1.

Explain the relationship between financial management and other disciplines

Finance and economics:
The relevance of economics to financial management can be described in the light of the two
broad areas of economics: macroeconomics and microeconomics.
Macroeconomics is concerned with the overall institutional environment in which the firm
operates. It looks at the economy as a whole. Macroeconomics is concerned with the institutional
structure of the banking system, money and capital markets, and financial intermediaries,
monetary and fiscal policies. Since business firms operate in the macroeconomic environment, it
is important for financial managers to understand the broad economic environment. They should
recognize and understand how monetary policy affects the cost and the availability of funds; they
should be versed in fiscal policy and its effects on the economy; they should be aware of the
various financial institutions; they should understand the consequences of various levels of
economic activity and changes in economic policy for their decision environment and so on.
Microeconomics deals with the economic decisions of individuals and organizations. It concerns
itself with the determination of optimal operating strategies. In other words, the theories of
microeconomics provide for effective operations of business firms. The concepts and theories of
microeconomics relevant to financial management are those involving supply and demand
relationships and profit maximization strategies, issues related to the mix of productive factors,
optimal sales level and product pricing strategies, measurement of utility preference, risk and
value and rationale of depreciating assets.
In addition, the primary principle that applies in financial management is marginal analysis; it
suggests that financial should be made on the basis of comparison of marginal revenue and
marginal cost. Such decisions will lead to an increase in profits of the firm.
Thus, knowledge of economics is necessary for a financial manager to understand both the
financial environment and the decision theories.
Finance and accounting:
Accounting function is a necessary input into the finance function. That is, accounting is a sub
function of finance. Accounting generates information or data relating to operations of the firm.
The end product of accounting constitutes financial statements. The information contained in
these statements assists financial managers in assessing the past performance and future
directions of the firm and in meeting legal obligations. Thus finance and accounting are
functionally closely related.
But there are two key differences between finance and accounting.

1. Treatment of funds: the measurement of funds in accounting is based on the accrual

principle. For example, revenue is recognized at the point of sale and not when collected.
Similarly, expenses are recognized when they are incurred rather than when actually paid.
The view point of finance relating to the treatment of funds is based on cash flows. The
revenues are recognized only when actually received in cash and expenses are recognized
on actual payment. Financial manager is concerned with maintaining solvency of the firm
and acquiring and financing the assets needed to achieve the goals of the firm.
2. Decision making: finance and accounting also differ in respect of their purpose. The
purpose of accounting is collection and presentation of financial data. It provides
consistently developed and easily interpreted data. The financial manager uses such data
for financial decision making. It does not mean that accounts never make decisions or
financial managers never collect data. Generally finance begins where accounting ends.
3. Financial managers should consider the impact of new product development and
promotion plans made in marketing area since their plans will require capital outlays and
have an impact on the projected cash flows.
4. Changes in the production process may necessitate capital expenditures which the
financial managers must evaluate and finance.
5. The recruitment, training and placement of staff is the responsibility of the personnel
department. However, all this requires finance and therefore, the decisions regarding
these aspects cannot be taken by the personnel department in isolation of the finance
department.
6. The tools of analysis developed in the quantitative methods area are helpful in analyzing
complex financial management problems.
2. EXPLAIN MAJOR DECISIONS OF FINANCIAL MANAGEMENT.
Investment decision:
The investment decision relates to the selection of assets in which funds will be invested by a
firm. The assets which can be acquired fall into two broad groups: (i) long term assets which
yield a return over a period of time in future, (ii) current assets which in the normal course of
business are convertible into cash without diminution in the value usually within a year.
Capital budgeting is probably the most crucial financial decision of a firm. It relates to the
selection of an asset or investment proposal whose benefits are likely to be available in future
over the lifetime of the project. The first aspect of the capital budgeting decision relates to the
choice of the new asset out of the alternatives available. Whether an asset will be accepted or not
will depend upon the relative benefits and returns associated with it. The second element of the

capital budgeting decision is the analysis of risk and uncertainty. Since the benefits from the
investment proposals extend into the future, their accrual is uncertain. They have to be estimated
under various assumptions like volume of sales and the level of prices. The returns from capital
budgeting decisions should be evaluated in relation to the risk associated with it. Finally, the
evaluation of the worth of a long term project implies a certain norm or standard against which
the benefits are to be judged. The standard is known by different names such as cut off rate,
hurdle rate, required rate, minimum rate of return, cost of capital, and so on.
Working capital management is concerned with the management of current assets. It is important
as short term survival is a prerequisite for long term success. It is the trade off between
profitability and liquidity. If a firm does not have adequate working capital, it may not have the
ability to meet its current obligations and thus, invite the risk of bankruptcy. If the current assets
are too large, profitability is adversely affected. In addition, the individual current assets should
be efficiently managed so that neither inadequate nor unnecessary funds are locked up.
Financing decision:
The concern of the financing decision is with the financing mix or capital structure or leverage.
The term capital structure refers to the proportion of debt and equity capital. The financing
decision of a firm relates to the choice of the proportion of these sources to finance the
investment requirements. There are two aspects of the financing decision. First, the theory of
capital structure which shows the theoretical relationship between the employment of debt and
the return to the shareholders. The use of debt implies a higher return and also higher risk.
Therefore, it is necessary to have balance between risk and return. A capital structure with a
reasonable proportion of debt and equity capital is called the optimum capital structure.
Dividend policy decision:
The dividend decision should be analyzed in relation to the financing decision of a firm. Two
alternatives are available in dealing with the profits of a firm: (i) they can be distributed to the
shareholders in the form of dividends or (ii) they can be retained in the business itself. The
proportion of profits distributed as dividends is called the dividend payout ratio and the retained
portion of profits is known as the retention ratio. The dividend policy should be determined in
terms of its impact on the shareholders value. The optimum dividend policy is one that maximizes
the market value of the firms shares. Thus, if shareholders are not indifferent to the firms
dividend policy, the financial manager must determine the optimum dividend payout ratio.
Dividends are generally paid in cash. But a firm may issue bonus shares. Bonus shares are shares
issued to the existing shareholders without any charge.
3. DISCUSS OBJECTIVES OF FINANCIAL MANAGEMENT

1. Profit maximization objective:

According to this approach, actions that increase profits should be undertaken and those that
decrease profits are to be avoided. Profit maximization criterion implies that the investment,
financing and dividend policy decisions of a firm should be oriented to the maximization of
profits. The term profit can be used in two senses. As an owner oriented concept, it refers to the
amount and share of national income which is paid to the owners of business, that is, those who
supply equity capital. As a variant, it is described as profitability. It is an operational concept and
signifies economic efficiency. In other words, profitability refers to a situation where output
exceeds input, that is, the value created by the use of resources is more than the total of the input
resources. In the current financial literature, there is a general agreement that profit maximization
is used in the second sense.
The rationale behind profitability maximization is simple. Profit is a test of economic efficiency.
It provides the yardstick by which economic performance can be judged.
Moreover, it leads to efficient allocation of resources, as resources tend to be directed to uses
which in terms of profitability are the most desirable.
Finally, it ensures maximum social welfare. The individual search for maximum profitability
provides the famous invisible hand by which total economic welfare is maximized.
Financial management is concerned with the efficient use of an important economic resource,
namely, capital. It is therefore argued that profitability maximization should serve as the basic
criterion for financial management decisions.
The main flaws of this criterion are:
Ambiguity the term profit is a vague and ambiguous concept. It is amenable to different
interpretations by different people. To illustrate, profit may be short term or long term; it may be
total profit or rate of profit; it may be before tax or after tax; it may be return on total capitol
employed or total assets and so on. If profit maximization is taken to be the objective, the
question arises, which of these variants of profit should a firm try to maximize?
Timing of benefits- it ignores the differences in the time pattern of benefits received over working
life of the asset.
Time A (Rs in lakh) B (Rs in lakh)
1
50
0
2
100
100
3
50
100
Total 200
200
The total profits associated with the alternatives, A and B, are identical. If the profit maximization
is the decision criterion, both the alternatives would be ranked equally. But the returns from both
the alternatives differ in one important respect, while alternative A provides higher returns in

earlier years, the returns from alternative B are larger in later years. As a result, the two
alternative courses of action are not strictly identical. This is primarily because benefits received
sooner are more valuable than benefits received later. The former can be reinvested to earn a
return. This is referred to as time value of money. The profit maximization criterion does not
consider the distinction between returns received in different time periods and treats all benefits
irrespective of the timing, as equally valuable. This is not true in actual practice.
Quality of benefits- it ignores the quality aspect of benefits associated with a financial course of
action. The term quality here refers to the degree of certainty with which benefits can be
expected. As a rule, the more certain the expected return, the higher is the quality of the benefits
and vice versa. An uncertain and fluctuating return implies risk to the investors. Profit
maximization considers only the size of benefits and gives no weight to the degree of uncertainty
of the future benefits.
State of the economy A (Rs in lakh) B (Rs in lakh)
Recession
9
0
Normal
10
10
Boom
11
20
Total
30
30
The total returns associated with the two alternatives are identical in a normal situation but the
range of variations is very wide in case of alternative B, while it is narrow in respect of
alternative A. obviously, alternative A is better in terms of risk and uncertainty.
2. Wealth Maximization:
This is known as value maximization or net present worth maximization. It is almost universally
accepted as an appropriate operational decision criterion for financial management. It removes all
weaknesses of profit maximization criterion.
The value of an asset should be viewed in terms of the benefits it can produce. The worth of a
course of action can similarly be judged in terms of the value of the benefits it produces less the
cost of undertaking it. The wealth maximization criterion is based on the concept of cash flows
generated by the decision rather than accounting profit which is the basis for profit maximization
criterion. Measuring benefits in terms of cash flows avoids the ambiguity associated with
accounting profits.
Secondly, it considers both the quantity and quality dimensions of benefits. At the same time it
also incorporates the time value of money. The operational implication of the uncertainty and
timing dimensions of the benefits emanating from a financial decision is that adjustments should
be made in the cash flow pattern, firstly, to incorporate risk and secondly, to make an allowance
for differences in the timing of benefits. The value of a stream of cash flows with value
maximization criterion is calculated by discounting its element back to the present at a

capitalization rate that reflects both times and risk. The discounted value exceeding its cost can be
said to create value. Such actions should be undertaken.

W V C
Where W = Net present worth
V = Gross present worth
C = Investment
V

E
K

E= Size of the future benefits available

K = Discount rate
E G (M I T )

G = Average future flow of gross annual earnings

M = Average annual reinvestment required to maintain
T = Taxes
I = Interest, preference dividends and other prior charges

(1 k ) (1 k )

....

(1 k )n

A represents stream of cash flows and K is the appropriate discount rate to measure risk and
timing.
It would also be noted that the focus of financial management is on the value to the owners or
suppliers of equity capital. The wealth of the owners is reflected in the market value of shares. So
wealth maximization implies the maximization of the market price of shares.
4. Explain Meaning and features of Options
An option is a claim without liability. More specifically, an option is a contract that gives the
holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a
specified period of time. The option to buy an asset is known as a call option. The option to sell
an asset is called a put option. The price at which option can be exercised is called an exercise
price or a strike price. The asset on which the put or call option is created is referred to as the
underlying asset.
European option is an option that is allowed to be exercised only on the maturity date.
American option is an option that can be exercised any time before its maturity.

An option holder will exercise his option when it provides him a benefit over buying or selling a
underlying asset from the market at the prevailing price.
There are three possibilities

In the money: a call or put option is said to be in the money when it is advantages for the
investor to exercise it.

Out of the money: a call or put option is out of the money if it is not advantageous for the
investor to exercise it.

At the money: when the holder of a call or a put option does not lose or gain whether or
not he exercise his option, it is called as at the money.

The option premium is the price that the holder of an option has to pay for obtaining a call or put
option.
Call option
A call option on a share is a right to buy the share at an agreed exercise price. The call option
holder exercises his option, when he benefits from it.
Exercise call option when
Share price at expiration>exercise price = St>E
Do not exercise call option when
Share price at exirationexercise price = StE
The value of call option at expiration is:
Value of call option at expiration = Maximum[share price-Exercise price,0]
Ct = Max[St-E,0]
Call premium:
A call buyer exercises his right only when the outcomes are favourable to him. The seller of a call
option being the owner of the asset gives away the good outcomes in favour of the option buyer.
The buyer, therefore, pay up front a price called call premium to the call seller to buy the option.
The call premium is a cost to the option buyer and a gain to the call seller. The net pay off is value
of call option minus call premium.
Put option:
A put option is a contract that gives the holder a right to sell a specified share at an agreed
exercise price on or before a given maturity period. A put buyer gains when the share price falls
below the exercise price. He will forgo his put option if the share price rises above the exercise
price.
Exercise put option when
Exercise price>Share price at expiration = E>St

Do not exercise put option when

Exercise price Share price at expiration = ESt
The value of a put option = Maximum [Exercise price Share price at expiration, 0]
Pt = Max [E-St,0]
Put option pay off is put option value minus put option premium.
6. How do you measure Time value of money? Illustrate
Future value or compound value
Compounding is the process of finding the future values of cash flows by applying the concept of
compound interest.
1. Compound value of lump sum
F=P(1+i)n
F- future value at the nth period
i- interest rate
n- number of years
Suppose that Rs.1000 is placed in the savings account of a bank at 5 percent interest rate.
How much shall it grow at the end of three years?
F = 1000(1+0.05)
F = 1157.60
Compound value of an annuity
Annuity is the fixed payment or receipt for specified number of years. Suppose Rs.100 is
deposited at the end of each of the next three years at 10 percent interest rate. What will be
the value at the end of third year? For which, the following formula can be used for
calculation

n
F=A 1 i 1

A-annuity
=331

Present value:
Present value is also called discount value that is the future cash flow is discounted to present
worth.

Present value of lump sum

The present values can be worked out for any combination of number of years and interest
rate. The following general formula can be employed to calculate the present value of single
cash flow to be received after some periods.

1
n
1 i

P=F

Suppose that an investor wants to find out the present value of Rs.50000 to be received after
15 years. The interest rate is 9 percent.
P=50000[1/(1+0.09)15=13750
Present value of an annuity
An investor may have an investment opportunity of receiving a constant period amount for
certain specific period. The present value of this amount can be estimated with following
equation.
1
1

n
i i 1 i

P=A

To illustrate, let us suppose that a person receives an annuity of Rs.5000 for four years. If the
rate of interest is 10 percent, the present value is

Present value of perpetuity

Perpetuity is an annuity that occurs indefinitely. Its present value is arrived at using following
equation.
P=

A
i

To take an example, let us assume that an investor expects a perpetual sum of Rs.500
annually from his investment. The present value if interest rate is 10 percent is
P = 500/0.1=5000.
Present value of growing annuity
In financial decision making there are number of situations where cash flows may grow at a
constant rate. In this case the present value is

A company paid a dividend of Rs.60 last year. This dividend stream is expected to grow at 10
percent per annum for 15 years and then ends. If the discount rate is 21 percent, what is the
present value?
=456.36

Present value of growing perpetuity

Constantly growing perpetuities are annuities growing indefinitely. Suppose dividends of Rs.66
after one year are expected to grow at 10 percent indefinitely and discount rate is 21 percent. The
present value calculation uses following equation.

P =66/ (0.21-0.1)=Rs.600

7. What are the functions of financial manager?

Finance manager performs the following major functions:
1. Forecasting Financial Requirements
It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to acquire
fixed assets and forecast the amount needed to meet the working capital requirements in future.
2. Acquiring Necessary Capital
After deciding the financial requirement, the finance manager should concentrate how the finance
is mobilized and where it will be available. It is also highly critical in nature.
3. Investment Decision
The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability while investing capital.
4. Cash Management
Present days cash management plays a major role in the area of finance because proper cash
management is not only essential for effective utilization of cash but it also helps to meet the
short-term liquidity position of the concern.
5. Interrelation with Other Departments
Finance manager deals with various functional departments such as marketing, production,
personnel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization.
8. List out Factors affecting capital budgeting:
Capital budgeting or capital expenditure decision depends on many factors such as
1. Opportunities:
The first and foremost factor which decides the capital budgeting decision is investment
opportunities available for the firm. Without investment opportunity, there is no need of
considering capital expenditure. When firm has more opportunities, the capital budgeting
becomes significant and complex.
2. Certainty:

Every project has its own risk. The cash flow variation differs from project to project. Greater the
risk the firm has, more the profitability it earns and vice versa. Though aim of the finance
manager is to maximise wealth, he has to look in to quality of cash flow.
3. Urgency:
Sometimes an investment may require immediate attention in view of survival of business.
Owing to urgency of investment, the firm may not follow stringent evaluation procedure.
4. Availability of funds:
It is another important factor that decides capital budgeting decision. Some due to lack of funds,
even highly profitable project may not be in a position to undertake. When a firm posses
abundant resources, even low profitable project may undertaken.
5. Future earnings:
A project may not be profitable today or in short term but it may be more profitable in long term
or in future. When projects are evaluated this case may be short listed for investment.
6. Obsolescence:
There are certain projects which have greater risk of obsolescence than others. In case of projects
with high rate of obsolescence, the project with lesser payback period may be preferred than one
which may have higher profitability but still longer pay back period.
7. cost considerations:
Cost of capital, cost of production, opportunity cost of capital etc., are other consideration
involved in the capital budgeting decisions.
8. Intangible factors:
Sometimes a capital expenditure has to be made due to certain emotional and intangible factors
such as safety and welfare of workers, prestigious project, social welfare, goodwill etc.
9. Legal factors:
An investment which is required by the provisions of law is solely influenced by this factor.
Though projects may not be profitable, investment should be made.
9. Explain Return and risk of single security and portfolio
Return is the excess earnings over investment. Return consists of regular income and capital gain
or loss. For shares, the regular income is dividend and capital appreciation is price changes
between two periods.

P1- current price, P0- last year price and DIV1-current dividend, and R- return

Risk is variation in return or volatility in return. It can be calculated using range, variance and
standard deviation.
Range is the difference between highest return and lowest return. Suppose a share earns returns of
5%, 4%, 7% and 8% for 1 through 4 years respectively.
The range is 4% (8-4).
Variance
Standard deviation of single portfolio

For the above example

year
1
2
3
4

Return
5
4
7
8

Difference square
1
4
1
4

Mean return =6
Variance = 10/3 = 3.33
Standard deviation = 1,825
Return with probability:
Expected return is the sum of the product of each outcome or return and its associated probability.
E(R) =

The share of hypothetical company limited has the following anticipated returns with associated
probabilities.
Return
Probabilit

-20
0.05

-10
0.10

10
0.20

15
0.25

20
0.20

y
Using formula the expected return and standard deviation are calculated.
E(R) = 13%
Standard deviation = 12.49%
Risk and return of two assets portfolio:

25
0.15

30
0.05

The return of the portfolio is equal to the weighted average of the returns of individual assets in
the portfolio with the weights being equal to the proportion of investment value in each asset
There is a direct and simple method of calculating the expected rate of return on a portfolio if we
know the expected rates of return on individual assets and their weights.

We can use variance or standard deviation to measure the risk of the portfolio of assets. The
portfolio variance or standard deviation depends on the co movements of returns on two assets.
Covariance of returns on two assets measures their comovement.
Three steps are involved in the calculation of covariance between two assets:
Determine the expected returns on assets
Determine the deviation of possible returns from the expected return for each asset.
Determine the sum of the product of each deviation of returns of two assets and respective
probability.

The variance of two asset portfolio is not the weighted average of assets since they covary as
well. The standard deviation of two security portfolio is given by the following equation.

It is noted from equation that the variance of a portfolio includes the proportion of variances of
the individual securities. The covariance depends on the correlation between the securities in the
portfolio.