Fundamental of Financial Management PDF

Fundamental of Financial Management 14-BAE254-2C Mr. Soyabkhan Baloch Assistant Professor BBA - SSBPIBM 7/2/2024  What is Finance? Finance is the study of currency, money, capital markets and investment that is related to the study of econ...

Fundamental of Financial Management 14-BAE254-2C Mr. Soyabkhan Baloch Assistant Professor BBA - SSBPIBM 7/2/2024  What is Finance? Finance is the study of currency, money, capital markets and investment that is related to the study of economics. It is the management of money which includes different activities like - investment, saving, borrowing, budgeting, accounting, etc. Finance is a very important subject that ensures the stability of economies, banking systems, financial markets, businesses and individuals. Without proper financial planning, business would become inoperable since they can face the lack of capital for crucial business operations.  Scope of Financial Management The scope and functions of financial management is classified in two categories. 1. Traditional approach 2. Modern approach. Traditional approach According to this approach, the scope of the finance function is restricted to “procurement of funds” by corporate enterprise to meet their financial needs. The term ‘procurement’ refers to raising of funds externally as well as the inter related aspects of raising funds. The inter related aspects are the institutional arrangement for finance, financial instruments through which funds are raised and legal and accounting aspects between the firm and its sources of funds. In traditional approach the resources could be raised from the combination of the available sources.  Limitations of traditional approach This approach is confirmed to ‘procurement of funds’ only. It fails to consider an important aspects i.e. allocation of funds. It deals with only outside I.e. investors, investment bankers. The internal decision making is completely ignored in this approach. The traditional approach fails to consider the problems involved in working capital management. The traditional approach neglected the issues relating to the allocation and management of funds and failed to make financial decisions. Modern approach The modern approach is an analytical way of looking into financial problems of the firm. According to this approach, the finance function covers both acquisition of funds as well as the allocation of funds to various uses. Financial management is concerned with the issues involved in raising of funds and efficient and wise allocation of funds Main Contents of Modern approach How large should an enterprise be and how far it should grow? In what form should it hold its assets? How should the funds required be raised? - Financial management is concerned with finding answer to the above problems. Functions of Finance There are three finance functions Investment decision Financing decision Dividend decision  What is the Financial Decision? The Financial Decision is a crucial decision that is to be made by the financial manager, the decision is about the financing-mix of an organization. Financing Decision is focused on the borrowing and allocation of funds required for the investment decisions of the firm. The financing decision comes from two sources from where the funds can be raised – 1. Company’s own money, such as the share capital, retained earnings. 2. Borrowing funds from the outside the corporate in the form debenture, loan, bond, etc. The objective of the financial decision is to balance an optimum capital structure.  Importance of Financial Decision Making 1. Long-term Growth and Effect: Financial decisions are concerned with the long-term use of assets. These assets are very helpful in the process of production. Profit is also earned by selling the goods that are produced. This can, therefore, be accurate decisions. The greater the growth of business in the long run, the more effective the decision needs to be. In addition to that, these affect the future prospect of the business. 2. Large Amount of Funds Involved: Funds are the base of this business decision. Decisions regarding the fixed assets are included in the context of capital budgeting. Huge capital is invested in these assets. If these decisions turn out to be a wrong, then it will cause heavy loss of capital which is indeed a scarce resource. 3. Risk Involved: Capital budgeting decisions come with risks. There are two reasons for the risk factor to be involved in it. First, these decisions are analysed for a long period, and thus the expected profits for several years are to be anticipated which even lead to fluctuations. These are human estimations which may turn out to be wrong. Secondly, as a heavy investment is involved, it is very difficult to change the decision once it has been taken. 4. Irreversible Decisions: Nature of these decisions is irreversible, once taken it cannot be reformed. For instance, if soon after setting up a sugar mill, the owner thought of changing it, then the old machinery used for the purpose and other fixed assets will have to be sold at a loss. In doing this, the heavy loss will have to be incurred by the owner.  What are the Basic Financial Decisions? Basic Financial Decisions that financial managers need to take: Investment Decision Financing Decision Dividend Decision  Investment Decision Investment Decision is also referred to as Capital Budgeting Decisions. The assets and resources of the company are rare and must be put into utmost utilization. In order to gain the highest conceivable returns, a firm should pick where to invest. Funds will be invested based on the careful selection of assets by the firms. In procuring fixed assets and current assets, the firm funds are invested. If the choice is taken with respect to a fixed asset it is called a capital budgeting decision. The investment decisions can be classified under two broad groups: (i) Long-term investment decision (ii) Short-term investment decision The long-term investment decision is referred to as the capital budgeting and the short-term investment decision as working capital management  Factors Affecting Investment Decision Cash flow of the venture: If an organization starts a venture it begins to invest a large amount of capital at the initial stage. Though, the organization expects at least a source of income to meet daily expenses. Hence, within the venture, there must be some regular cash flow to sustain. Profits: The fundamental criteria to start a venture is to generate income but moreover profits. The most crucial criteria in choosing the venture involve the rate of return for the organization with respect to its profit nature. For example: if venture A gets 10% return and venture В gets 15% return then project B must be preferred. Investment Criteria: Various Capital Budgeting procedures are used for a business to assess various investment propositions. Most importantly, they are based on calculations with respect to investment, interest rates, cash flows, and rate of returns associated with propositions. These are applied to the investment proposals to make a decision on the best proposal.  Financing Decision Financial decision is significant in decision-making on when, where, and how a business acquire funds. When the market estimation of an organization’s share expands the firm tends to gain more profit, it is not only a sign of development of the firm but also fastens investors’ wealth. A finance manager has to select such sources of funds which will make optimum capital structure. The important thing to be decided here is the proportion of various sources in the overall capital mix of the firm. The debt-equity ratio should be fixed in such a way that it helps in maximising the profitability of the concern Example of Debt Capital – Example of Equity 1.Term Loans, 1. Equity shares and 2.Debentures and 2. Preference shares 3.Bonds.  Financing Decision Factors Affecting Financing Decisions Cost: Financing decisions are based on the allocation of funds and cost-cutting. The cost of fundraising from different sources differs a lot and the most cost-efficient source should be chosen. Risk: The dangers of starting a venture with funds differ based on various sources. Borrowed funds have a larger risk compared to equity funds. Cash flow position: Cash flow is the daily earnings of the company. A good cash flow position gives confidence to the investors to invest funds in the company. Control: In this case where existing investors hold control of the business and raise finance through borrowing money, however, equity can be utilized for raising funds when they are prepared for diluting control of the business. Condition of the market: The condition of the market plays a major role in financing decisions. Issuance of equity is in majority during the boom period, but debt of a firm is used during a depression.  Dividend Decision Dividends decisions relate to the distribution of profits earned by the organization. The major alternatives are whether to retain the earnings profit or to distribute to the shareholders. A decision has to be taken whether all the profits are to be distributed, to retain all the profits in business or to keep a part of profits in the business and distribute others among shareholders Factors Affecting Dividend Decisions Earnings: Returns to investors are paid out of the present and past income. Consequently, earning is a noteworthy determinant of the dividend. Dependability in Earnings: An organization having higher and stable earnings can announce higher dividend than an organization with lower income. Balancing Dividends: For the most part, organizations attempt to balance out dividends per share. A consistent dividend is given every year. A change is made, if the organization’s income potential has gone up and not only the income of the present year. Development Opportunity: Organizations having great development openings if they hold more cash out of their income to fund their required investment. The dividend announced in growing organizations is smaller than that in the non-development companies. Financial Goal Financial Goal Profit Wealth Maximization Maximization  What is Profit Maximization? Profit Maximization is the core objective of many businesses that represent the pursuit of strategies to achieve the highest possible net income. This involves identifying optimal production levels, pricing strategies, and cost management practices to ensure that revenues exceed costs, leading to increased profitability. In essence, it is about striking the right balance between income generation and cost management to ensure sustained financial success. Key points: Profit maximization involves strategies to boost the company's total revenue. This can be achieved through various means, such as increasing sales, entering new markets, introducing new products, or implementing effective pricing strategies. Besides focusing on revenue, minimizing costs is crucial for profit maximization. Companies seek ways to streamline operations, improve efficiency, and cut unnecessary expenses to enhance their profit margins.  Limitation / Criticisms against profit maximization Lack of clarity: - According to the concept of profit maximization, max of economic welfare can take place only through profit maximization but there are no specific directions as to this correct meaning of profit. Does it mean short term profits or long term profits does it mean total profits or earnings per share. Should we take profits before or after tax etc? Ignores time value of money: - This concept ignores the time value of money is the concept is purely based on the comparison b/w cash inflows and outflow and the net inflows are tried to be maximized without any references to the change in money value. It does not consider the magnitude and timing of earnings. It treats all earnings as equal even though they occur in different periods. “A rupee earned today is better than a rupee earned tomorrow is ignored here” Limitation / Criticisms against profit maximization Ignores risk factors: - Risk and profit are positively related. More risk may result in more return and hence to get more return, the finance manager may take huge risks and this may affect the future or survival of the concern. The risks of the prospective earnings stream are ignored. Ignoring human values: - This involves increasing profit by the nonpayment of due payments to the various factors of production. It leads to closed inequalities and lowers human values which are an essential part of an ideal social system.  Wealth maximization Wealth maximization focuses on increasing the net present value (NPV) of a company's cash flows, thus maximizing the market value of the firm's shares and enhancing shareholder wealth. Wealth maximization in financial management means making smart choices to grow the value of a business, investment, or personal finances over time. It’s about making decisions that lead to more money in the long run for shareholders or investors.  Wealth maximization NPV (net present value) of course of action = PV of its benefit - PV of its Cost A Financial action > Positive NPV > Created Wealth of Shareholders > Desirable/Accepted A Financial action > Negative NPV > Destroy Wealth of Shareholders > Rejected Net Present Value (NPV): NPV measures the gap between the current value of cash coming in and going out over time. To maximize wealth, it is essential to choose projects that yield a positive NPV. Risk & Return Trade-off: Balancing potential returns against associated risks ensures that decisions contribute positively to shareholder wealth.  Aspect Wealth Maximization Profit Maximization Objective Focuses on increasing Focuses on short-term shareholders wealth earnings Time Horizon Long-term Short-term Risk Includes risk and uncertainty Often ignores risk factors Consideration Measure of Market value of shares or NPV Net profits Success Sustainability Promotes sustainable growth May overlook long-term effects What Is Risk-Return Tradeoff? Definition: Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return. This trade off which an investor faces between risk and return while considering investment decisions is called the risk return trade off. For example, Rohan faces a risk return trade off while making his decision to invest. If he deposits all his money in a saving bank account, he will earn a low return i.e. the interest rate paid by the bank, but all his money will be insured up to an amount of Rs 1 lakh (currently the Deposit Insurance and Credit Guarantee Corporation in India provides insurance up to Rs 1 lakh). However, if he invests in equities, he faces the risk of losing a major part of his capital along with a chance to get a much higher return than compared to a saving deposit in a bank.  What Is Risk-Return Tradeoff? 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. Risk refers to the possibility of losing money on an investment. the risk return tradeoff is the relationship between amount of risk taken and the potential return on investment. it simple terms, its implies that investors expects higher returns for taking on more risk. if investment riskier, investor would expect a higher return as compensation.  Importance of risk-return trade-off in mutual funds Risk management: The trade-off provides a framework to investors for assessing potential risks and rewards for different investment opportunities. Return optimisation: Investors can identify investments that offer the best potential return for their level of risk tolerance. This allows them to optimise their portfolio for investment objectives, such as capital preservation, growth, or income. Diversification: The risk-return trade-off formula explains the current risk exposure in the investment instruments included in the portfolio. This can allow investors to manage their portfolios and reduce risk by investing in low-risk investment instruments.