FOUNDATIONS OF FINANCE Financial Management : An Overview Meaning Financial management is that part of management which is concerned mainly with

raising funds in the most economic and suitable manner; using these funds as profitably (for a given risk level) as possible; planning future operations; and controlling current performances and future developments through financial accounting, cost accounting, budgeting, statistics and other means. It guides investment where opportunity is the greatest, producing relatively uniform yardsticks for judging most of the firm s operations and projects, and is continually concerned with achieving an ade!uate rate of return on investment, as this is necessary for survival and attracting new capital. Financial management is dynamic, in the making of day" to"day financial decisions in a business of any si#e. $he old concept of finance as treasurer"ship has broadened to include the new, meaningful concept of controllership. %hile the treasurer keeps track of the money, the controller s duties e&tend to planning analysis and the improvement of every phase of the company s operations, which are measured with a financial yardstick. Financial management is thus an integrated and composite subject. It welds together much of the material that is found in 'ccounting, (conomics, )athematics, *ystems analysis and +ehavioral sciences, and uses other disciplines as its tool. For a long time, finance has been considered as a rather sterile function concerned with a certain necessary recording of activities alone. financial management makes a significant contribution to the management revolution that is taking place. Financial management s central role is concerned with the same objectives as those of the management; with the way in which the resources of the business are employed and how the business is financed. Financial management has been divided into three

main areas " decisions on the capital structure; allocation of available funds to specific uses and analysis and appraisal of problems. Financial management includes planning or finance, cash budgets and source of finance. Definitions "Financial management is the operational activity of a business that is responsible for obtaining and effectively utili#ing the funds necessary for efficient operations,. " -oseph and )assie. ,Financial management is an area of financial decision"making, harmoni#ing individual motives and enterprise goals". "%eston and +righam. ,Financial management is the area of business management devoted to a judicious used of capital and a careful selection of sources of capital in order to enable a business firm to move in the direction of reaching its goals,."-.F.+radlery. .Financial management is the application of the planning and control Functions to the finance function,. " 'rcher and 'mbrosia. ,Financial management may be defined as that area or set of administrative functions in an organi#ation which relate with arrangement of cash and credit so that the organi#ation may have the means to carry out its objective as satisfactorily as possible., " /oward O !ECTI"E OF FINANCIA# MANA$EMENT Financial management evaluates how funds are procured and used. In all cases, it involves a sound judgement, combined with a logical approach to decision"making. $he core of a financial policy is to ma&imi#e earnings in the long run and to optimi#e them in the short"run. Financial management is concerned with the efficient use of an improved resource, mainly capital funds.

0rofit ma&imi#ation should serve as the basic criterion for decisions arrived at by financial managers of privately owned and controlled firms. 1ifferent alternatives are available to a business enterprise in the process of decisions" making. )a&imi#ation of profits is often considered to be a goal or an alternative goal of a firm. /owever, this is somewhat narrow in concept than the goal of ma&imi#ing the value of the firm because of the following reasons2 (a) $he ma&imi#ation of profits, as reflected in the earnings per share, is not an ade!uate goal in the first place because it does not take into consideration time value of money. (b) $he concept of ma&imi#ation of earnings per share does not include the risk of streams of alternative earnings. ' project may have an earning steam that will attain the goal of ma&imum earnings per share; but when compared with the risk involved in it, it may be totally unacceptable to a stockholder, who is generally hostile to risk"bearing activities. (c) $his concept of ma&imi#ation of earnings per share does not take into account the impact of dividend policy upon market price or value of the firm. $heoretically, a firm would never pay a dividend if the objective is to ma&imi#e earnings per share. 3ather, it would reinvest all its earnings so as to generate greater earnings in the future. Financial management techni!ues are applicable to decisions of individuals, nonprofit organi#ations and of business firms. 'lso, it is applicable to different situations in different organi#ations. Financial managers are interested in providing answers to the following !uestions2 4. 5iven a firm s market position, the market demand for its products, its productive capacity and investment opportunities, what specific assets should it purchase6 $his Indirectly emphasi#es the approach to capital budgeting.

7. 5iven a firm s market position and investment opportunities, what is the total volume of funds that it should commit6 $his indirectly emphasi#es the composition of a firm s assets. 8. 5iven a firm s market position and investment opportunities, how should it ac!uire the funds which are necessary for the implementation of its investment decisions6 $his underscores the approach to capital financing. %&OFIT MA'IMI(ATION "s )EA#T* MA'IMI(ATION

'lthough in general profit ma&imi#ation is the prime goal of financial management, there are arguments against the same. $he following table presents points in favour as well

as against profit ma&imi#ation.

)ealt+ Ma,imi-ation2 $he goals of financial management may be such that they should be beneficial to owners, management, employees and customers. $hese goals may be achieved only by ma&imi#ing the value of the firm. Increase in %rofits: ' firm should increase its revenues in order to ma&imi#e its value. For this purpose, the volume of sales or any other activities should be stepped up. It is a normal practice for a firm to formulate and implement all possible plans of e&pansion and take every opportunity to ma&imi#e its profits. In theory, profits are ma&imi#ed when a firm is in e!uilibrium. 't this stage, the average cost is minimum and the marginal cost and marginal revenue are e!ual. ' word of caution, however, should be sounded here. 'n increase in sales will not necessarily result in a rise in profits unless there is a

market for increased supply of goods and unless overhead costs are properly controlled. &e./ction in Cost: 9apital and e!uity funds are factor inputs in production. ' firm has to make every effort to reduce cost of capital and launch economy drive in all its operations. So/rces of F/n.s2 ' firm has to make a judicious choice of funds so that they ma&imi#e its value. $he sources of funds are not risk"free. ' firm will have to assess risks involved in each source of funds. %hile issuing e!uity stock, it will have to increase ownership funds into the corporation. %hile issuing debentures and preferred stock, it will have to accept fi&ed and recurring obligauons. $he advantages of leverage, too, will have to be weighed properly. Minim/m &is0s: 1ifferent types of risks confront a firm. ,:o risk, no gain, " is a common adage. /owever, in the world of business uncertainties, a corporate manager will have to calculate business risks, financial risks or any other risk that may work to the disadvantage of the firm before embarking on any particular course of action. %hile keeping the goal of ma&imi#ation of the value of the firm, the management will have to consider the interest of pure or e!uity stockholders as the central focus of financial policies. #ong1r/n "al/e: $he goal of financial management should be to ma&imi#e long run value of the firm. It may be worthwhile for a firm to ma&imi#e profits by pricing its products high, or by pushing an inferior !uality into the market, or by ignoring interests of employees, or, to be precise, by resorting to cheap and ,get"rich" !uick, methods. *uch tactics, however, are bound to affect the prospects of a firm rather adversely over a period of time. For permanent progress and sound reputation, it will have to adopt an approach which is consistent with the goals of financial management in the long"run. A.vantages of )ealt+ Ma,imi-ation

 %ealth ma&imi#ation is a clear term. /ere, the present value of cash flow is taken into consideration. $he net effect of investment and benefits can be measured clearly. (;uantitatively) It considers the concept of time value of money. $he present values of cash inflows and outflows helps the management to achieve the overall objectives of a company. $he concept of wealth ma&imi#ation is universally accepted, because, it takes care of interests of financial institution, owners, employees and society at large. %ealth ma&imi#ation guide the management in framing consistent strong dividend policy, to earn ma&imum returns to the e!uity holders. $he concept of wealth ma&imi#ation considers the impact of risk factor, while calculating the :et 0resent <alue at a particular discount rate, adjustment is made to cover the risk that is associated with the investments. Criticisms of )ealt+ Ma,imi-ation $he concept of wealth ma&imi#ation is being critici#ed on the following grounds2 $he objective of wealth ma&imi#ation is not descriptive. $he concept of increasing the wealth of the stockholders differs from one business entity to another. It also leads to confusion in and misinterpretation of financial policy because different yardsticks may be used by different interests in a company. 's corporations have grown bigger and more powerful, their influence has become more pervasive; they have created an imbalance which is widely believed to have been instrumental in generating a movement to promote more socially conscious business behaviour. 'cademicians and corporate officers alike have urged the advisability of more socially conscious business management. Financial management will then have to rise e!ual to the acceptance of social responsibility of business.

Financial management should not only maintain the financial health of a business, but should also help to produce a rate of earning which will reward the owners ade!uately for the use of the capital they have provided. $o the creditors, the management must ensure administration, which will keep the business li!uid and solvent. )oreover, financial management will have to ensure that e&pectations raised by the corporation are fulfilled with a proper use of several tools at is disposal. In other words, it should ensure an effective management of finance so that it may bear the desired fruits for the organi#ation. If it is properly supported and nurtured by efficient activities at all stages, it will positively ensure desired results. Financial management should take into account the enterprise s legal obligations to its employees. It should try to have a healthy concern which can maintain regular employment under favourable working conditions. /owever, a good financial management alone cannot guarantee that a business will succeed. +ut it is a necessary condition for business success, though not the only one. It may, however, be described as a pre"re!uisite of a successful business. In other words, there are various other factors which may support or frustrate financial management by supportive or non" supportive policies. %ealth ma&imi#ation is as important objective as profit ma&imi#ation. $he operating objective for Financial )anagement is to ma&imi#e wealth or the net present worth of a firm. %ealth ma&imi#ation is an objective which has to be achieved by those who supply loan capital, employees, society and management. $he objective finds its place in these segments of the corporate sector, although the immediate objectives of Financial )anagement may be to maintain li!uidity and improve profitability. $he wealth of owners of a firm is ma&imi#ed by raising the price of the common stock. $his is achieved when the management of a firm operates efficiently and makes optimal decisions in areas of capital investments, financing, dividends and current assets

management. If this is done, the aggregate value of the common stock will be ma&imi#ed. DIMENSIONS OF FINANCIA# MANA$EMENT $he different dimensions of financial management are dealt below2 Antici2ating Financial Nee.s: $he financial manager has to forecast e&pected events in business and note their financial implications. Financial )anager anticipates financial needs by consulting an array of documents such as the cash budget, the pro"forma income statement, the pro"forma balance sheet, the statement of the sources and uses of funds, etc. Financial needs can be anticipated by forecasting e&pected funds in a business and their financial implications. Ac3/iring Financial &eso/rces: $his implies knowing when, where and how to obtain the funds which a business needs. Funds should be ac!uired well before the need for them is actually felt. $he financial manager should know how to tap the different sources of funds. /e may re!uire short"term and long"term funds. $he terms and conditions of the different financial sources may vary significantly at a given point of time. )uch will also depend upon the si#e and strength of the borrowing firm. $he financial image of a corporation has to be improved in appropriate financial circles which are primarily responsible for supplying finance. Allocating F/n.s in /siness: 'llocating funds in a business means investing them in

the best plans of assets. 'ssets are balanced by weighing their profitability against their li!uidity. 0rofitability refers to the earning of profits and li!uidity means closeness to money. $he financial manager should steer a prudent course between over"financing and under"financing. A.ministering t+e Allocation of F/n.s 2 =nce the funds are allocated to various investment opportunities it is the basic responsibility of the finance manager to watch the performance of each rupee that has been invested. /e has to adopt close

supervision and marking of flow of funds. $his will ensure continuous flow of funds as per the re!uirements of the organisation. $his helps the management to increase efficiency by reducing the cost of operations > earn fair amount of profits out of investments. Anal4sing t+e 2erformance of finance2 =nce the funds are administered, it is very comfortable for the finance manager to take decisions. $hrough the budgeting, he will be able to compare the actuals with standards. $he returns on the investments must be continuous and consistent. $he cost of each financial decision and returns of each investment must be analysed. %here ever the deviations are found, necessary steps or strategies are to be adopted to overcome such events. $his helps in achieving .?i!uidity of a business unit. Acco/nting an. &e2orting to Management: :ow, the role of the finance manager is changing. $he department of finance has gained substantial recognition. /e not only acts as line e&ecutive but also as staff. /e has to advise and supply information about the performance of finance to top management. /e is also responsible for maintaining upto date records of the peformance of financial decisions. If need arises, he has to offer his suggestion to improve the overall functioning of the organisation. $he financial manager will have to keep the assets intact, which enable a firm to conduct its business. 'sset management has assumed an important role in Financial )anagement. It is also necessary for the finance manager to ensure that sufficient funds are available for smooth conduct of the business. In this connection, it may be pointed out that management of funds has both li!uidity and profitability aspects. Financial )anagement is concered with the many responsibilities which are the main thrust of a business enterprise. Sco2e an. F/nctions of Financial Management

' priori definition of the scope of financial management fall into three groups. =ne view is that finance is concerned with cash. 't the other e&treme is the relatively narrow definition that financial management is concerned with raising and administering of funds to an enterprise. $he third approach is that it is an integral part of overall management rather than a staff specialty concerned with fundraising operations. In this connection. Financial )anagement plays two significant roles2 $o participate in the process of putting funds to work within the business and to control their productivity; and $o identify the need for funds and select sources from which they may be obtained. $he functions of financial management may be classified on the basis of li!uidity, profitability and management. 567 #i3/i.it42 ?i!uidity is ascertained on the basis of three important considerations2 (a) Forecasting cash flows, that is, matching the inflows against cash outflows; (b) 3aising funds, that is, financial management will have to ascertain the sources from which funds may be raised and the time when these funds are needed; (c) )anaging the flow of internal funds, that is, keeping its accounts, with a number of banks to ensure a high degree of li!uidity with minimum e&ternal borrowing. 587 %rofita9ilit4: %hile ascertaining profitability, the following factors are taken into account2 (a) 9ost 9ontrol2 (&penditure in the different operational areas of an enterprise can be analysed with the help of an appropriate cost accounting system to enable the financial manager to bring costs under control.

(b) 0ricing2 0ricing is of great significance in the company s marketing effort, image and sales level. $he formulation of pricing policies should lead to profitability, keeping, of course, the image of the organi#ation intact. (c) Forecasting Future 0rofits2 (&pected profits are determined and evaluated. 0rofit levels have to be forecasted from time to time in order to strengthen the organi#ation. (d) )easuring 9ost of 9apital2 (ach source of funds has a different cost of capital which must be measured because cost of capital is linked with profitability of an enterprise. 5:7 Management: $he financial manager will have to keep assets intact, for assets are resources which enable a firm to conduct its business. 'sset management has assumed an important role in financial management. It is also necessary for the financial manager to ensure that sufficient funds are available for smooth conduct of the business. =ne of the functions of financial management is co"ordination of different activities of a business house. ' business depends upon availability of funds which, in turn, depends upon the e&tent to which a firm is able to effect cash sales.

&ole an. F/nctions of t+e Financial Manager $he financial manager performs important activities in connection with each of the general functions of the management. /e groups activities in such a way that areas of responsibility and accountability are cleared defined. $he profit centre is a techni!ue by which activities are decentralised for the development of strategic control points. $he determination of the nature and e&tent of staffing is aided by financial budget programme. 1irection is based, to a considerable e&tent, on instruments of financial reporting. 0lanning involves heavy reliance on financial tools and analysis. 9ontrol re!uires the use of the techni!ues of financial ratios and standards. +riefly, an informed and enlightened use of financial information is necessary for the purpose of co" ordinating the activities of an enterprise. (very business, irrespective of its si#e, should, therefore, have a financial manager who has to take key decisions on the allocation and use of money by various departments. *pecifically the financial manager should anticipate financial needs; ac!uire financial resources; and allocate funds to various departments of the business. If the financial manager handles each of these tasks well, his firm is on the road to good financial health. $he financial manager s concern is to2 1etermine the total amount of funds to be employed by a firm; 'llocate these funds efficiently to various assets; =btain the best mi& of financing in relation to the overall evaluation of the firm. *ince the financial manager is an integral part of the top management, he should so shape his decisions and recommendations as to contribute to the overall progress of the business, on which depends the value of the firing. $hat is his primary objective is to ma&imise the value of the firm to its stockholders. 'lthough, decisions are the end product of the financial manager s task, his day"to"day work consists of more than just decision"making. ' great deal of his time is spent on financial planning, which may be described as the co"ordination of a series of inter"

dependent decisions over an e&tended period. =f the many environments in which the firm operates, the one closest to the financial manager is the financial market, which ultimately determines whether a firm s policies are a success or a failure. In a fundamental sense, financial management is nothing more or less than a continuing two"way interaction between a firm and its financial environment. . $he financial manager should2 *upervise the overall working of an organi#ation instead of confining himself to technical matters as a top management e&ecutive )ake sure that funds have been ac!uired in sufficient, but not e&cessive amounts (nsure that disbursements do not create shortage of funds 'nalyse, plan and control the use of funds )aintain li!uidity while retaining the acceptable level of profits (conomise on the ac!uisition of funds and hold down their cost )ake allowances for uncertainties that e&ist in the business world 'dminister effectively cash, receivables, inventory and other components of working capital 'nalyse financial aspects of e&ternal growth 1evelop the means to rejuvenate and revitalise the enterprise or to assist in li!uidity and distribution of its assets to the various claimants. ' financial manager is often up against a dilemma. /e has to choose between profitability and li!uidity. 'lthough both are desirable, sometimes one has to be sacrificed for the other. *ince cash earns no return, a firm increases its li!uidity at the cost of its profitability. $he financial manager does something more than co"ordinate business activities in a mechanical way. /is central role re!uires that he understands

the nature of problems so that he may take proper decisions. In several situations, he faces a challenge2 should he choose profitability or li!uidity6 1espite the knowledge that a particular investment is !uite profitable, he is forced to sacrifice this option, if the investment is going to lock up funds for an unreasonable period; the longer the period, the greater is the risk. )ost financial managers are, therefore, tempted to compromise between profitability and li!uidity, and select projects which are reasonably profitable and, at the same time, sound from the li!uidity point of view. Financial Management an. Economics @nowledge of economics is necessary for the understanding of financial environment and the decision theories which underline contemporary financial management. )acro" economics gives an insight into the policies of the government and private institutions through which money flows, credit flows and general economic activity are controlled. In recent years, a significant change has taken place in the study of financial management, as it has in all other aspects of business and public administration. ' considerable progress has been made in the development of theoretical structures for the solution of business problems. $he model"building approach to financial management has been developed from two separate branches of study " economics and operations research, aided by computer science. $he link between economics and financial management is close. ' study of financial management is likely to be barren if it is divorced from the study of economics. Financial management has, in fact, evolved over the years as an autonomous branch of economics. Financial Management an. Acco/nting It is of greater managerial interest to think of financial management as something of which accounting is a part, which is concerned mainly with the raising of funds, in the most economic and suitable manner; using the funds as profitably as possible (for a given risk level); planning future operations and controlling current performance and

future developments through financial accounting, cost accounting, budgeting, statistics and other means. (ffective planning and direction depends on ade!uate accounting information available to a management on the financial condition of an enterprise. $his includes2 1ecisions which affect e&ternal, legal and financial relationships of funds; decisions on methods of financing, fi&ed and working capital in general Financial structure, credit policy, payment of dividends, creation of reserves 1ecisions which are mainly internal and refer to the deployment of funds on different projects ;uasi"financial decisions which arise from marketing; personnel, production or any other discipline and other problems which have financial aspects 1ecisions for which accounting records and reports are widely used. 'ccounting is a tool for handling only the financial aspects of business operations. It is geared to the financial ends of a business only because these are measurable on the scale of money values. $he distinction between financial management and management accounting is a semantic one, but the gap between the two is rapidly closing. Financial management, however, has the broader meaning of planning and control of all activities by financial means, while management accounting originally meant the internal management of finance in industry. $he accountant devotes his attention to the collection and presentation of financial data. $he financial officer evaluates the accountant s statements, develops additional data and arrives at decisions based on his analysis. Evol/tion of Financial Management $he main stream of academic writing and teaching followed the scope and pattern suggested by the narrower and by now traditional definition of the finance function. Financial management, as it was then more generally called, emerged as a separate branch of economics. $he traditional approach to the entire subject of finance was from the point of view of the investment banker rather than that of the financial decision" maker in an enterprise. $he traditional treatment placed altogether too much emphasis

on corporation finance and too little on the financing problems of non"corporate enterprises. $he se!uence of treatment was built too closely around the episodic phases during the life cycle of a hypothetical corporation in which e&ternal financial relations happened to be dominant. )atters like promotion, incorporation, merger, consolidation,

recapitali#ation and reorgani#ation left too little room for problems of a normal growing company. Finally, it placed heavy emphasis on long"term financial instruments and problems and corresponding lack of emphasis on problems of working capital management. $he basic contents of the traditional approach may now be summarised. $he emphasis in the traditional approach is on raising of funds $he traditional approach circumscribes episodic financial function $he traditional approach places great emphasis on long"term problems It pays hardly any attention to financing problems of non"corporate enterprises. It is difficult to say at what stage the traditional approach was replaced by modern approach. It is clear, however, that (#ra *olomon, $homas ?. 3ein, (dward *. )eade and 'rthur *tone 1ewing among others were profoundly impressed by subjects like promotion, securities, floatation s, reorgani#ation, consolidations, li!uidation, etc. $heir works laid emphasis on these topics. $hey did not consider routine managerial problems relating to financing of a firm, problems of profit planning and control, budgeting, finance and cost control, and working capital management which constitute the cru& of the financial problems of modern financial management. $he central issue of financial policies is a wise use of funds and the central process involved is a rational matching of advantages of potential uses against the caution of advantages of potential uses against the caution of alternative potential sources so as to achieve broad financial goals which an enterprise sets for itself. $he new or modern approach is an analytical way of looking at the financial problems of a firm. Financial problems are a vital and an integral part of overall management. In this connection, (#ra *olomon observes2 If the scope of financial management is re"defined to cover

decisions about both the use and the ac!uisition of funds, it is clear that the principal content of the subject should be concerned with how financial management should make judgements about whether an enterprise should hold, reduce, or increase its investments in all forms of assets that re!uire company funds. %ith the advent of industrial combination the financial manager of corporation was confronted with the comple&ities of budgeting and financial operations. $he si#e and composition of the capital structure was of particular importance. $he major concern of financial management was survival. Its attitude to long"term trade was hostile. It looked upon dividend as a residual payment. $he discipline of financial management was conditioned by changes in the socio"economic and legal environment. Its emphasis shifted from profitability analysis to cash flow generation; and it developed an interest in internal management procedures and control. In the circumstances, cost, budget forecasting, aging of accounts receivable and monetary management assured considerable importance. %ith technological progress, financial management was almost forced to improve its methodology. *uch things as cost of capital, optimal capital structure, effects of capital structure upon cost of capital and market value of a firm were incorporated in the subject. )oreover, financial management laid emphasis on international business and finance, and showed a serious concern for the effects of multi"nationals upon price level movements. $he concern for li!uidity and profit margins was indeed tremendous throughout the several phases of financial management. )odern financial management, however, is basically concerned with optimal matching of uses and sources of corporate funds that lead to the ma&imisation of a firm s market value. F/nctional Areas of Financial Management It would indeed be an e&tremely difficult task to delineate functions of modern financial management. $he subject management has been stretched to such a limit that a

finance manager today has to be conversant with a large variety of subjects, while the traditional finance manager concerned him with such macroeconomic areas of finance as long"term financing, short"term financing, study of financial institutions, capital market (more particularly, the stock e&change), promotion, planning of corporations, underwriting of securities, and so on. Determining Financial Nee.s: =ne of the most important functions of the financial manager is to ensure availability of ade!uate funds. Financial needs have to be assessed for different purposes. )oney may be re!uired for initial promotional e&penses, fi&ed capital and working capital needs. 0romotional e&penditure includes e&penditure incurred in the process of company formation. Fi&ed assets needs depend upon the nature of the business enterprise " whether It is a manufacturing, non" manufacturing or merchandising enterprise. 9urrent asset needs depend upon the si#e of the working capital re!uired by an enterprise.

Fig/re: 6 F/nctional areas of financial management Determining t+e So/rces of F/n.s 2 $he financial manager has to choose the various sources of funds. /e may issue different types of securities. /e may borrow from a number of financial institutions and the public. %hen a firm is new and small and little known in financial circles, the financial manager faces a great challenge in raising funds. (ven when he has a choice in selecting sources of funds, he should e&ercise it with great care and caution.

Financial Anal4sis 2 It is the evaluation and interpretation of a firm s financial position and operations, and involves the comparison and interpretation of accounting data. $he financial manager has to interpret different statements. /e has to use a large number of ratios to analyse the financial status and activities of his firm. /e is re!uired to measure its li!uidity, determine its profitability and assets and overall performance in financial terms. O2timal Ca2ital Str/ct/re: $he financial manager has to establish an optimum capital structure and ensure the ma&imum rate of return on investment. $he ratio between e!uity and other liabilities carrying fi&ed charges has to be defined. In the process, he has to consider the operating and financial leverages of his firm. $he financial manager should have ade!uate knowledge of different empirical studies on the optimum capital structure and find out whether, and to what e&tent, he can apply their findings to the advantage of the firm. Cost1"ol/me1%rofit Anal4sis 2 $his is popularly known as the .9<0 relationship . For this purpose, fi&ed costs, variable costs and semi"variable costs have to be analysed. Fi&ed costs are more or less constant for varying sales volumes. <ariable costs vary according to sales volume. *emi"variable costs are either fi&ed or variable in the short run. $he finance manager has to ensure that the income for the firm will cover its variable costs, for there is no point in being in business, if this is not accomplished. %rofit %lanning an. Control: 0rofit planning and control have assumed great importance in the financial activities of modern business. (conomists have long before considered the importance of profit ma&imi#ation in influencing business decisions. 0rofit planning ensures attainment of stability and growth. In view of the fact that earnings are the most important measure of corporate performance, the profit test is constantly used to gauge success of a firm s activities.

Fi,e. Assets Management: ' firm s fi&ed assets include tangibles such as land, building, machinery and e!uipment, furniture and also intangibles such as patents, copyrights, goodwill, and so on. $he ac!uisition of fi&ed assets involves capital e&penditure decisions and long"term commitments of funds. $hese fi&ed assets are justified to the e&tent of their utility andAor their productive capacity. +ecause of this long"term commitment of funds, decisions governing their purchase, replacement, etc., should be taken with great care and caution. %ro;ect %lanning an. Eval/ation 2 ' substantial portion of the initial capital is sunk in long"term assets of a firm. $he error of judgment in project planning and evaluation should be minimi#ed. 1ecisions are taken on the basis of feasibility and project reports, containing analysis of economic, commercial, technical, financial and organi#ational viabilities. (ssentiality of a project is ensured by technical analysis. $he economic and commercial analysis study demand position for the product. $he economy of si#e, choice of technology and availability of factors favouring a particular industrial site are all considerations which merit attention in technical analysis. Ca2ital /.geting2 9apital budgeting decisions are most crucial; for they have long"

term implications. $hey relate to judicious allocation of capital. 9urrent funds have to be invested in long"term activities in anticipation of an e&pected flow of future benefits spread over a long period of time. 9apital budgeting forecasts returns on proposed long"term investments and compares profitability of different investments and their cost of capital. It results in capital e&penditure investments. )or0ing Ca2ital Management2 %orking capital is rightly an adjunct of fi&ed capital investment. It is a financial lubricant which keeps business operations going. It is the life"blood of a firm. 9ash, accounts receivable and inventory are the important components of working capital, which is rotating in its nature. 9ash is the central reservoir of a firm that ensures li!uidity. 'ccounts receivables and inventory form the

principal of production and sales; they also represent li!uid funds in the ultimate analysis. $he financial manager should weigh the advantage of customer trade credit, such as increase in volume of sales, against limitations of costs and risks involved therein. /e should match inventory trends with level of sales. $he uncertainties of inventory planning should be dealt within a rational manner. $here are several costs and risks which are related to inventory management. $he risks are there when inventory is inade!uate or in e&cess of re!uirements. Divi.en. %olicies: 1ividend policies constitute a crucial area of minancial management. %hile owners are interested in getting the highest dividend from a corporation, the board of directors may be interested in maintaining its financial health by retaining the surplus to be used when contingencies arise. ' firm may try to improve its internal financing so that it may avail itself of benefits of future e&pansion. $he dividend policy of a firm depends on a number of financial considerations, the most critical among them being profitability. $hus, there are different dividend policy patters which a firm may choose to adopt, depending upon their suitability for the firm and its stockholders. Ac3/isitions an. Mergers: Firms may e&pand e&ternally through co"operative arrangements, by ac!uiring other concerns or by entering into mergers. 'c!uisitions consist of either the purchase or lease of a smaller firm by a bigger organi#ation. )ergers may be accomplished with a minimum cash outlay, though these involve major problems of valuation and control. $he process of valuing a firm and its securities is difficult, comple& and prone to errors. $he financial manager should, therefore, go through the valuation process very carefully. $he most difficult interest to value in a corporation is that of the e!uity stockholder because he is the residual owner. Cor2orate Ta,ation2 9orporate ta&ation is an important function of the financial management, for the former has a serious impact on the financial planning of a firm.

*ince the corporation is a separate legal entity, it is subject to an income" ta& structure which is distinct from that which is applied to personal income. Financial Decisions Financial decisions are the decisions relating to financial matters of a corporate entity. Financial re!uirement, Investment, Financing and 1ividend 1ecisions are the most important areas of financial management, which facilitate a business firm to achieve wealth ma&imisation. Financial decisions have been considered as the means to achieve long"term objective of the corporates. F/n.s &e3/irement Decision2 Financial re!uirement decision is one of the most important decisions of finance manager. $his decision is considered with estimation of the total funds re!uired by a business unit. $he total amount of capital and revenue e&penditure of a company facilitates the financial manager in finding the total funds re!uirement. 9apital e&penditure consists of ac!uiring fi&ed assets. 3evenue e&penditure consists of maintaining the day"to"day activities of a business unit. /ence the total of this e&penditure helps the finance manager in determining the total funds re!uirement. Investment Decision2 Investment decision is concerned with allocation of funds to both capital and current assets. 9apital assets are financed through long"term funds and current assets are financed through short"term funds. $he financial manager has to carefully allocate the available funds to recover not only the cost of funds but also must earn sufficient returns on the investments. 9apital budgeting, 9<0 analysis are the techni!ues generally used fir the process of investment decisions. Financing Decisions: Financing decision is concerned with identification of various sources of funds. Funds are available through primary market, financial institution and through the commercial banks. 9ost associated with each of the instrument or source is different. $he overall cost of that capital composition must be kept at minimum proper

debt. (!uity ratio should be maintained to ma&imi#e the returns to the shareholders. $his decision will be made by considering the different factors. vi#., inflation, si#e of the organisation, government policies, etc. Divi.en. Decisions2 3egular and assured percentage of dividend and capital gains are the basic desires of e!uity shareholders. $he overall objective of a corporation is to fulfill the desires of the shareholders and attain wealth ma&imi#ation in the long run. $his decision has been considered as the barometer through which a business firm s performance is measured. $he suppliers of materials, bankers, creditors, shareholders and the government will measure and understand the soundness of the company through dividend decisions. $herefore, dividend decision has been considered as another important decision of the finance function. TIME "A#UE OF MONE< INT&ODUCTION ' project is an activity that involves investing a sum of money now in anticipation of benefits spread over a period of time in the future. /ow do we determine whether the project is financially viable or not6 =ur immediate response to this !uestion will be to sum up the benefits accruing over the future period and compare the total value of the benefits with the initial investment. If the aggregate value of the benefits e&ceeds the initial investment, we will consider the project to the financially viable. %hile this approach prima facia appears to be satisfactory, we must be aware of an important assumption that underlies our approach. %e have assumed that irrespective of the time when money is invested or received, the value of money remains the same. %e know intuitively that this assumption is incorrect because money has time value. /ow do we define this value of money and build it into the cash flow of a project6 $he answer to this !uestion forms the subject matter of this lesson.

)oney has time value. ' rupee today is more valuable than a rupee a year hence. %hy6 $here are several reasons2 Individuals, in general, prefer current consumption to future consumption. 9apital can be employed productively to generate positive returns. 'n investment of one rupee today would grow to (4Br) a year hence (r is the rate of return earned on the investment). In an inflationary period, a rupee today represents a greater real purchasing power than a rupee a year hence. &easons for time val/e of mone4 )any financial problems involve cash flows occurring at different points of time. For evaluating such cash flows an e&plicit consideration of time value of money is re!uired. $his chapter, discussing the methods for dealing with time value of money, is divided into four sections as follows2 Future value of a single cash flow Future value of an annuity 0resent value of a single cash flow 0resent value of an annuity F/t/re val/e of a single cas+ flow *uppose you have 3s. 4,CCC today and you deposit it with a financial institution, which pays 4C per cent interest compounded annually, for a period of 8 years. $he deposit would grow as follows2 3s.

Formula $he general formula for the future value of a single cash flow is2 F<n D 0< (I B k) n F<nD future value n years hence

0<D cash flow today (present value) k D interest rate per year S+orter Com2o/n.ing %erio. *o far, we assumed that compounding is done annually. :ow, we consider the case where compounding is done more fre!uently. *uppose, you depoit 3s. 4,CCC with a finance company which advertises that it pays 47 per cent interest semi"annuallyE this means that interest is paid every si& months. Four deposit (if interest is not withdrawn) grows as follows2

:ote that, if compounding is done annually the principal at the end of one year would be 3s. 4,CCC (4.47) D 3s. 4.47C.C. $he difference of 3s. 8.G (between 3s.4,478.GC under semi"annual compounding and 3s. 4,47C.C under annual compounding represents interest on interest for the second G months. $he general formula value of a single cash flow when compounding is done more fre!uently than annually is2

%here F<n D future value after n years 0<D cash flow today (present value) k D nominal annual rate of interest m D number of times compounding is done during a year n D number of years for which compounding is done. (&ample2 /ow much does a deposit of 3s. H,CCC grow to at the end of G years, if the nominal rate of interest is 47 per cent and the fre!uency is I times a year6

$he amount after G years will be2 3s. H,CCC (4 JC.47) I.G D 3s. H,CCC (4.C8) 7I D 3s. H,CCC & 7.C87K D 3s. 4C,4GI F/t/re val/e of an ann/it4 'n annuity is a series of periodic cash flows (payments or receipts) of e!ual amounts. $he premium payments of a life insurance policy, for e&ample, are an annuity. %hen the cash flows occur at the end of each period the annuity is called a regular annuity or a deferred annuity. %hen the cash flows occur at the beginning of each period the annuity is called an annuity due. *uppose you deposit 3s. 4,CCC annually in a bank for H years and your deposits earn a compound interest rate of 4C per cent, what will be the value of this series of deposits (an annuity) at the end of H years6 'ssuming that each deposit occurs at the end of the year, the future value of this annuity will be2 3s. 4,CCC(4.lC) B 3s. 4,CCC(4.4C) 8 B 3s. 4,CCC (4.4C) 7 B 3s. 4,CCC (4.4C) B 3s. 4,CCC D 3s. 4,CCC (4.IGI4) B 3s. 4.CCC (4.884C) B 3s. 4,CCC (4.74CC) B 3s. 4,CCC (4.4C) B 3s. 4,CCCD 3s. G,4CH $he time line for this annuity is shown in the following.

%resent val/e of a single cas+ flow *uppose, someone promises to give you 3s. 4,CCC three years hence. %hat is the present value of this amount if the interest rate is 4C per cent6 $he present value can be calculated by discounting 3s. 4,CCC, to the present point of time, as follows2

Form/la $he process of discounting, used for calculating the present value, is simply the inverse of compounding. $he present value formula can be readily obtained by manipulating the compounding formula2

1ividing both the sides of (!. (I.4) by (lBk)n, we get,

(&ample2 Find the present value of 3s. 4,CCC receivable G years hence if the rate of discount is 4C per cent. $he present value is2 3s. 4,CCC & 0<IF4CL,G D 3s. 4,CCC (C.HGIH) D 3s. HGI.H (&ample2 4 Find the present value of 3s. 4,CCC receivable 7C years hence if the discount rate is K per cent. *ince $able M does not have the value of 0<IF we obtain the answer as follows2

Ta9le = "al/e of %"IF 0>n for "ario/s Com9inations of 0 an. n

&IS? AND &ETU&N Intro./ction $he value of a firm is affected by two key factors2 risk and return. /igher the risk, other things being e!ual, lower the value; higher the return, other things being e!ual, higher the value. %hile intuitively the meaning of risk and return is grasped by almost every person who reflects on his e&periences, the financial manager needs an e&plicit and !uantitative understanding of these concepts, and, more importantly, the nature of relationship between them. &IS? AND &ETU&N: CONCE%TS 3isk and return may be defined in relation to a single investment or a portfolio of investments. %e will first look at risk and return of a single investment held in isolation and then discuss risk and return of a portfolio of investments.

&IS? 3isk refers to the dispersion of a probability distribution2 /ow much do individual outcomes deviate from the e&pected value6 ' simple measure of dispersion is the range of possible outcomes, which is simply the difference between the highest and lowest outcomes. ' more sophisticated measure of risk, employed commonly in finance, is standard deviation . 4. $he differences between the various possible values and the e&pected value it s!uared. $his means that values which are far away from the e&pected value have much more effect on standard deviation than values which are close to the e&pected value. 7. $he s!uared differences are multiplied by the probabilities associated with the respective values. $his means that the smaller the probability that a particular value will occur, the lesser its effect on standard deviation. 8. $he standard deviation is obtained as the s!uare root of the sum of s!uared differences (multiplied by their probabilities). $his means that the standard deviation and e&pected value is measured in the same units and hence the two can be directly compared. DI"E&SIFIA #E AND NON1DI"E&SIFIA #E &IS? %hat happens when more and more securities are added to a portfolio6 In general, the portfolio risk decreases and approaches a limit. (mpirical studies have suggested that the bulk of the benefit from diversification, in the form of risk reduction, can be achieved by forming a portfolio of 4C"4H securities " thereafter the gains from diversification are negligible or even nil. Figure H.7 represents graphically the effect of diversification on portfolio risk.

1iversifiable risk (also referred to as unsystematic risk or non"market risk) of a security stems from firm"specific factors like emergence of a new competitor, plant breakdown, lawsuit, non"availability of raw materials, etc. (vents of this kind affect primarily a specific firm and not all firms in general. /ence, risks arising from them can be diversified away by including several securities in a portfolio. :on"diversifiable risk (also referred to as systematic risk or market risk) of a security stems from the influence of certain economy"wide factors like money supply, inflation, level of government spending, and industrial policy, which have a bearing on the fortune of almost every firm. *ince, these factors affect returns on all firms, investors cannot avoid the risk arising from them, however, diversified their portfolios may be. 0ut differently such risk cannot be diversified away. /ence, it is referred to as non" diversifiable risk or market risk (as it is applicable to all the securities in the market place) or systematic risk (as it systematically affects all securities). eta 3ational investors hold diversified portfolios from which the diversifiable risk is more or less eliminated. /ence, the relevant measure of risk of an investment is its no diversifiable risk (or systematic risk). 1o all securities have the same degree of non" diversifiable risk6 'll securities do not have the same degree of non"diversifiable risk because the magnitude of influence of economy"wide factors tends to vary from one firm to another. 1ifferent securities have differing sensitivities to variations in market returns. $his is illustrated graphically in the above figure. It shows the returns on the

market portfolio (km) over time along with the returns on two other securities, a risky security (whose return is denoted by kr) and a conservation security (whose return is denoted by k,). It is evident that the return on the risky security (k r) is more volatile than the return on the market portfolio (k m) whereas, the return on the conservative security (kc) is less volatile than turn on the market portfolio (k m). &et/rn $he return from an investment is the realisable cash flow earned by its owner during a given period of time. $ypically, it is e&pressed as a percentage of the beginning of period value of the investment. $o illustrate, suppose you buy a share of the e!uity stock of =lympic ?imited for 3s. KC today. 'fter a year you e&pect that (i) a dividend of 3s. 7 per share will be received and (ii) the price per share will rise to 3s. NC. $he e&pected return, given this information, is simply2

%ro9a9ilit4 %hen you buy an e!uity stock you are aware that the rate of return from it is likely to vary"and often vary widely. For e&ample, if you buy a share of =lympic ?imited for 3s. KC today, you may be confronted with the following possible outcomes as far as the price after a year is concerned2

'll the three outcomes may not be e!ually likely. $he first outcome, for e&ample, may be more likely than the others. In more formal terms we say that the probability associated with outcome ' is greater than the probability associated with the other outcomes.

$he probability of an event represents the chance of its occurrence. For e&ample, suppose an investor says that there is a I to I chance that the market price of a certain stock will rise during the ne&t fortnight. $his implies that there is an KC per cent chance that the price of the stock will increase and a 7C per cent chance that it will not increase during the ne&t fortnight. $his judgment can be represented in the form of a probability distribution as follows2

=ne more e&ample may be given to illustrate the notion of probability distribution. 9onsider investment in two e!uity stocks. $he first stock, +harath Foods, may provide a rate of return of 4H percent, 7C per cent, or 7H per cent with certain probabilities associated with them based on the state of the economy as shown in $able 8. $he second stock, =riental *hipping, being more volatile, may earn a rate of rate return of E 7C per cent, 4C per cent, or IC per cent with the same probabilities, based on the state of the economy as shown in $able 8. E,2ecte. &ate of &et/rn %hen the rate of return can take several possible values because of the investment risk, it is common to calculate the e&pected rate of return, a measure of central tendency. &et/rns /ow is non"diversifiable risk measured6 It is generally measured by beta,. $hough not perfect, beta represents the most widely accepted measure of the e&tent to which the return on a financial set fluctuates with the return on the market portfolio. +y definition, the beta for the market portfolio is 4. ' security which has a beta of say, 4.H, e&periences greater fluctuation than the market portfolio. )ore precisely, if the return on market portfolio is e&pected to increase by 4C per cent, the return on the security with a

beta of 4.H is e&pected to increase by 4H per cent (4.H & 4C per cent). =n the other hand, a security which has a beta of, say, C.K fluctuates lesser than the market portfolio. If the return on the market portfolio is e&pected to rise by 4C per cent, the return on the security with a beta of C.K is e&pected to rise by K per cent (C.K & 4C per cent). Individual security betas generally fall in the range C.GC to 4.KC and rarely, if ever, assume a negative value. &elations+i2 9etween &is0 an. &et/rn Ca2ital Asset %ricing Mo.el %hat is the relationship between the risk of a security measured by its beta and its re!uired rate of return6 'ccording to the capital asset pricing model (9'0)) the following e!uation represents the relationship between risk and return.

's per the above e!uation the re!uired rate of return of a security consists of two components2 (4) the risk"free rate of return (3 f) and (ii) the risk premium (k m"3f). $he risk premium, it may be noted, is the product of the level of risk () and the compensation per unit of risk (km"3f). $hus, for a risky security j, if 3 f is K per cent, is 4.I, and k) is 4I per cent, the re!uired rate of return is2

It is evident that, ceteris paribus, the higher the beta, the greater the re!uired rate of return, and vice versa.

Sec/rit4 Mar0et #ine $he graphical version of the 9'0) is called the security market lines (*)?), which shows the relationship between beta and the re!uired rate of return. $he figure below shows the *)? for the basic data given above. In this figure, the re!uired rate of return for three securities, '. + and 9, is shown. *ecurity ' is a defensive security with a beta of C.H.

fig/re :.@ Sec/rit4 mar0et line Its re!uired rate of return is 44 per cent. *ecurity + is a neutral security with a beta of 4. Its re!uired rate of return is e!ual to the rate of return on the market portfolio. *ecurity 9 is an aggressive security with a beta of 4.H. Its re!uired rate return is 4M per cent. (In general, if the beta of a security is less than 4 it is characterised as defensive, if the beta of a security is e!ual to I it is characterised as neutral; and if the beta of a security is more than 4 it is characterised as aggressive.) C+anges in Sec/rit4 Mar0et #ine $he two parameters defining the security market line are the intercept (34) and the slope (k) " 34). $he intercept represents the nominal rate of return on the risk"free security. It is e&pected to be e!ual to2 risk"free security real rate of return plus inflation rate. For e&ample, if the risk"free real rate of return is 7 per cent and the inflation rate is K per cent the nominal rate of return on the risk"free security is e&pected to be 4C per cent. $he slope represents the price per unit of risk and is a function of the risk"aversion of investors.

If the real risk"free rate of return andAor the inflation rate change, the intercept of the security market line changes. If the risk"aversion of investors changes the slope of the security market line changes. Figure 8.H below shows the change in the security market line when the inflation rate increases and Figure 8.G shows the change in the security market line when the risk"aversion of investors decreases

fig/re :.A c+ange in t+e sec/rit4 mar0et line ca/se. 94 an increase in inflation 9hange In the *ecurity )arket ?ine caused by an Increase in Inflation Sec/rit4 Mar0et E3/ili9ri/m S/22ose t+e re3/ire. ret/rn on stoc0 A is 6A 2er cent> calc/late. as follows:

C+anges in E3/ili9ri/m Stoc0 %rices *tock market prices tend to change in response to changes in the underlying factors. $o illustrate, let us assume that stock ', described above, is in e!uilibrium and sells at a price of 3s. 7C.CC per share. If the e&pectations with respect to this stock are fulfilled, its e!uilibrium price a year hence will be 3s. 74.7C,G per cent higher than the current price.

/owever, several factors could change in the course of a year and alter its e!uilibrium price. *uppose the values of underlying factors change as follows2 Ta9le: B

$he changes in the first three factors cause k'to change from 4H per cent to 48 cent.

$he change in e&pected growth rate, along with the change in the re!uired rate return, causes the e!uilibrium price to increase from 3s2 7C.CC to 3s. 8G.KC.

"al/ation of Sec/rities Intro./ction $he goal of investors and investment managers is to ma&imi#e their rate of return, or in other words, market value of their investments. $hus, investment management is an ongoing process that calls for continuous monitoring of information that may affect the value of securities or rate of return of such securities. $herefore, in making valuation judgements about securities, the analyst applies consistently a process which will achieve a true picture of a company over a representative time span, an estimate of current normal earning power and dividend pay"out; estimate of future profitability; growth and reliability of such e&pectations and the translation of all these estimates into valuation of the company and its securities. "al/ation Conce2t From a financial point of view, the value of an asset is e!ual to the present value of the benefits associated with it. *ymbolically,

%here <C D value of the asset at time #ero 9t D e&pected cash flow at the end of period r k D discount rate applicable to the cash flows n D e&pected life of the asset on. "al/ation a7 Terminolog4 ' bond or debenture (hereafter referred to as only bond), akin to a promissory note, is an instrument of debt issued by a business or governmental unit. In order to understand the valuation of bonds, we need familiarity with certain bond"related terms. 0ar <alue2 $his is the value stated on the face of the bond. It represents the amount the firm borrows and promises to repay at the time of maturity. Osually, the par or face value of bonds issued by business Finns is 3s. 4CC. *ometimes it is 3s 4,CCC. 9oupon 3ate and Interest ' bond carries a specific interest rate which is called the coupon rate. $he interest payable to the bondholder is simply, par value of the bond & coupon rate. For e&ample, the annual interest payable on a bond which has a par value of 3s. 4CC and a coupon rate of 48.H percent is 3s. 48.H (3s. 4CC & 48.H per cent). Mat/rit4 %erio.: $ypically corporate bonds have a maturity period of M to 4C years, whereas government bonds have maturity periods e&tending up to 7C"7H years. 't the time of maturity the par (face) value plus, perhaps a nominal premium, is payable to the bondholder.

97

asic

on. "al/ation Mo.el

's noted above. the holder of a bond receives a fi&ed annual interest"payment for a certain number of years and a fi&ed principal repayment (e!ual to par value) at the time of maturity. /ence, the value of a bond is2

%here < D value of the bond I D annual interest payable on the bond F D principal amount (par value) of the bond repayable at the time of maturity n D maturity period of the bond. (&ample2 ' 3s. 4CC par value bond, bearing a coupon rate of 47 per cent, will mature after K years. $he re!uired rate of return on this bond is 4I per cent. %hat is the value of this bond6 *ince, the annual interest payment will be 3s. 47 for K years and the principal repayment will be 3s. 4CC at the end of K years, the value of the bond will be2

(&ample2 ' 3s. 4,CCC par value bond, bearing a coupon rate of 4I per cent, will mature after H years. $he re!uired rate of return on this bond is 48 per cent. %hat is the value

of this bond6 *ince, the annual interest payment will be 3s. 4IC for H years and the principal repayment will be 3s. 4,CCC at the end of H years, the value of the bond will be2

c7 on. "al/e T+eorems +ased on the bond valuation model, several bond value theorems have been derived. $hey state the effect of the following factors on bond values2 4. 3elationship between the re!uired rate of return and the coupon rate. 7. :umber of years to maturity. $he following theorem show how bond values are influenced by the relationship between the re!uired rate of return and the coupon rate. Ia %hen the re!uired rate of return is e!ual to the coupon rate, the value of a bond is e!ual to its par value. lb %hen the re!uired rate of return is greater than the coupon rate, the value of a bond is less than its par value. Ic %hen the re!uired rate of return is less than the coupon rate, the value of a bond is more than its par value. .7 <iel. to Mat/rit4 5<TM7 *uppose the market price of a 3s. 4,CCC par value bond, carrying a coupon rate of N percent and maturing after K years, is 3s. KCC. %hat rate of return would an investor earn if he buys this bond and holds it till its maturity6 $he rate of return that he earns, called the yield to maturity (F$) hereafter), is the value of led in the following e!uation2

e7 on. "al/es wit+ Semi1ann/al Interest )ost of the bonds pay interest semi"annually. $o value such bonds, we have to work with a unit period of si& months, and not one year. $his means that the bond valuation e!uation has to be modified along the following lines2 $he annual interest payment, 4, must be divided by two to obtain the semi"annual interest payment. $he number of years to maturity must be multiplied by two to get the number of half" yearly periods. $he discount rate has to be divided by two to get the discount rate applicable to half" yearly periods. E3/it4 "al/ation: Divi.e. Ca2itali-ation a22roac+ 'ccording to the dividend capitali#ation approach, a conceptually very sound approach, the value of an e!uity share is e!ual to the present value of dividends e&pected from its ownership plus the present value of the resale price e&pected when the e!uity share is sold. For applying the dividend capitalisation approach to e!uity stock valuation, we will make the following assumptions2 (i) dividends are paid annuallyEthis seems to be a common practice for business firms in India; and (ii) the first dividend is received one year after the e!uity share is bought. Single1%erio. "al/ation Mo.el ?et us begin with the case where the investor e&pects to hold the e!uity share for one year. $he price of the e!uity share will be2

%here 0C D current price of the e!uity share 14D dividend e&pected a year hence 04 D price of the share e&pected a year hence ksD rate of return re!uired on the e!uity share. E,2ecte. &ate of &et/rn

In the preceding discussion we calculated the intrinsic value of an e!uity share, given information about (i) the forecast values of dividend and share price, and (ii) the re!uired rate of return. :ow, we look at a different !uestion2 %hat rate of return can the investor e&pect, given the current market price and forecast values of dividend and sham price6 $he e&pected rate of return is e!ual to2

M/lti1%erio. "al/ation Mo.el /aving learnt the basics of e!uity share valuation in a single"period frame"work, we now, discuss the more realistic, and also the most comple&, case of multiperiod valuation. "al/ation wit+ Constant Divi.en.s If we assume that the dividend per share remains constant year after year at a value of 4), the (!. becomes2

"al/ation wit+ Constant $rowt+ of Divi.en.s )ost stock valuation models are based on the assumption that dividends tend to increase over time. $his is a reasonable hypothesis because business firms typically grow over time. If we assume that dividends grow at a constant compound rate, we get2

$he dividend H years hence will be2 C+anging $rowt+ rates of Divi.en.s )any firms enjoy a period of super normal growth which is followed by a normal rate of growth. Im2act of $rowt+ on %rice> &et/rns> an. %CE &atio

$he e&pected growth rates of companies differ widely. *ome companies are e&pected to remain virtually stagnant; other companies are e&pected to show normal growth; still others are e&pected to achieve super"normal growth rate. 'ssuming a constant total re!uired return, differing e&pected growth rates mean differing stock prices, dividend yields, capital gains yields, and price"earnings ratios. $o illustrate, consider three cases2

$he e&pected earnings per share and dividend per share of each of the three firms are 3s. 8.CC and 3s. 7.CC respectively. Investors re!uired total return from e!uity investments is 4H per cent. 5iven the above information, we may calculate the stock price, dividend yield, capital gains yield, and price"earnings ratio for the three cases as shown in $able 4. E3/it4 "al/ation: &atio A22roac+ %hile conceptually the dividend capitali#ation approach is unassailable, it is often not as widely practised as it should be. 0ractitioners seem to prefer the ratio approach, largely because of its simplicity. $he kinds of ratios employed in the conte&t of valuation are discussed below. oo0 "al/e $he book value per share is simply the net worth of the company (which is e!ual to paid up e!uity capital plus reserves and surplus) divided by the number of outstanding e!uity shares. For e&ample, if the net worth of Penith ?imited is 3s. 8M million and the number of outstanding e!uity shares of Penith is 7 million, the book value per share works out to 3s. 4K.HC ;ts. 8M mitlion divided by 7 million).

/ow relevant and useful is the book value per share as a measure of investment value6 $he book value per sham is firmly rooted in financial accounting and hence can be established relatively easily. 1ue to this, its proponents argue that it represents. $otal return D 1ividend yield B 9apital gains yield an .objective measure of value. ' closer e&amination, however, !uickly reveals that what is regarded as .objective is based on accounting conventions and policies which are characterised by a great deal of subjectivity and arbitrariness. 'n allied, and a more powerful, criticism against the book value measure is that the historical balance sheet figures on which it is based are often very divergent from current economic values. +alance sheet figures rarely reflect earnings power and hence the book value per share cannot be regarded as a good pro&y for true investment value. #i3/i.ation "al/e $he li!uidation value per share is e!ual to

%hile the li!uidation value appears more realistic than the book value, there are two serious problems in applying it. First, it is very difficult to estimate what amounts would be realised from the li!uidation of various assets. *econd, the li!uidation value does not reflect earnings capacity. 5iven these problems, the measure of li!uidation value seems to make sense only for firms which are .better dead than alive E such firms are not viable and economic values cannot be established for them. $o establish the appropriate price"earnings ratio for a given share, one may, to begin with, consider the price"earnings ratio for the market as a whole and also for the industrial grouping to which the share belongs. $he ne&t step would be to judge the price"earnings ratio applicable to the particular share under consideration. In forming this judgment the following factors may be taken into account2

4. 5rowth rate 7. *tability of earnings 8. *i#e of the company I. ;uality of management H. 1ividend payout ratio %hile it is difficult to !uantify the impact of these factors on the price"earnings ratio, the following !ualitative observations may be made2 the higher the growth rate, the higher the price"earnings ratio; the greater the stability of earnings, the higher the price" earnings ratio; the larger the si#e of the company, the higher the price" earnings ratio; the higher the dividend payout ratio, the higher the price"earning ratio. $he popularity of the price"earnings ratio approach seems to stem from two main advantages2 (i) *ince the price"earnings ratio reflects the price per rupee of earnings, it provides a convenient measure for comparing the prices of shares which have different levels of earnings per share. (ii) $he estimates re!uired for using the price"earnings ratio approach are fewer in comparison to the estimates re!uired for applying the dividend capitali#ation approach. %hile these advantages make the price"earnings approach attractive to the practitioner, it must be emphasised that this approach, as it is practised, does not have a sound conceptual basis E the estimate of the price" earnings ratio does not have a firm theoretical underpinning. *hould an attempt be made to develop a sound conceptual basis for this approach, it becomes identical to the dividend capitali#ation approach. DUESTIONS 4. ,Financial management is the appendage of the finance function,. " 9omment. 7. *tate the objectives of financial management. 8. Indicate the possible areas of conflict between management and stockholders. I. 1iscuss briefly the scope and functions of financial management.

H. *tate the role of the financial manager and e&plain his functions in an organi#ation. G. 1escribe the evolution of financial management. M. 1iscuss briefly different functional areas of financial management. K. 1istinguish between2 a. Financial management and economics; b. Financial management and accounting. N. 1iscuss briefly the problems of international financial management. 4C. %hy does money have time value6 44. *tate the general formula for the future value of a single cash flow. 47. %hat is the relationship between effective rate of interest and nominal rate of interest6 48. %hat is an annuity6 4I. *tate the formula for the future value of an annuity. 4H. %hat is a sinking fund factor6 Illustrate it with an e&ample. 4G. *tate the general formula for calculating the present value of a single cash flow. 4M. %hat is the general formula for calculating the present value of a cash flow series6 4K. %hy is standard deviation regarded as the most important measure of risk in financial theory6 4N. %hat happens to risk when we add more and more securities to a portfolio6 7C. 1istinguish between non"diversifiable risk and diversifiable risk. 74. /ow is the systematic risk of a security measured6 77. %hat is the relationship between the risk of a security measured by its beta and its re!uired rate of return6 78. %hat is a defensive security6 :eutral security6 'ggressive security6

7I. %hat is the effect of change in risk aversion on the security market line6 7H. ,$he increase in the risk"premium of all stocks, irrespective of their beta, is the " same, when risk"aversion increases,. 9omment. 7G. %hat is the empirical evidence on 9'0)6 7M. 1iscuss the basic bond valuation model. 7K. %hen the re!uired rate of return is e!ual toAgreater thanAless than the coupon rate, the value of a bond is e!ual toAless thanAmore than its par value. Illustrate this with a numerical e&ample. 7N. ,%hen the re!uired rate of return is greater thanAless than the coupon rate the discountApremium on the bond declines as maturity approaches., Illustrate this with a numerical e&ample. 8C. ,$he longer the maturity of a bond, the greater its price change in response to a given change in the re!uired rate of return., Illustrate this with a numerical e&ample. 84. (&plain and illustrate the concept of yield to maturity. 87. *tate the formula for valuing a bond which pays interest semi"annually and which is redeemable. 88. %hat is the e&pected rate of return on an e!uity share when dividends are e&pected to grow at a constant annual rate6 8I. 1iscuss the valuation of an e!uity share with variable growth in dividends. 8H. 1iscuss the impact of growth on price, dividend yield, capital gains yield, and price" earnings ratio. 8G. /ow relevant and useful is the book value per share as a measure of investment value6 8M. %hat are the limitations of the li!uidation value approach6

8K. %hat factors are relevant in establishing an appropriate price"earnings ratio for a given share6 %hat is the likely effect of these factors on the price"earnings ratio6 8N. %hat are the advantages and limitation of the price"earnings ratio approach6