Among the factors on which depends the success of a business enterprise, liquidity is most important. An optimist business organiser indulging in rosy dreams of success of his business will lead his business to failure, if he ignores the importance of liquidity... Here is an interesting example underlining the importance of liquidity in business. A plumber undertook to provide the plumbing for 150 new residences on the outskirts of a city. One of the conditions of the contract was that no contractor would be paid until the building had been completed and satisfied the requirements of the Federal Housing Authority. This contract offered substantial profit opportunities, the contractor was skilled in plumbing trade, but the cash requirements were beyond his available resources. By the time he had completed most of the job, he had tapped all available financing methods, even his house was mortgaged. His employees also donated their services for a period of three weeks without 8 pay. But in the end, his estate had to be taken over by the courts, because of inability to meet obligations. This example shows very clearly how a defective cash planning can play havoc in spite of having skill and profitable opportunities to earn handsome profit. Finance Function (Traditional Vs Modern) Traditional Approach Modern Approach 1. Finance function means raising of finance 1. Finance function means the function of for business. That is, to procure funds when raising finance as also of utilising it most needed from the most advantageous sources. effectively for business. That is, the financial The function of efficient utilisation of funds manager has also to decide- how to invest the is ignored under this approach. funds available to him. 2. The traditional approach concentrates on 2. The modern approach deals with the the problem of finance of joint stock problem of finance of all types of business companies only. The non-corporate business units. It suggests the principles and units are not taken into consideration. procedures applicable to sole proprietors, partnership firms, cooperatives and companies. 3. It considers the sources of long term only. 3. It gives importance to both types of It assumes that there are no problems financial problems. The problems of long pertaining to working capital management. term finance as well as those of working capital are included in the scope of finance function. 4. It observes the finance function from the 4. The finance function is examined from the angle of consideration to business, such as view- point of insiders and outsiders both. In investors, creditors, financial institutions etc., fact the view point of insiders is given same where as the view point of insiders, that is the importance as that of the outsiders. This financial decision makers who deal with means, that it examines not only the problem finance problems daily in business are of procurement of finance but the problem of ignored. its efficient utilisation also. 9 5. It represents an episodic approach which 5. The modern approach is all inclusive. It assumes that finance function is basically the takes into consideration the requirements of function of raising funds on such events as finance arising during major events as also promotion, reorganisation and liquidation of during the routine operation of the business the business enterprise. from day to day. 6. It represents a narrow view of finance 6. It represents the most practical and function as it takes into account only one realistic approach as it covers all aspects of aspect of it. finance function. Function of Financial Manager The following are some of the responsibilities of the finance manager of a company: To estimate capital requirements for various projects and offers to fund for them. To maintain liquidity and solvency to fulfill short-term and long-term obligations. To keep in contact with the stock exchanges, stockholders, bankers, and financial institutions. To estimate the risk and propose alternative risk-reduction strategies. To take established practices into account while deciding on credit policy. To report to external agencies, viz., financial institutions, tax authorities, government, etc. To meet numerous duties under various laws, such as tax laws, SEBI, and so on. To arrange for an internal audit to be carried out to ensure that suitable checks and controls are in place. To decide the dividend policy of the company. All of the aforementioned responsibilities are expected to be carried out by the financial manager, within the confines of the applicable legislation, to maximise shareholder wealth. 10 Time Value of Money Introduction The concept of time value of money implies that the value of money depends on the time when it is received. The value of a certain amount of money received earlier is higher than that of money received after a longer period of time. For instance the value of Rs. 100 available today is greater than Rs. 100 available after a year because at 10% rate of interest, today's Rs. 100 will grow to Rs. 110 after one year. Anybody would accept that if we are given a choice between Rs. 100 today and Rs. 100 after a year, we will prefer to take Rs. 100 today. This is because Rs. 100 at present has a greater time value than Rs. 100 after a year. If the current rate of interest is 10 per cent per annum, Rs. 100 will grow to Rs. 110 after one year. Thus, money also has time-value. The compounded value and discounted cash flow methods recognise the time value of money. We must calculate the present value of money that we are to receive in future. For instance, at 10 per cent rate of interest, the present value of Rs. 100 available after a year is 90.91. At the same rate of interest, the present value of Rs. 100 available after 2 years will be Rs. 82.65. This will be clear from the following: Cash on hand on 1-1-2012 Rs. 82.65 + 10% interest for the year 2012 + 8.26 Value at the end of the year 2012 Rs. 90.91 + 10% interest for the year 2013 9.09 Total amount on 1-1-2014 100.00 It follows that at 10% compound rate of interest. Rs. 82.65 grows into Rs. 100 after 2 years. To put the same in other words, Rs. 82.65 is the present value of Rs. 100 available after 2 years. Two things are essential to find out the present value of any amount of money. First, at what rate to discount it. Second, when will it be available, i.e. rate of discount and time period. Naturally, that investment will be most advisable which gives more income within the shortest period of time. The following formula can be used to find out the present value of income available in future: P.V.=E /(1+r)" 11 where r rate of interest n = number of years E future earnings For example, Rs. 100 is available after 2 years. Its present value at 10% rate of discount will be as follows: Present Value = 100 (1+0.1) 100 1.21 = = 82.65 The easy way to calculate present value is to use calculator. If the rate of discount is 10% then put 1 in numerator and 110 in denominator. Then press the button % in calculator two times and we get present value of Re. 1 for 2 years. If we want to find out P.V. for 5 years, press the % button of calculator five times. Readymade tables are available showing present value of a rupee for different time periods and at different rates of interest. For instance, Rs. 1,000 is receivable after 5 years. What will be its present value at 8% rate of interest? The table shows that at 8% rate of interest, present value of a rupee receivable after 5 years is Rs. 0.681: Rs. 1000 x 0.681 Rs. 681. Thus, at 8% rate of discount, the present value of Rs. 1,000 receivable, after 5 years is Rs. 681. We have seen that an individual will prefer to have money at present than at a future point of time. It means. (i) that a person will have to pay in future more for a rupee received today. This concept is compound value concept. (ii) A person will accept something less for a rupee today for an amount to be received in future. This is called present value concept. We can say clearly that the value of a sum of money received today is more than value of the same sum received at a later date. In other words, future cash flows are less valuable because 12 of the investment opportunities of the present cash flows. A rational person always values the opportunity to receive money now than waiting for one or more years, to receive the same amount. It is said, "A bird in hand is worth two in bush.." Money has time value due to following reasons: (1) Individuals generally prefer current consumption. (2) An investor can profitably employ a rupee received today to give him a higher value to be received after a certain period. (3) In an inflationary economy, the money received today has more ( purchasing power than the same sum of money to be received in future. Factors affecting time value of money Three reasons may be attributed to the individual's time preference for money: (1) Risk (2) Preference for current consumption (3) Investment opportunities Future is uncertain. As an individual is not very certain about future cash receipts, he prefers receiving cash now. What is available at present is preferable to what may be available in the future. The more distant the future is, the more uncertain it is likely to be. Most people have subjective preference for present consumption over future consumption of goods and services because of the risk of not being in a position to enjoy future consumption that may be caused by illness or death. The main reason for time preference for money is to be found in reinvestment opportunities for the funds which are received early. The funds received earlier can earn a rate of return, which would not be possible if they are received at a later date. The time value of money is therefore generally expressed in terms of a rate of return or more popularly as a discount rate. 13  Techniques of time value of Money All time value of money problems involve two fundamental techniques: 1. Compounding i. Future Value of Single Amount F= P(1+ r)n ii. Future Value of an annuity (𝟏+𝒓)𝒏 −𝟏 F =P 𝒓 2. Discounting. i. Present Value of Single Amount 𝑭 P= (𝟏+𝒓 )𝒏 ii. Present Value of Single Annuity (𝟏+𝒓)𝒏 −𝟏 P=F 𝒓(𝟏+𝒓)𝒏 Compounding and discounting is a process used to compare dollars in our pocket today versus dollars we have to wait to receive at some time in the future. 14 Practical Sums Sum 1 What Amount will amount to Rs. 10000 in 3 years at 12% compounded interest per annum? 1. Compounding is done annually 2. Compounding is done semi annually 3. Compounding is done quarterly. Ans:1. Rs. 14050 2. Rs.14185 3. RS. 14260 Sum 2 Find in How many years RS. 30000 will become Rs. 60000 at 5% compound Interest. Ans : 15 years Sum 3 What sum of money invested a4 4% p.a. Compound interest for 18 years will amount to RS.50000? Ans : Rs. 24680 Sum 4 Find the amount that Rs. 10000 will become after 20 years at compound interest at 5% calculated annually. Ans: Rs. 26530 Sum 5 Determine the present value of RS. 1000 paid at the end of each year from the 10 th year to 25th year. Assume 10% rate of interest. Ans: Rs. 3318 Sum 6 An Investor has two option to choose from 15  (A) Rs. 9000 after 4 years (B) Rs. 2000 every year for 4 years Asssuming a discount rate of 10%, which alternative should he opt for? Ans: Alternative 1 =9000*0.683 = 6147 Alternative 2 =2000*3.170 6340 Sum 7 An investor is likely to retire at the end of 10th year. In order to receive RS 200000 annually for 10 years after retirement, how much amount should he have at the time of retirement. Assume the required rate of retirement. Assume the required rate of return to be 10 %. Ans : =200000*6.1446 =12,28,930 Sum 8 A man borrowed Rs. 300000 from state bank of India to finance the purchase of a car for 15 years. Assuming the rate of interest on such loans at 12% per annum, find out the amount of annual installment Answer: To find out the installment amount, present value of all installments must be equal to the amount of loan taken: Hence If x be the amount of installments paid, then X*PVIFA=300000 X*6.811=300000 16 X=44046 Sum 9 Compute the present value of a perpetuity of Rs. 100 per year, if the discount rate is 10% Ans: Present Value of a perpectuity =A/i Hence, PV= 100/0.10 =Rs. 1000 Sum 10 Compute the present value of Rs. 100 a perpetuity of per year to be received from the end of third year, if the discount rate is 10 percent. Answer: Present value at the end of second year = perpetuity of RS. 100 from third year onwards. =100/0.1 Rs.1000 Present Value today (year-0)= 1000 *0.826 =Rs. 826 THEORY QUESTIONS Q.1. Briefly explain the concept of time value of money. Q. 2. Explain the concept of compounding and discounting in brief. MULTIPLE CHOICE QUESTIONS (MCQ'S) 1. Compound interest is calculated on: (a) Principal amount (b) Interest amount (c) Principal amount + interest amount (d) Installment amount 17 2. As per the concept of "Time value of money", the value of money (a) is higher in later years than in earlier years. (b) is higher in earlier years than in later years. (c) is equal in all the years. (d) None of the above. 3. Compound interest is calculated on: (a) Principal amount only (b) Interest amount (c) Time value of money (d) None of these 4. While evaluating capital investment proposals, the time value of money is considered in case of: (a) Pay-back method (b) Discounted cash flow method (c) ARR method (d) None of these 5. To increase a given present value, the discount rate should be adjusted: (a) Downward (b) Upward (c) No adjustments (d) None of these 6. Both the future and present value of a sum of money are based on: (a) Interest rate (b) Number of time period 18 (c) Both a and b (d) None of these 7. An anuity is: (a) A series of unequal but consecutive payments (b) A series of equal but consecutive payments (c) A series of equal but non-consecutive payments (d) More than one payment ANSWERS 1. (c); 2. (b); 3. (d); 4. (b); 5. (a); 6. (d); 7. (b). *********************************************************** 19