UNIT – I

Introduction
Finance is regarded as the life blood of a business enterprise. In the money oriented economy finance
is one of the basic foundations of all kinds of economic activities. Hence efficient management of economic
activities. Hence efficient management of every business enterprise is closely linked with efficient
management of its finance.
Finance is regarded as the lifeblood of a business enterprise. This is because in the modern
money-oriented economy finance is one of the basic foundations of all kinds of economic activities. It is the
master key which provides access to all the sources for being employed in manufacturing and merchandising
activities. It has rightly been said that business needs money to make more money.

Meaning of business finance

In general finance may be defined as “ the provision of money at the time it is wanted”.

Meaning of financial Management

Financial management which is today recognized as the most important branch of business
administration. Howard and upton view that financial management is the application of general
management function to the area of financial decision making.
Therefore financial management is planning execution and control of investment of money resources
rising of such resources and retention of profits (08) payments of dividends.

Definition
Prof. Ezra soloman defines “Financial management is concerned with efficient use of an important
economic resource namely capital funds”.
Osborn defines “Financial Management as a process of acquiring and utilizing of funds by a
business”.
Archer and Ambrosio defines “Financial Management is the application of the planning and control
functions to the finance function”.

Nature of Financial Management:

(i) Financial management is a specialized branch of general management, in the

present-day-times. Long back, in traditional times, the finance function was coupled, either
with production or with marketing; without being assigned a separate status.

(ii) (ii) Financial management is growing as a profession. Young educated persons, aspiring for a
career in management, undergo specialized courses in Financial Management, offered by
universities, management institutes etc.; and take up the profession of financial management.

(iii) (iii) Despite a separate status financial management, is intermingled with other aspects of
management. To some extent, financial management is the responsibility of every functional
manager. For example, the production manager proposing the installation of a new plant to be
operated with modern technology; is also involved in a financial decision.

(iv) Likewise, the Advertising Manager thinking, in terms of launching an aggressive advertising
programme, is too, considering a financial decision; and so on for other functional managers.
This intermingling nature of financial management calls for efforts in producing a coordinated
financial system for the whole enterprise.
 (v) (iv) Financial management is multi-disciplinary in approach. It depends on other disciplines,
like Economics, Accounting etc., for a better procurement and utilisation of finances.

(vi) (v) The finance manager is often called the Controller; and the financial management function
is given name of controllership function; in as much as the basic guideline for the formulation
and implementation of plans-throughout the enterprise-come from this quarter.

(vii) The finance manager, very often, is a highly responsible member of the Top Management
Team. He performs a trinity of roles-that of a line officer over the Finance Department; a
functional expert commanding subordinates throughout the enterprise in matters requiring
financial discipline and a staff adviser, suggesting the best financial plans, policies and
procedures to the Top Management.

(viii) In any case, however, the scope of authority of the finance manager is defined by the Top
Management; in view of the role desired of him- depending on his financial expertise and the
system of organizational functioning.

(vi) Despite a hue and cry about decentralisation of authority; finance is a matter to be found still
centralised, even in enterprises which are so called highly decentralised.

(vii) Financial management is not simply a basic business function along with production and
marketing; it is more significantly, the backbone of commerce and industry. It turns the sand
of dreams into the gold of reality.

IMPORTANCE OF FINANCIAL MANAGEMENT

● It provides guidance in financial planning.

● It assists in acquiring funds from different sources.
● It helps in investing an appropriate amount of funds.
● It increases organizational efficiency.
● It reduces delay production.
● It cut down financial costs.
● It reduces cost of fund.
● It ensures proper use of fund.
● It helps business firm to take financial decisions.
● It prepares guideline for earning maximum profits with minimum cost.
● It increases shareholders’ wealth.
● It can control the financial aspects of the business.
● It provides information through financial reporting.
● It makes the employees aware of saving funds.

SCOPE OF FINANCIAL MANAGEMENT

 1. Investment Decision:The investment decision involves the evaluation of risk, measurement of
cost of capital and estimation of expected benefits from a project. Capital budgeting and liquidity are the two
major components of investment decision. Capital budgeting is concerned with the allocation of capital and
commitment of funds in permanent assets which would yield earnings in future.
2. Financing Decision:While the investment decision involves decision with respect to composition
or mix of assets, financing decision is concerned with the financing mix or financial structure of the firm.
The raising of funds requires decisions regarding the methods and sources of finance, relative proportion and
choice between alternative sources, time of floatation of securities, etc. In order to meet its investment needs,
a firm can raise funds from various sources.
3. Dividend Decision:In order to achieve the wealth maximisation objective, an appropriate dividend
policy must be developed. One aspect of dividend policy is to decide whether to distribute all the profits in
the form of dividends or to distribute a part of the profits and retain the balance. While deciding the optimum
dividend payout ratio (proportion of net profits to be paid out to shareholders).
4. Working Capital Decision:Working capital decision is related to the investment in current assets
and current liabilities. Current assets include cash, receivables, inventory, short-term securities, etc. Current
liabilities consist of creditors, bills payable, outstanding expenses, bank overdraft, etc. Current assets are
those assets which are convertible into a cash within a year. Similarly, current liabilities are those liabilities,
which are likely to mature for payment within an accounting year.

OBJECTIVES OF FINANCIAL MANAGEMENT

The firm’s investment and financing decisions are unavoidable and continuous. In order to make
them rationally the firm must have goal. Without goal and objectives no companies will do anything. It is
generally agreed that financial goals of the firm should be as follows:

BASIC OBJECTIVES
1. Profit Maximization
2. Wealth Maximization
Basic Objectives:
It is the objective of any company/firm is profit maximization or wealth maximization or combined
maximization.
● Profit Maximization: Profit maximization means maximizing the rupee income of the firm. Profit is
a measure of efficiency of a business enterprise. No business can survive without earning profit.
Profit also serves as a protection against risks which cannot be ensured. The following are the
favorable arguments of profit maximization:
1. If the firm does not earn profit no investors can be attracted.
2. A considerable increase in the profit alone can lead to satisfy the existing shareholders. The
investment made will be in vain, if profit is not maximized.
3. Employees can be given more financial incentives and bonus through profit maximization.
4. Profit maximization leads/results in the organization growth and development.
5. Profit maximization in an organization helps the firm to meet out all its obligations at all
times.
 On the Other hand, the concept of profit maximization has come under severe criticism in recent times
because of the following reasons:
● The term ‘Profit’ is Vague: It is not precisely defined, as this objective does not clarify which profit
does it mean whether it is short-term profit or long-term profit. Other things like: Does it mean profit
before tax or after tax or operating profit or profit available for shareholders.
● It ignores the time value of Money: Profit maximization does not consider the magnitude and timing
of earnings. It does not help in making a choice between the projects giving different benefits spread
over a periods. It treats all earnings as equal though they occur in different periods.
● It overlooks quality aspects of future activities: It does not take into the consideration the risk of
prospective earnings stream will also be risky in the former than the latter.
● The effect of dividend policy on the market price of the shares is also not considered in the objective
of profit maximization.
On the account of the above reasons, these days profit maximization is not considered to be an ideal
criterion for making investment and financing decisions.
● Wealth Maximization or Value Maximization:
Wealth Maximization means maximizing the value of net worth or the share value. Wealth
Maximization is the appropriate objective of an enterprise. It increase the firm’s value in the long run.
Therefore the equity shareholder’s can enjoy more benefits. When a firm maximizes the stock holder’s
wealth, the individual stockholder can use this wealth to maximize his individual utility. There by we
can say the firm is operating consistently towards stockholder’s utility.
When an organization is at good value, name and fame it need not go for advertisement. Hence the
expenditure can be kept under control. Firm’s value will lead to better quality of product and service at
cheaper cost. Therefore, it is easy to keep away the competitors from industrial scene. The public and
consumers may be enjoying good quality of product at lower cost without side effects. Moreover nations
economy will be flourished simultaneously the standard of living and purchasing power of citizens will
be uplifted.
A financial manager is a person who is responsible for taking care of all the essential financial functions of
an organization. Nowadays, Finance Managers spend less time producing financial reports and prefer to
invest more time in conducting data analysis, planning and strategizing, or advising senior managers or top
executives.

Responsibilities of Finance Manager:

● Raising of funds: to meet the needs of the business, it is essential to have cash and liquidity so, that a firm
can raise funds by way of equity or debt. A financial manager is responsible for maintaining the right balance
between equity and debt.
● Allocation of funds: After the funds are raised, the next important thing is to allocate the funds. The best
possible manner of allocating the funds:
● Size of the organizations and their growth capability
● Status of assets about long term or short term
● The mode by which the funds are raised
These types of financial decisions can, directly and indirectly, influence other activities.
● Profit Planning: It is one of the primary functions of any business organizations. Profit earning is essential
for the survival and livelihood of any organization. Profits emerge due to various factors such as pricing,
industry competition, state of the economy, mechanism of demand and supply, cost and output.
● Understanding capital markets: Shares of a company are traded on the stock exchange for a continuous
sale and purchase. It is understood that the capital market is an essential factor for a financial manager.
Hence, it is the responsibility of a concern person to understand and calculate the risk involved in this trading
of shares debts.

Role of a Financial Manager

The role of a financial manager is rapidly increasing due to advance technology which has significantly
reduced the amount of time that was occupied to produce financial reports.

● They analyze market trends to find opportunities for expansion or for acquiring companies.
● They have to do some tasks that are specific to their organization or industry
● They manage company credit
● Make some dividend pay-out decisions
● Keep in touch with the stock market if the company is listed
● Appreciate the financial performance concerning return investments
● They maximize the wealth for company shareholders
● To handle financial negotiations with banks and financial institutions
Types of Financial Managers:

● Controllers: They direct the preparation of financial reports that summarize and forecast the organization's
financial reports such as income statements, balance sheets, etc.
● Treasures and finance officers: These officers direct their organization's budgets to meet its financial goals
to oversee the investment of funds.
● Credit managers- They manage the organization's credit business.
● Cash managers: They monitor the flow of the cash that comes in and goes out of the company to meet the
investment needs of an organization.
● Risk managers: They control financial risk by using strategies to limit the probability of a financial loss.
Time value of money (TVM) is the idea that money that is available at the present time is worth more than
the same amount in the future, due to its potential earning capacity. This core principle of finance holds that
provided money can earn interest, any amount of money is worth more the sooner it is received. One of the
most fundamental concepts in finance is that money has a time value attached to it. In simpler terms, it would
be safe to say that a dollar was worth more yesterday than today and a dollar today is worth more than a
dollar tomorrow.
 This chapter is a practical approach to the time value of money. We fully understand that today's
technology provides multiple calculators and applications to help you derive both present value and future
value of money. If you do not take the time to comprehend how these calculations are derived, you may
make critical financial decisions using inaccurate data (because you may not be able to recognize whether
the answers are correct or incorrect). There are five (5) variables that you need to know:

1. Present value (PV) - This is your current starting amount. It is the money you have in your hand at the
present time, your initial investment for your future.
2. Future value (FV) - This is your ending amount at a point in time in the future. It should be worth more
than the present value, provided it is earning interest and growing over time.
3. The number of periods (N) - This is the timeline for your investment (or debts). It is usually measured
in years, but it could be any scale of time such as quarterly, monthly, or even daily.
4. Interest rate (I) - This is the growth rate of your money over the lifetime of the investment. It is stated
in a percentage value, such as 8% or .08.
5. Payment amount (PMT) - These are a series of equal, evenly-spaced cash flows.

You can calculate the fifth variable if you are given any four of the five (all) variables listed above. A simple
example of this would be: If you invest one dollar (PV) for one year (N) at 6% (I), you will receive $1.06
(FV). This would be the same as saying the present value of $1.06 you expect to receive in one year, is only
$1.00 (PV).
 Risk and Return Relationship in Financial Management
The relationship between risk and required return was introduced. The relationship between risk and required rate
of return can be expressed as follows:
Required rate of return = Risk-free rate of return + Risk premium

A risk premium is a potential “reward” that an investor expects to receive when making a risky
investment. Investors are generally considered to be risk averse; that is, they expect, on average, to be
compensated for the risk they assume when making an investment. Thus, over the long term, expected returns and
required returns from securities will tend to be equal.
The rate of return required by investors in financial assets is determined in the financial marketplace and
depends on the supply of funds available as well as the demand for these funds. Investors who buy bonds receive
interest payments and a return of principal as compensation for postponing consumption and accepting risk.
Similarly, common stock investors expect to receive dividends and price appreciation from their stock. The rate of
return required by these investors represents a cost of capital to the firm.
This required rate of return is used by a firm’s managers when computing the net present value of the
cash flows expected to be generated from the company’s investments. The required rate of return on a security is
also an important determinant of the market value of financial securities, including common stock, preferred
stock, and bonds. The following sections focus on the two components of the required rate of return —the
risk-free return and the risk premium—and also look at the historical relationship between risk and rates of return
on various types of securities.

Explain the Relationship Between Risk and Return

Risk-Free Rate of Return The concept of a (nominal) risk-free rate of return, rf , refers to the return available
on a security with no risk of default. In the case of debt securities, no default risk means that promised interest
and principal payments are guaranteed to be made. Short-term U.S. government securities, such as Treasury bills,
are generally considered to be risk-free investments.The risk-free rate of return, rf , is equal to the sum of a real
rate of return and an expected inflation premium:
rf= Real rate of return + Expected inflation premium

The real rate of return is the return that investors would require from a security having no risk of default
in a period of no expected inflation. It is the return necessary to convince investors to postpone
current, real consumption opportunities. The real rate of return is determined by the interaction of the supply of
funds made available by savers and the demand for funds for investment. Historically, the real rate of return has
been estimated to average in the range of 2 to 4 percent.
The second component of the risk-free rate of return is an inflation premium or purchasing power loss
premium. Investors require compensation for expected losses in purchasing power when they postpone current
consumption and lend funds. Consequently, a premium for expected inflation is included in the required return on
any security. The inflation premium is normally equal to investors’ expectations about future purchasing power
changes. If, for example, inflation is expected to average 4 percent over some future period, the risk-free rate of
return on U.S. Treasury bills (assuming a real rate of return of 3 percent) should be approximately equal to 3
percent + 4 percent = 7 percent by Equation . By extension, if inflation expectations suddenly increase from 4 to 6
percent, the risk-free rate should increase from 7 to 9 percent (3 percent real return plus 6 percent inflation
premium).
At any point in time, the required risk-free rate of return on any security can be estimated from the yields
on short-term U.S. government securities, such as 90-day Treasury bills. When considering return requirements
on all types of securities, it is important to remember that increases in expected inflation rates normally lead to
increases in the required rates of return on all securities.
Risk Premium
The risk premium assigned by an investor to a given security in determining the required rate of return (Equation
6.5) is a function of several different risk elements. These risk elements (and premiums) include
● Maturity risk premium
● Default risk premium
● Seniority risk premium
● Marketability risk premium
Each of these risk elements is examined here.
Maturity Risk Premium The return required on a security is influenced by the maturity of that security.
The term structure of interest rates is the pattern of interest rate yields (required returns) for securities that
differ only in the length of time to maturity. Plotting interest rate yields (percent) on the vertical axis and the
length of time to maturity (years) on the horizontal axis results in a yield curve. Two yield curves for U.S.
government securities are shown in Figure.

Note the different shapes of the two yield curves. The yield curve for August 1981 is downward sloping,
indicating that the longer the time to maturity, the lower the required return on the security. The yield curve for
April 2004 is upward sloping, indicating that the longer the time to maturity, the higher the required return on the
security.In general, the yield curve has been upward sloping more often than it has been downward sloping. For
example, in April 2004, the yield on 3-month U.S. government Treasury bills was 0.97 percent. In contrast, the
yield on 10-year U.S. government bonds was 4.54 percent, and the yield on 30-year U.S. government bonds was
5.31 percent.
Yield Curves Showing the Term Structure of Interest Rates for U.S.Treasury Securities
A number of theories have been advanced to explain the shape of the yield curve, including the expectations
theory, liquidity (or maturity) premium theory, and market segmentation theory.
According to the expectations theory, long-term interest rates are a function of expected future (that is,
forward) short-term interest rates. If future short-term interest rates are expected to rise, the yield curve will tend
to be upward sloping. In contrast, a downwardsloping yield curve reflects an expectation of declining future
short-term interest rates. According to the expectations theory, current and expected future interest rates are
dependent on expectations about future rates of inflation. Many economic and political conditions can cause
expected future inflation and interest rates to rise or fall. These conditions include expected future government
deficits (or surpluses), changes in Federal Reserve monetary policy (that is, the rate of growth of the money
supply), and cyclical business conditions.
 The liquidity (or maturity) premium theory of the yield curve holds that required returns on long-term
securities tend to be greater the longer the time to maturity. The maturity premium reflects a preference by many
lenders for shorter maturities because the interest rate risk associated with these securities is less than with
longer-term securities. As we shall see in Chapter, the value of a bond tends to vary more as interest rates change,
the longer the term to maturity. Thus, if interest rates rise, the holder of a long-term bond will find that the value
of the investment has declined substantially more than that of the holder of a short-term bond.
In addition, the short-term bondholder has the option of holding the bond for the short time remaining to
maturity and then reinvesting the proceeds from that bond at the new higher interest rate. The long-term
bondholder must wait much longer before this opportunity is available. Accordingly, it is argued that whatever the
shape of the yield curve, a liquidity (or maturity) premium is reflected in it. The liquidity premium is la rger for
long-term bonds than for short-term bonds.
Finally, according to the market segmentation theory, the securities markets are segmented by maturity.
Furthermore, interest rates within each maturity segment are determined to a certain extent by the supply and
demand interactions of the segment’s borrowers and lenders. If strong borrower demand exists for long-term
funds and these funds are in short supply, the yield curve will be upward sloping. Conversely, if strong borrower
demand exists for short-term funds and these funds are in short supply, the yield curve will be downward sloping.
Several factors limit the choice of maturities by lenders. One such factor is the legal regulations that limit the
types of investments commercial banks, savings and loan associations, insurance companies, and other financial
institutions are permitted to make. Another limitation faced by lenders is the desire (or need) to match the
maturity structure of their liabilities with assets of equivalent maturity.
For example, insurance companies and pension funds, because of the long-term nature of their contractual
obligations to clients, are interested primarily in making long-term investments. Commercial banks and money
market funds, in contrast, are primarily short-term lenders because a large proportion of their liabilities is in the
form of deposits that can be withdrawn on demand. At any point in time, the term structure of interest rates is the
result of the interaction of the factors just described. All three theories are useful in explaining the shape of the
yield curve.
The Default Risk Premium U.S. government securities are generally considered to be free of default
risk—that is, the risk that interest and principal will not be paid as promised in the bond indenture. In contrast,
corporate bonds are subject to varying degrees of default risk. Investors require higher rates of return on securities
subject to default risk. Bond rating agencies, such as Moody’s and Standard & Poor’s, provide evaluations of the
default risk of many corporate bonds in the form of bond ratings.Moody’s, for example, rates bonds on a 9-point
scale from Aaa through C,where Aaa-rated bonds have the lowest expected default risk.9 As seen in Table , the
yields on bonds increase as the risk of default increases, reflecting the positive relationship between risk and
required return.
Over time, the spread between the required returns on bonds having various levels of default risk varies,
reflecting the economic prospects and the resulting probability of default. For example, during the relative
prosperity of 1989, the yield on Baa-rated corporate bonds was approximately .97 percentage points greater than
the yield on higher-quality (lower default risk) Aaa-rated bonds. By late 1990, as the U.S. economy weakened and
headed toward a recession, this spread had increased to 1.38 percentage points. In mid-2000, the spread narrowed
to 0.66 percentage points. The spread expanded to 0.71 percent in mid-2004.
Seniority Risk Premium Corporations issue many different types of securities. These securities differ
with respect to their claim on the cash flows generated by the company and the claim on the company’s assets in
the case of default. A partial listing of these securities, from the least senior (that is, from the security having the
lowest priority claim on cash flows and assets) to the most senior, includes the following: common stock,
preferred stock, income bonds, subordinated debentures, debentures, second mortgage bonds, and first mortgage
bonds.
Generally, the less senior the claims of the security holder, the greater the required rate of return
demanded by investors in that security. For example, the holders of bonds issued by ExxonMobil are assured that
they will receive interest and principal payments on these bonds except in the highly unlikely event that the
company faces bankruptcy.
In contrast, ExxonMobil common stockholders have no such assurance regarding dividend payments.
Also, in the case of bankruptcy, all senior claim holders must be paid before common stockholders receive any
proceeds from the liquidation of the firm. Accordingly, common stockholders require a higher rate of return on
their investment in ExxonMobil stock than do the company’s bondholders.
Marketability Risk Premium Marketability risk refers to the ability of an investor to buy and sell a
company’s securities quickly and without a significant loss of value. For example, there is very little marketability
risk for the shares of stock of most companies that are traded on the New York or American Stock Exchange or
listed on the NASDAQ system for over the counter stocks. For these securities, there is an active market.
Trades can be executed almost instantaneously with low transaction costs at the current market price. In
contrast, if you own shares in a rural Nebraska bank, you might find it difficult to locate a buyer for those shares
(unless you owned a controlling interest in the bank).When a buyer is found,that buyer may not be willing to pay
the price that you could get for similar shares of a largerbank listed on the New York Stock Exchange. The
marketability risk premium can be significantfor securities that are not regularly traded, such as the shares of
many small- and medium-size firm.
Business and Financial Risk11
Within individual security classes, one observes significant differences in required rates of return between
firms. For example, the required rate of return on the common stock of US Airways is considerably higher than
the required rate of return on the common stock of Southwest Airlines. The difference in the required rate of
return on the securities of these two companies reflects differences in their business and financial risk.
The business risk of a firm refers to the variability in the firm’s operating earnings over time. Business
risk is influencedby many factors, including the variability in sales and operating costs over a business cycle,the
diversity of a firm’s product line, the market power of the firm, and the choice of production technology. Over the
decade from 1991 to 2000, the operating profit margin ratio for Southwest Airlines was consistently higher and
much less variable from year to year than for US Airways.As a stronger, and more efficient firm, Southwest
Airlines can be expected to have a lower perceived level of business risk and a resulting lower required return on
its common stock (all other things held constant).

Financial risk refers to the additional variability in a company’s earnings per share that results from the
use of fixed-cost sources of funds, such as debt and preferred stock. In addition, as debt financing increases, the
risk of bankruptcy increases. For example, US Airways had a debt-to-total-capitalization ratio of 91.6 percent in
2001. By August 2002, US Airways was forced to enter Chapter 11 bankruptcy as a way of reorganizing and
hopefully saving the company. Although it emerged from bankruptcy in 2003, it faced renewed bankruptcy riskin
2004.
In comparison, the debt-to-total-capitalization ratio was 33.3 percent for Southwest Airlines in 2001. This
difference in financial risk will lead to lower required returns on thecommon stock of Southwest Airlines
compared to the common stock of US Airways, all other things being equal. Indeed, because of the 2002
bankruptcy filing, common stock investors in US Airways lost virtually all of their investment value in the firm.
Business and financial risk are reflected in the default risk premium applied by investors to a firm’s securities.
The higher these risks are, the higher the risk premium and required rate of return on the firm’s securities.
Risk and Required Returns for Various Types of Securities
illustrates the relationship between required rates of return and risk, as represented by the various risk
premiums just discussed. As shown in Figure 6.5, the lowest risk security is represented by short-term U.S.
Treasury bills. All other securities have one or more elements of additional risk, resulting in increasing required
returns by investors. The order illustrated in this figure is indicative of the general relationship between risk and
required returns of various security types. There will be situations that result in differences in the ordering of risk
and required returns.

For example, it is possible that the risk of some junk (high-risk) bonds may be so great that investors
require a higher rate of return on these bonds than they require on high-grade common stocks. The relationship
between risk and return can be observed by examining the returns actually earned by investors in various types of
securities over long periods of time. Finance professionals believe that investor expectations of the relative
returns anticipated from various types of securities are heavily influenced by the returns that have been earned on
these securities over long periods in the past. Over the period from 1926 to 2003, investors in small-company
common stocks earned average returns of 17.5 percent compared with 12.4 percent for investors in
large-company stocks.12 However, these higher returns on smallcompany stocks have come with substantially
more variability in annual returns. This variation, as measured by the standard deviation, has been approximately
33 percent for smallcompany stocks versus about 20 percent for large-company stocks.
Returns on long-term corporate bonds have averaged about 6 percent, or less than one-half the returns on
largecompany stocks, but the risk (standard deviation) of the returns on these bonds have also been much lower.
Short-term U.S. Treasury bills have offered the lowest average annual returns (less than 4 percent), but have also
had the lowest risk of all the securiites examined.