Aims of Finance Function

8/13/2019 Aims of Finance Function

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Aims of Finance Function


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The primary aim of Finance function is to

arrange as much as funds for the business as

are required from time to time. This function

has the following aims.

Acquiring sufficient funds

Proper Utilization of Funds

Increasing Profitability

Maximizing firms value


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Profit Maximization :

Profit maximization is a term which denotes the

maximum profit to be earned by an organization in agiven time period. The profit maximization goal

implies that the investment, financing and dividend

policy decision of the enterprise should be oriented

to profit maximization. The term profit can be used in two senses first

as the owner oriented concept, second as the

operational concept. Profit as the owner concept

refers to the amount of net profit which goes intoform of dividend to the share holders. Profit as the

operational concept means profitability. Which is an

indicator of economic efficiency of the enterprise.


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Profitability maximization implies that

the enterprise should select assets.

Project and decisions, that are profitable

and reject the non profitable ones. It is

in this sense the term profit

maximization is used in financial

management.


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Merits of Profit Maximization :

Best criterion on Decision Making: The goal

of profit maximization is regarded as the bestcriterion of decision making as it provides asign to judge the economic performance of theenterprise.

Barometer : Profitability is a barometer formeasuring efficiency of a economic prosperityof a business enterprise.

Efficient allocation of resources: It leads to

efficient allocation of scarce resources as tendto be diverted to those uses which in terms ofprofitability are the most desirable.


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Optimum Utilization : Optimum utilization of

available resources is possible if the business

enterprise objective is profit maximization .

Maximum Social Welfare : It ensures maximumsocial welfare in the form of maximum dividend to

share holders, timely payment to creditors, higher

wages, better quality & lower prices, more

employment opportunities to the society &maximization of capital to the owners.


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However, the profit maximization objective suffers from several drawbacks

which are as follows :

Time factor ignored:The term profit does

not speak anything about the period of profit

whether it is short term or long term profit.

It is Vague :The term profit is very vague.It is not clear in what exact sense the term

profit is used. Whether it is profit after tax or

profit before tax.


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The term maximum is also ambiguous:The term maximum is also not clear. The

concept of profit is also not clear. It istherefore, not possible to maximize whatcannot be known.

It ignores Time Value : The profit

maximization objective fails to provide anyidea regarding the timing of expected cashearnings. The choice of a more worthyproject lies in the study of time value of

future inflows of cash earnings. It ignoresthe fact that the rupee earned today is morevaluable than, the rupee earned later.


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Wealth Maximisation :

Wealth Maximisation appropriate objective of an enterprisewhen the firm maximizes the stock holders wealth, the

individual stock holders can use this wealth to maximize

his individual utility. It means that by maximizing share

holders wealth the firm is operating consistently towards

maximizing share holders utility. Every financial decision

should be based on the cost benefit analysis. If the benefit is

more than the cost the decision will help in maximizing the

wealth on the other hand if cost is more than the benefit the

design will not be sensing the purpose of maximizing

wealth .


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It serves the interests of suppliers of loaned

capital, employee, management & society

besides shareholders there are short term &long term suppliers of funds who have

financial interests in the concern. Short term

lenders are primarily interested in liquidityposition. So that they get their payments in

time. The long-term lenders get a fixed rate

of interest from the earnings and also have

a priority over shareholders in return of their

funds.


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Criticism of Wealth Maximisation :The wealth maximisation objectives has been

criticized by certain financial theoriests mainly onfollowing accounts :

1. It is a perspective idea.

2. The objective is not descriptive at what the firms

actually do.

3. The objective of wealth maximization is not

necessarily socially desirable.

4. There is some contraversy as to whether theobjective is to maximise share holders wealth or

wealth of the firm which includes other financial

claim holders such as debenture holders. Preferred

stock holders etc.


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EPS Maximisation (Earnings per Share) :

Besides the profit maximization and wealth maximization to

objectives firms also try to ensure a fair return to share holders.

The EPS is one of the important measures of economic

performance of a corporate entity. The flow of capital to the

company under the present imperfect capital market conditions

would be made on the evaluation of EPS.

A higher EPS means better capital productivity. EPS is one of the

most important ratios which measure the net profit earned per

share. EPS is one of the major factors effecting the dividend policy

of the firm and the market prices of a company. A steady growth in

EPS year after year indicates a good track of Profitability. EPS iscomputed by dividing the net profit and dividend to Preference

share holders. This avoids confusion and indicates the Profit

available to the ordinary share holders on a per share basis.


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Net Profit after tax & preference dividend

EPS = --------------------------------------- No. of Equity shares.


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An overview of Managerial Finance Functions :

Financial management is emerged as a

district field of study only in the early part ofthe century. As a result of consolidation

movement & formation of large enterprise. Its

evaluation may be divided into 3 phrases.They are :

1. The Traditional phase

2. The Transitional phase

3. The Modern phase.


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1. The Traditional Phase :

This phase has lasted for about 4 decades. Its first

expression was shown in the work of Arthur S.Dewing in his book titled thefinancial policy of the

corporation in 1920s. In this phase the focus of

financial management was on the following

aspects. 1. It treats the entire subject of finance from the

outsiders point of view rather than the financial

decision makes in the firm.

2. The sequence of treatment was on certain

episodic events like formation, issuing of capital,

major expansion, merger, reorganisation &

liquidation during the life cycle of an enterprise.


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3. It laid heavy emphasis long term

financing institutions, proceduresused in capital markets. It lacks

emphasis on the problems of working

capital management.

Traditional phase was only

outsiders looking approach over

emphasis on episodic events & lack

of importance to day-to-day problems.


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2. The Transitional Phase : It begin in the early 1940s and

continued through the early 1950s.The nature of financial management

in this phase is almost similar to the

earlier phase, but more important is

given to the day to day problems

faced by the finance managers.

Capital budgeting techniques were

developed in this phase.


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3. Modern Phase : It begin in the mid 1950sand has shown development

with combination of ideas from economic statistic has

led the financial management is to be more analytical

and quantitative. The main issue of the phase is

rational matching of funds to their user which leads to

the maximization of share holders wealth. Thefollowing are the area of advancements in this phase.

The study says that cost of capital and capital structure

are independent in nature. Dividend policy suggest that

there is the effect of dividend policy on the value of

the firm. This phase has also seen one of the first

applications of linear programming.


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Portfolio analysis gives the idea for the allocation of a

fixed sum of money among the available investment

securities. Capital asset Pricing Model (CAPM) suggeststhat some of the risks in investments can be neutralized

by holding a diversified portfolio of securities.

Financial engineering that involves the design,

development and implementation of innovative financial

instrument and formulation of creative optional solutions

to problems in finance. Even though the above mentioned

developed areas of finance is remarkable, butunderstanding the international dimension of corporate

finance formed a very small part of it. Which is not

sufficient in this era of globalization.


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The Importance of Financial Management /

Financial Decision :

Financial management indeed, the key tosuccessful business operation without proper

administration effective utilisation of finance. No

business enterprise can utilise its potential for

growth expansion.

The discussion on financial management can be

divided into 3 major decisions: Investment Decision

Financing Decision

Dividend Decision


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1)Investment Decision : It is most important than other two decisions.

It begins with determination of the total

amount of assets need to be held by firm. Inother words it relay to the selection of assets

that a firm will invest funds. The required

assets follow two groups.

Long term assets :P&M, Land & Buildings

..etc.- Capital Budgeting Short term assets : raw material, work-in-

progress, closing stockWorking capital.


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2)Financing Decision :

Once the firm has taken the investment

decision and committed itself to newinvestment, it must decide the best means of

financing these commitments. Since firms

regularly make new investments, the needs for

financing and financial decisions are ongoing.

Hence a firm will be continuously planning for

new financial needs. The financing decisions is

not only concerned with how best to financenew assets, but also concerned with the best

overall mix of financing for the firm.


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3)Dividend Decision :

This is the third financial decision which relates to dividend

policy. Dividend is a part of profits that are available fordistribution, to equity share holders for payment of dividend

should be analyzed in relation to the financial decision of a

firm. There are two options available in dealing with the net

profits of a firm i.e., distribution of profits as dividend to theordinary shareholders, where there is no need of retention of

earnings or they can be retained in the firm, it self it they

required for financing business activity. But distribution of

dividends or retaining should be determined interms of its

impact on the shareholders wealth. The financial manager

should determine optimum dividend policy which maximises

market value of the firm.


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Financial Management Process:

Information

Financial

Control

Financial

Analysis

Financial

Planning

Financial

Decision Making

Information

Information

Information


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Financial Management Process:

Financia l Analysis: This is the Preliminary

diagnostic stage and will include: A financial

analysis and review to determine the current

financial performance & conditions of the

business; & an identification of any particularfinancial problem, risk, limitation and an

assessment of financial strength, weakness, and

opportunities and threats (A financial SWOT

Analysis)


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Financial Decision Making: Based on the

finding of the review stage financial decisions

and choices are made. These are likely to

include strategic investment decisions such asinvesting in new production facilities or the

acquisition of another company and strategic

financial decision. For Example : The decision

to rise additional long term loans.


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Financial Planning: The essence of

financial planning is to ensure that the

right amount of funds is available at the

right time and at the right cost for the levelof risk involved to enable the firms

objectives to be achieved.


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Financial Contro l: The final stage of the

process involves the entire organization.

This is to ensure that plans are properly

implemented that progress is continuouslyreported to the management, and any

deviations from the plans are clearly

identified.


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Time Value of Money : Profit Maximization objective ignores the time

value of money & doesnt considered themagnitude and timing of money. It treats all

earnings as equal through they occur in different

periods. Thus, the wealth maximization of share

holders wealth is considered to be an

appropriate objective of a firm. Financial assets

that have share holders make a current sacrifice

by investing their funds into the firm. Theyexpect to get some future, either as dividend or

increases share price when the shares are sold.


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Most of the financial decisions, such as

acquisition assets or procurement of funds affect

firms cash flows in different time periods. If afirm acquires as assets today it will required at

immediate cash outlay, but the benefit of this

asset will be received in future. Similarly if fundsare raised through borrowings for present needs,

these will have to be returned in future as

principle & interest.


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While taking such financial decision, the firm

will have to compare the total of cash inflows

with the total cash outflows. The logical way

is to recognize the time value of money andmake appropriate adjustment for time

otherwise it may take faulty decisions.


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Concept of Time Value of Money:

The simple concept of time value of money is that the value of

money received today is more than the value of same amount ofmoney received after a certain period.

In other words money received in future is not as valuable

money the better it is. Taking the case of a rational human

being, given the option to receive a fixed amount of money ateither off the two time periods, he will prefer to receive it at the

earliest.

If you are given the choice of receiving Rs 100/- today or after

1 year. You will definitely opt to receive today than after 1year.

This is because value the current receipt of money is higher

than future receipt of money after one year. The phenomenon is

referred to as time preference for money.


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Reasons for Time Preference of Money:

The future is always uncertain and involves

risk. An individual can never be certain ofgetting cash inflows in future and hence he

will like to receive money instead of waiting

for the future. People generally prefer to use their money

for satisfying their present needs in buying

more food, clothes or another. Moreover their

may also be a fear is once mind that he may

not able to use the money in future for fear of

illness or death.


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Money has time value because of the

opportunities available to invest money

received at earlier dates at some interest or

otherwise to enhance future earnings.


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Factors contributing to the Time Value of

Money :

Individuals generally prefer current

consumption than future consumption

A investors can profitably employ a rupee

received today, to give him a higher value tobe received tomorrow or after a certain period

of time.

In an inflationary economy the moneyreceived today has more purchasing power

than money to be received in future.


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A bird in Hand is worth than two in the

bush; this statement implies that people

consider a rupee today worth more than a

rupee in the future. This is because ofuncertainty connected with the future.

Time value of money or Time preference of

money is one of the central ideas in Finance.It becomes most important and is vital

consideration in decision making.


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Techniques of Time Value of Money:

There are two techniques for adjusting the time

value of money :

1. Compounding technique

2. Discounting or Present Value concept


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1. Compounding Technique:

The time preference for money encourages

the person to receive money of present

instead of waiting for future. But he may like

to wait if he is duly compensated for thewaiting by way of ensuring more money in

future.

In this concept the interest earned the initialprincipal amount becomes a past of the

principal of the end of the compounding

period.


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V1= V0(1+i)

Where as V1= Future value of the period first

year

Vo= Value of money at time Zero or Original

sum of Money

I = Interest Rate

F l b i ff d R 100 t d


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For example a person being offered Rs. 100 today may

wait for a year if he is ensured of Rupees Rs. 100 at the

end of One year (taking the preference interest 10% per

annum) In the example given above we have only considered the

future value after one period. But we may need to

calculate future value over longer periods. For example

what will be value of Rs. 100 after two years at 10% P.A.Rate of interest if neither the principle sum of Rs. 100 nor

interest is withdrawn at the end of 1 year. The answer to

this question lies in understanding the second year interest

will be paid on both original principal and interest earnedat the end of first year. This paying of interest is called

compounding technique. The value of money after two

years can be calculated as :


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V1= 100 (1+i)

V2= V1(1+i) = 100 (1+0.10) = 110

Vn= Vo(1+i)n

Calculate the compounding interest for 10

years for the value of 100 @ 10% interest.

V10= 100 (1+0.10)10

= 100 (1.10)10

= 100 (1.10)10 = 259.4

D bli P i d


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Doubling Period : Compound factor tables can be easily used to calculate the

doubling period i.e., the length of period which an amount is

going to take to double of a certain given rate of interest.Doubling period can also be calculated by adopting the

following rules of Thumb

Rule of 72:

72

DP = -----------------------

Rate of Interest

Rule of 69 :

69

DP = 0.35 + ---------------------

Rate of Interest


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Example : If you deposit Rs. 5000 @ 6% Rate of Interest,

in how many years will this amount double work out this

problem by using the rule of 72 & rule of 69.

72

Rule of 72 = ---------------- = 12 years.

(6 / 100 )

69

Rule of 69 = 0.35 + --------

6

= 0.35 +11.50

= 11.85 years.


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Multiple Compounding Periods:

So far we have considered only the

compounding of interest actually. But in many

cases interest may have to be compounded

more than once a year for example banksmay allow interest on quarterly basis or a

company may allow compounding of interest

twice a year on 30th June & 31st Dec every

year.


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The future value of money in such

cases can be calculated as below : i

Vn= V0( 1 + ------ )m X n

m

Where as Vn = Future value of money after n

years

V0 = Value of money at time zero (or) Original

sum of money

I =interest rate

M= number of times of compounding per year.

C l l t th di l f R 10 000 t th d


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Calculate the compounding value of Rs. 10,000 at the end

3 years at 12 % rate of interest when interest is calculated

on a) Yearly basis b) Quarterly basis

A) Yearly basis interest is computed as Vn= V0( 1+i)

n

= 10000 (1+0.12)3

= 10000 (1.12)3

= 10000 X 1.405

= Rs. 14,050 /-

B) Quarterly basis :

Vn= V

0( 1+ (i/m)) m x n

= 10000 ( 1 + (0.12 / 4)) 4 x 3

= 10000 (1.03)12

= Rs. 14,260 /-


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Future Value of a Series of Payments : In previous models we have considered the future value

of a single payment made at time Zero. But in many

instances we may be interested to know the future valueof series of payments made at different time periods.

Vn = R1 ( 1 + i) n-1 + R2 ( 1+i) n-2 + ---- (Rn1 ) (1+i) + Rn

Where as Vn = future value of the period n R1 = Payment after period one

R2 = Payment after period two

Rn = Payment after period n

I = Interest rate


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For Ex: Calculate the future value at the end of 5years of the following series of payments of 10%

R.O.I. R1= Rs. 1000 at the end of Ist year

R2= Rs. 2000 at the end of 2ndyear

R3= Rs. 3000 at the end of 3rdyear

R4= Rs. 2000 at the end of 4thyear

R5 = Rs. 1500 at the end of 5thyear

Vn =1000 (1+0.10)5-1+ 2000 (1+0.10)5-2+ 3000 (1+0.10)5-3+ 2000 (1+0.10)5-4+ 1500

= 1000 (1.10)4+ 2000 (1+0.10)3+ 3000(1+0.10)2+ 2000(1+0.10)1+1500

= 1000 x 1.464 + 2000 (1.331) + 3000 (1.210) + 2000 (1.10) +1500

= 11456.


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Compound an Value of Annuity : An annuity is a series of equal payments

lasting for some specified duration. Thepremium payments of life Insurance company

is the best example for annuity. When the

cash flows occur at the end of cash period

the annuity is called a regular annuity or

deferred annuity. If the cash flows occur at

the beginning of each year the annuity is

called an annuity due. Vn= R(Annuity Compound Factor I, n)


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Mr. A deposit Rs. 1000 at the end of every

year for 4 years and the deposit earns a

compound interest at the rate of 10% P.a.

Determine how much money he will have atthe end of 4 years.

Vn= 1000 ( 4.641)

= Rs. 4641/-


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Discounting or Present Value Technique :

Present value is the exact opposite of

compound or future value, while future value

shows how much a sum of money becomes

of some future period, present value showswhat the value is today of some future sum of

money.


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In compound or future value approach the money invested

today appreciates because the compound interest is added to

the Principle. The present value of money to be received on

future date will be less because we have lost the opportunityof investing it yet some interest. Thus the present value of

money to be received in future will always be less. It is for

this reason the present value technique is called

Discounting. Vn

V0= --------

1 + I

Where Vn= Future Value

V0= Present Value

I = Interest Rate

E l If M X d i R 100 f


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Example : If Mr. X depositor, expects to get Rs. 100 after one

year@ 10%. Calculate Present Value of Money ?

Vn

V0= ------ 1 + I

100

= ------------

1 + 0.10

= 90.90

Present Value of Money for n Periods Vn

V0= ---------

( 1+i)n


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Present Value of a Series of Cash flows:

C1 C2 C3 Cn

P.V. = ----- + ------- + ------ + ---- + ------

(1+i)1 (1+i)2 (1+i)3 (1+i)n


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P.V. = R( D.F.)

= 5000 x 2.773

= 13865.

5% of 3 Years = 2.773.

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Aims of Finance Function