Key decision areas of finance The investment decision Management must allocate limited resources between competing opportunities

(projects) in a process known as capital budgeting [4]. Making this capital allocation decision requires estimating the value of each opportunity or project, which is a function of the size, timing and predictability of future cash flows. The investment decision is concerned with the selection of assets in which funds will be invested by a firm. The assets of a business firm include long term assets (fixed assets) and short term assets (current assets). Long term assets will yield a return over a period of time in future whereas short term assets are those assets which are easily convertible into cash within an accounting period i.e. a year. The long term investment decision is known as capital budgeting and the short term investment decision is identified as working capital management. Capital Budgeting may be defined as long term planning for making and financing proposed capital outlay. In other words Capital Budgeting means the long-range planning of allocation of funds among the various investment proposals. Another important element of capital budgeting decision is the analysis of risk and uncertainity. Since, the return on the investment proposals can be derived for a longer time in future, the capital budgeting decision should be evaluated in relation to the risk associated with it.

Capital budgeting analysis: Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that provide cash flow benefits for more than one year. We are trying to answer the following question: Will the future benefits of this project be large enough to justify the investment given the risk involved? It has been said that how we spend our money today determines what our value will be tomorrow. Therefore, we will focus much of our attention on present values so that we can understand how expenditures today influence values in the future. A very popular approach to looking at present values of projects is discounted cash flows or DCF. However, we will learn that this approach is too narrow for properly evaluating a project. We will include three stages within Capital Budgeting Analysis: ! Decision Analysis for Knowledge Building ! Option Pricing to Establish Position ! Discounted Cash Flow (DCF) for making the Investment Decision

Decision Analysis: Decision-making is increasingly more complex today because of uncertainty. Additionally, most capital projects will involve numerous variables and possible outcomes. For example, estimating cash flows associated with a project involves working capital requirements, project risk, tax considerations, expected rates of inflation, and disposal values. We have to understand existing markets to forecast project revenues, assess competitive impacts of the project, and determine the life cycle of the project. If our capital project involves production, we have to understand operating costs, additional overheads, capacity utilization, and start- up costs. Consequently, we can not manage capital projects by simply looking at the numbers; i.e. discounted cash flows. We must look at the entire decision and assess all relevant variables and outcomes within an analytical hierarchy. Option Pricing: The uncertainty about our project is first reduced by obtaining knowledge and working the decision through a decision tree. The second stage in this process is to consider all options or choices we have or should have for the project. Therefore, before we proceed to discounted cash flows we need to build a set of options into our project for managing unexpected changes. In financial management, consideration of options within capital budgeting is called contingent claims analysis or option pricing. For example, suppose you have a choice between two boiler units for your factory. Boiler A uses oil and Boiler B can use either oil or natural gas. Based on traditional approaches to capital budgeting, the least costs boiler was selected for purchase, namely Boiler A. However, if we consider option pricing Boiler B may be the best choice because we have a choice or option on what fuel we can use. Suppose we expect rising oil prices in the next five years. This will result in higher operating costs for Boiler A, but Boiler B can switch to a second fuel to better control operating costs. Consequently, we want to assess the options of capital projects.Options can take many forms; ability to delay, defer, postpone, alter, change, etc. These options

give us more opportunities for creating value within capital projects. We need to thinkof capital projects as a bundle of options. Three common sources of options are: 1. Timing Options: The ability to delay our investment in the project. 2. Abandonment Options: The ability to abandon or get out of a project that has gone bad. 3. Growth Options: The ability of a project to provide long-term growth despite negative values. For example, a new research program may appear negative, but it might lead to new product innovations and market growth. We need to consider the growth options of projects. Option pricing is the additional value that we recognize within a project because it has flexibilities over similar projects. These flexibilities help us manage capital projects and therefore, failure to recognize option values can result in an undervaluation of a project. Discounted Cash Flows: So we have completed the first two stages of capital budgeting analysis: (1) Build and organize knowledge within a decision tree and (2) Recognize and build options within our capital projects. We can now make an investment decision based on Discounted Cash Flows or DCF. Unlike accounting, financial management is concerned with the values of assets today; i.e. present values. Since capital projects provide benefits into the future and since we want to determine the present value of the project, we will discount the future cash flows of a project to the present. Discounting refers to taking a future amount and finding its value today. Future values differ from present values because of the time value of money. Financial management recognizes the time value of money because: 1. Inflation reduces values over time; i.e. $ 1,000 today will have less value five years from now due to rising prices (inflation). 2. Uncertainty in the future; i.e. we think we will receive $ 1,000 five years from now, but a lot can happen over the next five years. 3. Opportunity Costs of money; $ 1,000 today is worth more to us than $ 1,000 five years from now because we can invest $ 1,000 today and earn a return. Present values are calculated by referring to tables or we can use calculators and spreadsheets for discounting. The discount rate we will use is the opportunity costs of the investment; i.e. the rate of return we require on any other project with similar risks. One question that we must ask in capital budgeting is what is relevant:

1. Depreciation: Capital assets are subject to depreciation and we need to account for depreciation twice in our calculations of cash flows. We deduct depreciation once to calculate the taxes we pay on project revenues and we add back depreciation to arrive at cash flows because depreciation is a non-cash item. 2. Working Capital: Major investments may require increases to working capital. For example, new production facilities often require more inventories and higher salaries payable. Therefore, we need to consider the net change in working capital associated with our project. Changes in net working capital will sometimes reverse themselves at the end of the project. 3. Overhead: Many capital projects can result in increases to allocated overheads, such as computer support services. However, the subjective nature of overhead allocations may not make any difference at all. Therefore, you need to assess the impact of your capital project on overhead and determine if these costs are relevant. 4. Financing Costs: If we plan on financing a capital project, this will involve additional cash flows to investors. The best way to account for financing costs is to include them within our discount rate. This eliminates the possibility of double-counting the financing costs by deducting them in our cash flows and discounting at our cost of capital which also includes our financing costs. We also need to ignore costs that are sunk; i.e. costs that will not change if we invest in theproject. For example, a new product line may require some preliminary marketing research. This research is done regardless of the project and thus, it is sunk. The concept of sunk costs and relevant costs applies to all types of financing decisions.

Three Economic Criteria for Evaluating Capital Projects

Nvp: The first criterion we will use to evaluate capital projects is Net Present Value. Net PresentValue (NPV) is the total net present value of the project. It represents the total value added or subtracted from the organization if we invest in this project. If the Net Present Value is positive, we should proceed and make the investment. If the Net Present Value is negative (as is the case in Example 10), then we would not make the investment. Modified Internal Rate of Return: Besides determining the Net Present Value of a project, we can calculate the rate of return earned by the project. This is called the Internal Rate of Return. Internal Rate of Return (IRR) is one of the most popular economic criteria for

evaluating capital projects since managerscan identify with rates of return. Internal Rate of Return is calculating by finding the discount rate whereby the Net Investment amount equals the total present value of all cash inflows; i.e. Net Present Value = 0. If we have equal cash inflows each year, we can solve for IRR easily. if the Internal Rate of Return were higher than our cost of capital, then we would accept this project. Discounted Payback Period: The final economic criteria we will use is the Discounted Payback Period. Payback refers to the number of years it takes to recover our net investment. WORKING CAPITAL MANAGEMENT:

Working capital management

Working capital management is concerned with the problems arise in attempting to manage the current assets, the current liabilities and the inter relationship that exist between them. The term current assets refers to those assets which in ordinary course of business can be, or, will be, turned in to cash within one year without undergoing a diminution in value and without disrupting the operation of the firm. The major current assets are cash, marketable securities, account receivable and inventory. Current liabilities ware those liabilities which intended at there inception to be paid in ordinary course of business, within a year, out of the current assets or earnings of the concern. The basic current liabilities are account payable, bill payable, bank over-draft, and outstanding expenses. The goal of working capital management is to manage the firm s current assets and current liabilities in such way that the satisfactory level of working capital is mentioned. The current should be large enough to cover its current liabilities in order to ensure a reasonable margin of the safety.
Definition:According to Guttmann & DougallExcess of current assets over current liabilities According to Park & Gladson-

The excess of current assets of a business (i.e. cash, accounts receivables, inventories) over current items owned to employees and others (such as salaries & wages payable, accounts payable, taxes owned to government)

Operating cycle
The need of working capital arrived because of time gap between production of goods and their actual realization after sale. This time gap is called Operating Cycle or Working Capital Cycle. The operating cycle of a company consist of time period between procurement of inventory and the collection of cash from receivables. The operating cycle is the length of time between the company s outlay on raw materials, wages and other expanses and inflow of cash from sales of goods. Operating cycle is an important concept in management of cash and management of cash working capital. The operating cycle reveals the time that elapses between outlays of cash and inflow of cash. Quicker the operating cycle, less amount of investment in working capital is needed and it improves profitability. The duration of the operating cycle depends on nature of industries and efficiency in working capital management.

Types of working capital

The operating cycle creates the need for current assets (working capital). However the need does not come to an end after the cycle is completed to explain this continuing need of current assets a destination should be drawn between permanent and temporary working capital.

1) Permanent working capital:The need for current assets arises, as already observed, because of the cash cycle. To carry on business certain minimum level of working capital is necessary on continues and uninterrupted basis. For all practical purpose, this requirement will have to be met permanent as with other fixed assets. This requirement refers to as permanent or fixed working capital.

2) Temporary working capital:Any amount over and above the permanent level of working capital is temporary, fluctuating or variable, working capital. This portion of the required working capital is needed to meet fluctuation in demand consequent upon changes in production and sales as result of seasonal changes.

Management of Cash
Cash refers to money in the physical form of currency, such as

banknotes and coins. The word has various claims for sources. It was derived from Tamil word kasu meaning a coin by East India Company. Some claim that the word comes from the modern French word caisse, which means "money box". In other words it is a common purchasing power or medium of exchange As such, it forms the most important component of working capital. The term cash with reference to cash management is used in two senses, in narrow sense it is used broadly to cover cash and generally accepted equivalent of cash such as cheques, draft and demand deposits in banks. The broader view of cash also induce hear- cash assets, such as marketable sense as marketable securities and time deposits in banks. The main characteristics of this deposits that they can be really sold and convert in to cash in short term. They also provide short term investment outlet for excess and are also useful for meeting planned outflow of funds. We employ the term cash management in the broader sense. Irrespective of the form in which it is held, a distinguishing feature of cash as assets is that it was no earning power. Company have to always maintain the cash balance to fulfill the dally requirement of expenses. There are four primary motive for maintain the cash as follow:-

Motive of holding cash

There are four motives for holding cash as follow 1. Transaction motive 2. Precautionary motive 3. Speculative motive

4. Compensating motive

Transaction motive Cash balance is necessary to meet day-to-day transaction for carrying on with the operation of firms. Ordinarily, these transactions include payment for material, wages, expenses, dividends, taxation etc. there is a regular inflow of cash from operating sources, thus in case of JISL there will be two-way flow of cash- receipts and payments. But since they do not perfectly synchronize, a minimum cash balance is necessary to uphold the operations for the firm if cash payments exceed receipts. Always a major part of transaction balances is held in cash, a part may be held in the form of marketable securities whose maturity conforms to the timing of anticipated payments of certain items, such as taxation, dividend etc. Precautionary Motive
Cash flows are somewhat unpredictable, with the degree of predictability varying among firms and industries. Unexpected cash needs at short notice may also be the result of following: 1. Uncontrollable circumstances such as strike and natural calamities. 2. Unexpected delay in collection of trade dues. 3. Cancellation of some order for goods due unsatisfactory quality. 4. Increase in cost of raw material, rise in wages, etc. The higher the predictability of firm s cash flows, the lower will be the necessity of holding this balance and vice versa. The need for holding the precautionary cash balance is also influenced by the firm s capacity to have short term borrowed funds and also to convert short term marketable securities into cash.

Speculative motive: Speculative cash balances may be defined as cash balances that are held to enable the firm to take advantages of any bargain purchases

that might arise. While the precautionary motive is defensive in nature, the speculative motive is aggressive in approach. However, as with precautionary balances, firms today are more likely to rely on reserve borrowing power and on marketable securities portfolios than on actual cash holdings for speculative purposes.

INVESTMENT OF SURPLUS CASH

Investing surplus cash involves two basic problems: 1. 2. Determining the amount of Surplus Cash Determining the channels of Investment

Determining the amount of Surplus Cash The cash in excess of firm's normal cash requirements is termed as Surplus Cash. Before determining the amount of surplus cash, the minimum cash balance required by the firm has to be accounted. The minimum level may be termed as the 'safety level for cash' The safety level for cash is determined b the accounts manager separately for the normal and the peak period. In both the cases the two basic factors to be decided are:-

1. Desired days of Cash: This is the number of days for which the cash balance should be sufficient to cover the payments.

2. Average Daily Cash Outflows: This is the average amount of disbursements to be made daily.

After determining the "Desired days of Cash" and the "Average Daily Cash Outflows" separately for the normal and the peak period, the safety level of cash has to be calculated as follows:During Normal Period: - Desired Days of Cash X Average Daily Cash Outflows During Peak Period: - Desired of Cash at the business period X Average of highest Daily Cash Outflows

Determining the Channels of Investment

The Finance Manager can determine the amount of Surplus Cash by comparing the actual amount of Cash available with the safety level or Minimum Level of Cash. Such surplus cash may be either of a temporary or a permanent nature. Temporary cash surplus consists of funds which are available for Investment on a short-term basis (maximum 6 months), since they are require to meet the regular obligations such as those of taxes, dividends etc. Permanent Cash Surplus consists of funds which are kept by the firm to use in some unforeseen profitable opportunity of expansion or acquisition of some asset. Such funds are, therefore, available for Investment for a period ranging form 6 months to a year.

CRITERIA FOR INVESTMENT

In most of the companies, there are usually no formal written instructions for investing the surplus cash. It is left to the discretion and judgment of the Finance Manager. While exercising such discretion or judgment, he usually takes into consideration the following factors:a. Security: - This can be insured by investing money in securities whose price remains more or less stable and where a minimum return is guaranteed.

b. Liquidity: - This can be insured by investing the money in shortterm securities including short-term Fixed Deposits with the Banks.

c. Yield: - Most Corporate Managers give less emphasis to yield as compared to security and liquidity of the Investment. They, therefore, prefer short term Government Securities for investing the surplus Cash. However, some corporate managers follow aggressive Investment policies which maximize the yields on their Investments.

d. Maturity: - Surplus Cash is not available for an indefinite period. Hence, it will be advisable to select the securities according to their maturities keeping in view for which the cash is available. If such selection is done carefully, the Finance Manager can maximize the yield as well as maintain the liquidity if the Investments.

Inventory management
4.1. NATURE AND IMPORTANCE Working capital as net concept, is defined as the difference between current assets and current liabilities. Current assets being those assets that are likely to be converted into liquidity within an years time or so and include items like inventories of raw materials, semimanufactured articles or work-in-process, and finished goods, accounts receivable or dues from customers, hundies or bills receivable, bank balance and cash balance, etc.

Current liabilities are in essence short-term liabilities which have to be settles in a years time, e.g., accounts payable or amount payable to suppliers of goods and services delivered on credit, bills payable, bank overdraft, etc. Since inventories constitute a major item of current assets, the management of inventories is crucial to successful working capital management. Working capital requirements are influences by inventory

holding-the period during which raw materials remain in store, that during which processing takes place and that during which finished goods lie in the warehouse prior to sale. The level of inventory investment affects the total investment in working capital. Thus, operating ratios, such as the ratio of Turnover or sales to Working Capital are affected by it as well.

Return on investment can be reviewed as follows: Return/Investment = (Return/Sales) X (Sales/Investment) Today we continue out talk on inventory management. Therefore, return investment can improve if the return on sales improves and/or if the turnover ratio improves. Since, the two major components, of total investment are fixed capital or fixed assets (like, land and buildings, plant and machinery, furniture and fixture, motor vehicles, etc.) and working capital, proper management of working capital so as to avoid unnecessary blockage of funds in this area and to ensure that the optimum level of investment is made will make room for reduction in the investment and thus pave the way for a higher return on investment. (This would happen when the turnover of investment improves as the denominator declines.)

4.2. MOTIVE FOR HOLDING INVENTORIES It is possible to identify three major movies for holding inventories.

The transaction motive peoples a business to maintain inventories so that there are no bottlenecks in production and/or sales. It is natural for a business to plan inventory investment commensurate with the level of transactions in the business. The business seeks to ensure that on the shop floor production does not get stalled for want of materials, etc., and sales do not suffer on account of notavailability of finished goods.

The precautionary motive is also at work. Inventories are held so that there is a cushion against unpredictable events. For instance, there may be a sudden and unforeseen spurt in demand for finished goods or there may occur a sudden and unforeseen slump or delay of raw materials or other components needed for production. An enterprise would surely like to have some cushion to tide over such situations.

Inventories may also be held so that advantage can be taken of price fluctuations. For instance, if the price of a particular raw material in expected to go up rather steeply, an enterprise may decide to hold a larger than necessary stock of this item (acquired prior to escalation).

As indicated earlier inventories include stocks of raw materials, semi-manufactured or semi-processed goods or work-in-process and finished products. While trading businesses carry inventories of the merchants they offer for sale, manufacturing businesses carry inventories of all three kinds.

Raw materials inventories are maintained so that there remains some flexibility in purchasing and in production scheduling. Inventories of semi-manufactured goods ensure flexibility in production scheduling and utilization of resources, and inventories of finished products endures products scheduling and marketing.

By carrying inventories a firm can address to a large extent demand and lead time uncertainties. The principle followed is that of carrying what we call a buffer. Inventories can also ease out the flow of production when there are time lags in deliveries. Inventories may also help achieve some economies of scale in purchasing and help tide over the problems of seasonal variations. It follows from the above that there are several advantages to be

derived from holding a large inventory, such as economies in production and purchasing and flexibility in operations. However, there are several disadvantages and costs associated with carrying large inventories and that is why we must devote our attention to the question of inventory management.

RECEIVABLES MANAGEMENT AND FACTORING

Receivables or debtors are the one of the most important parts of the current assets which is created if the company sells the finished goods to the customer but not receive the cash for the same immediately. Trade credit arises when firm sells its products and services on credit and dose not receive cash immediately. It is essential marketing tool, acting as bridge for the movement of goods through production and distribution stages to customers. Trade credit creates receivables or book debts which the firm is expected to collect in the near future.

The receivables include three characteristics:1) It involve element of risk which should be carefully analysis. 2) It is based on economic value. To the buyer, the economic value in goods or services passes immediately at the time of sale, while seller expects an equivalent value to be received later on 3) It implies futurity. The cash payment for goods or serves received by the buyer will be made by him in a future period.

5.1. Objective of receivable management The sales of goods on credit basis are an essential part of the modern competitive economic system. The credit sales are generally made up on account in the sense that there are formal acknowledgements of debt obligation through a financial instrument. As a marketing tool, they are

intended to promote sales and there by profit. However extension of credit involves risk and cost, management should weigh the benefit as well as cost to determine the goal of receivable management. Thus the objective of receivable management is to promote sales and profit until that point is reached where the return on investment in further funding of receivables is less than the cost of funds raised to finance that additional credit

5.2. Average collection period The average collection period measures the quality of debtors since it indicate the speed of there collection. The shorter the average collection period, the better the quality of the debtors since a short collection period implies the prompt payment by debtors. The average collection period should be compared against the firm s credit terms and policy judges its credit and collection efficiency. The collection period ratio thus helps an analyst in two respects. 1. In determining the collectability of debtors and thus, the efficiency of collection efforts. 2. In ascertaining the firm s comparative strength and advantages related to its credit policy and performance. The debtor s turnover ratio can be transformed in to the number of days of holding of debtors.

ESTIMATION OF WORKING CAPITAL

After considering the various factors affecting the working capital needs, it is necessary to forecast the working capital requirements. For this purpose, first of all estimate of all current assets should be made, these should be followed by the estimation of all current liabilities. Difference between the estimated current assets and estimated current liabilities will represent the working capital requirements.

GROTH OF FINANCE: Early 1900s - emphasis was on the legal aspects of mergers, the formation of new firms, and the various types of securities firms could issue to raise capital During the depressions of the 1930s -emphasis shifted to bankruptcy and reorganisation, to corporate liquidity, and to the regulation of security markets During the 1940s and early 1950s finance continued to be taught as a descriptive, institutional subject, viewed more from the standpoint of an outsider rather than from that of a manager Late 1950s focus shifted to managerial decisions regarding the choice of assets and liabilities with the goal of maximizing the value of the firm 1990s to date focus on value maximization continued but two trends have become increasingly important: the globalization of business and the increased use of information technology

RELATION OF FINANCE WITH OTHER DICIPLINES: Finance and Accounting Accounting and finance are closely related. Accounting is an important input in financial decision making process. Accounting is concerned with recording of business transactions. It generates information relating to business transactions and reporting them to the concerned parties. The end product of accounting is financial statements namely profit and loss account, balance sheet and the statements of changes in financial position. The information contained in these statements assists the financial managers in evaluating the past performance and fu- ture direction of the firm (decisions) in meeting certain obligations like payment of taxes and so on. Thus, accounting and finance are closely related.

Finance and Production Finance and production are also functionally related. Any changes in production process may necessitate additional funds which the financial managers must evaluate and finance. Thus, the production processes, capacity of the firm are closely related to finance. Finance and Marketing Marketing and finance are functionally related. New product development, sales promotion plans, new channels of distribution, advertising campaign etc. in the area of marketing will require additional funds and have an impact on the expected cash flows of the business firm. Thus, the financial manager must be familiar with the basic concept of ideas of marketing. Finance and Quantitative Methods Financial management and Quantitative methods are closely related such as linear program- ming, probability, discounting techniques, present value techniques etc. are useful in analyz- ing complex financial management problems. Thus, the financial manager should be familiar with the tools of quantitative methods. In other way, the quantitative methods are indirectly related to the day-to-day decision making by financial managers. Finance and Costing Cost efficiency is a major strategic advantage to a firm, and will greatly contribute towards its competitiveness, sustainability and profitability. A finance manager has to understand, plan and manage cost, through appropriate tools and techniques including Budgeting and Activity Based Costing. Finance and Law A sound knowledge of legal environment, corporate laws, business laws, Import Export guide- lines, international laws, trade and patent laws, commercial contracts, etc. are again important for a finance executive in a globalized business scenario. For example The guidelines of Secu- rities and Exchange Board of India [SEBI] for raising money from the capital markets. Simi- larly, now many Indian corporate are sourcing from international capital markets and get their shares listed in the international exchanges. This calls for sound knowledge of Securities Ex- change Commission guidelines, dealing in the listing requirements of various international stock exchanges operating in different countries. Finance and Taxation A sound knowledge in taxation, both direct and indirect, is expected of a finance manager, as all financial decisions are likely to have tax implications. Tax

planning is an important func- tion of a finance manager. Some of the major business decisions are based on the economics of taxation. A finance manager should be able to assess the tax benefits before committing funds. Present value of the tax shield is the yardstick always applied by a finance manager in investment decisions. Finance and Treasury Management Treasury has become an important function and discipline, not only in banks, but in every organization. Every finance manager should be well grounded in treasury operations, which is considered as a profit center. It deals with optimal management of cash flows, judiciously investing surplus cash in the most appropriate investment avenues, anticipating and meeting emerging cash requirements and maximizing the overall returns, it helps in judicial asset li- ability management. It also includes, wherever necessary, managing the price and exchange rate risk through derivative instruments. In banks, it includes design of new financial products from existing products. Finance and Banking Banking has completely undergone a change in todays context. The type of financial assis- tance provided to corporate has become very customized and innovative. During the early and late 80s, commercial banks mainly used to provide working capital loans based on certain norms and development financial institutions like ICICI, IDBI, and IFCI used to provide long term loans for project finance. But, in todays context, these distinctions no longer exist. Moreover, the concept of development financial institutions also does not exist any longer. The same bank provides both long term and short term finance, besides a number of innovative corporate and retail banking products, which enable corporate to choose between them and reduce their cost of borrowings. It is imperative for every finance manager to be up-to date on the changes in services & products offered by banking sector including several foreign players in the field. Thanks to Governments liberalized investment norms in this sector. Finance and Insurance Evaluating and determining the commercial insurance requirements, choice of products and insurers, analyzing their applicability to the needs and cost effectiveness, techniques, ensuring appropriate and optimum coverage, claims handling, etc. fall within the ambit of a finance managers scope of work & responsibilities. Finance and Information Technology Information technology is the order of the day and is now driving all businesses. It is all per- vading. A finance manager needs to know how to integrate finance and costing with opera- tions through software packages including ERP. The

finance manager takes an active part in assessment of various available options, identifying the right one and in the implementation of such packages to suit the requirement.