FINANCIAL MANAGEMENT

UNIT I

Finance Function – Objectives

The main objective of finance function is to assess the financial needs of an organization and then finding out suitable sources for raising
them. The sources should be commensurate with the needs of the business. If funds are needed for longer periods then long-term sources
like share capital, debentures, term loans may be explored.
 
2. Proper Utilisation of Funds

Though raising of funds is important but their effective utilisation is more important. The funds should be used in such a way that maximum
benefit is derived from them. The returns from their use should be more than their cost. It should be ensured that funds do not remain idle at
any point of time. The funds committed to various operations should be effectively utilised. Those projects should be preferred which are
beneficial to the business.
 
3. Increasing Profitability

The planning and control of finance function aims at increasing profitability of the concern. It is true that money generates money. To
increase profitability, sufficient funds will have to be invested. Finance function should be so planned that the concern neither suffers from
inadequacy of funds nor wastes more funds than required. A proper
 control should also be exercised so that scarce resources are not frittered away on uneconomical operations. The cost of acquiring funds
also influences profitability of the business.
 
4. Maximising Value of Firm

Finance function also aims at maximizing the value of the firm. It is generally said that a concern’s value is linked with its profitability. 

ROLE OF FINANCE 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 manger 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/Her actions directly affect the Profitability, growth and goodwill of the firm.

Following are the main functions of a Financial Manager:

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

Finance Functions

The following explanation will help in understanding each finance function in detail

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

Evaluation of new investment in terms of profitability

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 is a wise decision 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)

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.

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.

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.

Current assets should properly be valued and disposed of from time to time once they become non profitable. Currents assets must be used
in times of liquidity problems and times of insolvency.
Financial Goal - Profit vs Wealth

Every firm has a predefined goal or an objective. Therefore the most important goal of a financial manager is to increase the owner’s
economic welfare. Here economics welfare may refer to maximization of profit or maximization of shareholders wealth. Therefore
Shareholders wealth maximization (SWM) plays a very crucial role as far as financial goals of a firm are concerned.

Profit is the remuneration paid to the entrepreneur after deduction of all expenses. Maximization of profit can be defined as
maximizing the income of the firm and minimizing the expenditure. The main responsibility of a firm is to carry out business by
manufacturing goods and services and selling them in the open market. The mechanism of demand and supply in an open market determine
the price of a commodity or a service.

A firm can only make profit if it produces a good or delivers a service at a lower cost than what is prevailing in the market. The margin
between these two prices would only increase if the firm strives to produce these goods more efficiently and at a lower price without
compromising on the quality.

The demand and supply mechanism plays a very important role in determining the price of a commodity. A commodity which has a greater
demand commands a higher price and hence may result in greater profits. Competition among other suppliers also effect profits.
Manufacturers tends to move towards production of those goods which guarantee higher profits. Hence there comes a time when
equilibrium is reached and profits are saturated.

According to Adam Smith - business person in order to fulfill their profit motive in turn benefits the society as well. It is seen that
when a firm tends to increase profit it eventually makes use of its resources in a more effective manner. Profit is regarded as a parameter to
measure firm’s productivity and efficiency.

Firms which tend to earn continuous profit eventually improvise their products according to the demand of the consumers. Bulk production
due to massive demand leads to economies of scale which eventually reduces the cost of production. Lower cost of production directly
impacts the profit margins.

There are two ways to increase the profit margin due to lower cost.

Firstly a firm can produce at lower sot but continue to sell at the original price, thereby increasing the revenue.

Secondly a firm can reduce the final price offered to the consumer and increase its market thereby superseding its competitors.

Both ways the firm will benefit. The second way would increase its sale and market share while the first way only tend to increase its
revenue. Profit is an important component of any business. Without profit earning capability it is very difficult to survive in the market.

If a firm continues to earn large amount of profits then only it can manage to serve the society in the long run. Therefore profit earning
capacity by a firm and public motive in some way goes hand in hand. This eventually also leads to the growth of an economy and increase in
National Income due to increasing purchasing power of the consumer.

Sources of Business Finance

To meet long-term, medium-term, and short-term financial requirements, companies can use various sources to raise funds for
their business.

Methods For Raising Long-Term Funds

Issue of shares

Issue of debentures

Loans from specialized financial institutions

Methods For Raising Medium-Term (or Intermediate-Term) Funds

Issue of preference shares

Issue of debentures

Public deposits

Bank loans (term loans)

Assistance from specialized financial institutions

Methods of Raising Short-Term Funds

Credit purchases or trade credit

Bank overdraft

Cash credit
Advances from customers

Sources of Raising Borrowed Funds

Debentures

Financial institutions

Public deposits

Commercial banks

Sources For Raising Long-Term Borrowed Funds

Debentures

Financial institutions

The Pattern of Capital Structure

A joint-stock company is free to choose its own capital structure. This may happen through:

Issuing equity shares

Issuing both equity shares and preference shares

Issuing equity shares, preference shares, and debentures

Sources of funds

A company might raise new funds from the following sources:

 The capital markets:

i) new share issues, for example, by companies acquiring a stock market listing for the first time

ii) rights issues

 Loan stock
 Retained earnings
 Bank borrowing
 Government sources
 Business expansion scheme funds
 Venture capital
 Franchising.

Ordinary (equity) shares

Ordinary shares are issued to the owners of a company. They have a nominal or 'face' value, typically of $1 or 50 cents. The market value of
a quoted company's shares bears no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price
must be equal to or be more than the nominal value of the shares.

Preference shares

Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary shareholders. As with ordinary shares a
preference dividend can only be paid if sufficient distributable profits are available, although with 'cumulative' preference shares the right to
an unpaid dividend is carried forward to later years. The arrears of dividend on cumulative preference shares must be paid before any
dividend is paid to the ordinary shareholders.

Loan stock

Loan stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of loan
stock are therefore long-term creditors of the company.

Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated "coupon yield" on this amount. For
example, if a company issues 10% loan stocky the coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will
receive $10 interest each year. The rate quoted is the gross rate, before tax.

Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing
provisions about the payment of interest and the eventual repayment of capital.

Debentures with a floating rate of interest

These are debentures for which the coupon rate of interest can be changed by the issuer, in accordance with changes in market rates of
interest. They may be attractive to both lenders and borrowers when interest rates are volatile.
Security

Loan stock and debentures will often be secured. Security may take the form of either a fixed charge  or a floating charge.

a) Fixed charge; Security would be related to a specific asset or group of assets, typically land and buildings. The company would be
unable to dispose of the asset without providing a substitute asset for security, or without the lender's consent.

b) Floating charge; With a floating charge on certain assets of the company (for example, stocks and debtors), the lender's security in the
event of a default payment is whatever assets of the appropriate class the company then owns (provided that another lender does not have a
prior charge on the assets). The company would be able, however, to dispose of its assets as it chose until a default took place. In the event

Retained earnings

For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as
retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new
investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows:

a) The management of many companies believes that retained earnings are funds which do not cost anything, although this is not true.
However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash.

b) The dividend policy of the company is in practice determined by the directors. From their standpoint, retained earnings are an attractive
source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders.

c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.

d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares.

Another factor that may be of importance is the financial and taxation position of the company's shareholders. If, for example, because of
taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income,
then finance through retained earnings would be preferred to other methods.

A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with
realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for
extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to owner-directors.

Bank lending

Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term
lending is quite common these days.

Short term lending may be in the form of:

a) an overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which
the company is overdrawn from day to day;

b) a short-term loan, for up to three years.

Medium-term loans are loans for a period of from three to ten years. The rate of interest charged on medium-term bank lending to large
companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower. A loan may have
a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months
in line with recent movements in the Base Lending Rate.

Leasing

A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows the lessee to use it.
The lessee makes payments under the terms of the lease to the lessor, for a specified period of time.

Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars and commercial vehicles, but might also be
computers and office equipment. There are two basic forms of lease: "operating leases" and "finance leases".

Hire purchase

Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the exception that ownership of the goods passes to the
hire purchase customer on payment of the final credit instalment, whereas a lessee never becomes the owner of the goods.

Hire purchase agreements usually involve a finance house.

i) The supplier sells the goods to the finance house.

The finance house will always insist that the hirer should pay a deposit towards the purchase price. The size of the deposit will depend on
the finance company's policy and its assessment of the hirer. This is in contrast to a finance lease, where the lessee might not be required to
make any large initial payment.
An industrial or commercial business can use hire purchase as a source of finance. With industrial hire purchase, a business customer
obtains hire purchase finance from a finance house in order to purchase the fixed asset. Goods bought by businesses on hire purchase
include company vehicles, plant and machinery, office equipment and farming machinery.

Government assistance

The government provides finance to companies in cash grants and other forms of direct assistance, as part of its policy of helping to develop
the national economy, especially in high technology industries and in areas of high unemployment. For example, the Indigenous Business
Development Corporation of Zimbabwe (IBDC) was set up by the government to assist small indigenous businesses in that country.

Venture capital

Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A businessman starting up a new business will
invest venture capital of his own, but he will probably need extra funding from a source other than his own pocket. However, the term
'venture capital' is more specifically associated with putting money, usually in return for an equity stake, into a new business, a management
buy-out or a major expansion scheme.

The institution that puts in the money recognises the gamble inherent in the funding. There is a serious risk of losing the entire investment,
and it might take a long time before any profits and returns materialise. But there is also the prospect of very high profits and a substantial
return on the investment. A venture capitalist will require a high expected rate of return on investments, to compensate for the high risk.

A venture capital organisation will not want to retain its investment in a business indefinitely, and when it considers putting money into a
business venture, it will also consider its "exit", that is, how it will be able to pull out of the business eventually (after five to seven years,
say) and realise its profits. Examples of venture capital organisations are: Merchant Bank of Central Africa Ltd and Anglo American
Corporation Services Ltd.

Franchising

Franchising is a method of expanding business on less capital than would otherwise be needed. For suitable businesses, it is an alternative to
raising extra capital for growth. Franchisors include Budget Rent-a-Car, Wimpy, Nando's Chicken and Chicken Inn.

Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local business, under the franchisor's trade name.
The franchisor must bear certain costs (possibly for architect's work, establishment costs, legal costs, marketing costs and the cost of other
support services) and will charge the franchisee an initial franchise fee to cover set-up costs, relying on the subsequent regular payments by
the franchisee for an operating profit. These regular payments will usually be a percentage of the franchisee's turnover.

Although the franchisor will probably pay a large part of the initial investment cost of a franchisee's outlet, the franchisee will be expected to
contribute a share of the investment himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share of the
investment cost.