Finance Function and

Financial Planning
Dr. Hemant Bherwani
Senior Scientist, CSIR-NEERI
Agenda:
✓ What is finance function?

✓ Importance of finance function

✓ Scope of financial management

✓ Financial goals: profit versus value maximization

✓ Finance function: relationship between finance function and other functional

areas of management

✓ Role of finance manager

✓ Meaning of financial planning

✓ Steps in financial planning

Understanding Finance Function
What is finance function?
✓ The finance function refers to practices and activities directed to manage
business finances.

✓ The functions are oriented toward acquiring and managing financial resources
to generate profit.

✓ The financial resources and information optimized by these functions

contribute to the productivity of other business functions, planning, and
decision-making activities.
Key Finance Functions
The finance function encompasses a variety of activities related to managing
the financial resources of an organization.

Here are the key finance functions:

1. Financial Planning and Analysis
2. Investment-Decision Making
3. Financial Decision Making
4. Liquidity Management
5. Risk Management
6. Capital Structure Management
Key Finance Functions

1.Financial Planning and Analysis

Key Finance Functions

1.Financial Planning and Analysis

This involves budgeting, forecasting, and analyzing financial performance to
support strategic decision-making.

Example: A company predicts its sales for the next year to prepare its
budget. It uses historical data to forecast future revenues and expenses.

Types of Financial Planning and Analysis:

a) Revenue Forecasting:
b) Break-Even Analysis:
1. Financial Planning and Analysis

a) Revenue Forecasting:

✓ Revenue forecasting is the process of estimating future revenue based on

historical data, market trends, and other relevant information.

✓ It helps businesses plan for the future, set budgets, and make informed
decisions about investments and expenses.
1. Financial Planning and Analysis

a) Revenue Forecasting:
While there is no single formula for revenue forecasting, a commonly used method
is the straight-line forecasting approach, which assumes that future revenue will
grow at a consistent rate. The formula for straight-line forecasting is:

Formula:

Projected Revenue = Historical Sales × (1+Growth Rate)n

Where:
i. Current Revenue is the revenue for the most recent period
ii. Growth Rate is the expected rate of revenue growth per period
iii. 𝑛 is the number of periods into the future you want to forecast.
a) Revenue Forecasting:
Example:
Let's say a company has a current revenue of $500,000, and it expects a growth rate of
10% per year. We want to forecast the revenue for the next 3 years.

Solution:

Projected Revenue = Historical Sales × (1+Growth Rate)n

i. First Year: Future Revenue_1 = 500,000 × (1 + 0.10)1 = 500,000 × 1.10 = 550,000

ii. Second Year: Future Revenue_2 = 500,000 ×(1 + 0.10)2 = 500,000 × 1.21 = 605,000
iii. Third Year: Future Revenue_3 = 500,000 ×(1 + 0.10)3 = 500,000 × 1.331 = 665,500

The forecasted revenue for the next three years would be $550,000, $605,000, and
$665,500, respectively.
1. Financial Planning and Analysis

b) Break-Even Analysis:

✓ Break-even point analysis is a financial calculation to determine the point at

which revenue received equals the costs associated with receiving the revenue.

✓ At this point, a business neither makes a profit nor incurs a loss.

✓ The analysis helps businesses understand the minimum sales volume needed to
cover their costs and start making a profit.
 b)Break-Even Point Analysis

Formula:
Break-even point (units) = fixed costs / (selling price per unit - variable cost per unit)

Where:
i. Fixed Costs (FC) are the costs that do not change with the level of production or sales
(e.g., rent, salaries)
ii. Selling Price per Unit (SP) is the price at which each unit is sold
iii. Variable Cost per Unit (VC) are the costs that vary directly with the level of production
(e.g., raw materials, direct labor)
b) Break-even point (units) Analysis
Example:
A company manufactures and sells widgets. The fixed costs for the production of widgets
are $10,000 per month. The selling price per widget is $50, and the variable cost per
widget is $30. Calculate the break-even point in units.

Given:
Fixed Costs (FC) = $10,000
Selling Price per Unit (SP) = $50
Variable Cost per Unit (VC) = $30

Solution:
Break-even point (units) = fixed costs / (selling price per unit - variable cost per unit)
Break-Even Point (units) = 10,000/(50-30)
Break-Even Point (units)=500

The company needs to sell 500 widgets per month to break even. At this sales volume,
the company will cover all its fixed and variable costs but will not make a profit .
Key Finance Functions:

2. Investment Decision-Making
 Key Finance Functions:

2. Investment Decision-Making
✓ This involves determining where to allocate the company’s funds to generate the
highest returns.

✓ It helps businesses to decide whether to invest in a new project or purchase new

equipment based on expected returns.

Key terms that requires in investment Decision-Making are:

a) Net Present Value
b) Internal Rate of Return (IRR)
c) Modified Rate of Return (MIRR)
Net Present Value (NPV):
✓ Net present value (NPV) is the difference between the present value of cash
inflows and the present value of cash outflows over a period of time.

✓ NPV is used in capital budgeting and investment planning to analyze the

profitability of a projected investment or project.

✓ NPV is used to find out the current value of a future stream of payments using
the proper discount rate.

✓ In general, projects with a positive NPV are worth undertaking, while those with
a negative NPV are not
Net Present Value (NPV) Formula

1. If there’s one cash flow from a project that will be paid

one year from now, then the formula for NPV is :
Net Present Value (NPV) Formula
2. If analyzing a longer-term project with multiple cash
flows, then the formula for the NPV is:

where:
Rt = net cash inflow-outflows during a single period t
i = discount rate or return that could be earned in alternative investments
t = number of time periods
Net Present Value (NPV)

Easier way to remember the concept of NPV:

NPV = (Today’s value of the expected cash flows)

− (Today’s value of invested cash)
Net Present Value (NPV): Example

Imagine a company can invest in equipment that

would cost $1 million and is expected to generate
$25,000 a month in revenue for five years.
Alternatively, the company could invest that money
in securities with an expected annual return of 8%.
Management views the equipment and securities as
comparable investment risks.

There are two key steps for calculating the NPV of the investment in equipment:
Net Present Value (NPV)

Identify the Cash Flows:

▪ Initial investment: $1,000,000
▪ Monthly revenue = Cash flows : $25,000
▪ Duration = t : 5 years (which is 60 months)
Step 1: NPV of the Initial Investment
▪ Because the equipment is paid for up front, this is the first cash flow
included in the calculation.
▪ No elapsed time needs to be accounted for, so the immediate
expenditure of $1 million doesn’t need to be discounted.
Step 2: NPV of Future Cash Flows

i. Identify the number of periods (t):

The equipment is expected to generate monthly cash flow for five
years, which means that there will be 60 periods included in the
calculation after multiplying the number of years of cash flows by the
number of months in a year.

No of Periods = t = 5 years = 60 months

Step 2: NPV of Future Cash Flows
ii. Identify the discount rate (i):
The alternative investment is expected to return 8 % per year.
Discount Rate = i = 8 %

iii. Discount Rate is taken as Periodic Rate

However, because the equipment generates a monthly stream of cash
flows, the annual discount rate needs to be turned into a periodic, or
monthly, compound rate.
Periodic rate = 0.64 %
Step 2: NPV of Future Cash Flows
iii. Discount Rate is taken as Periodic Rate

Periodic Rate = 0.64 %

Step 2: NPV of Future Cash Flows
The full calculation of the present value is equal to the present value of
all 60 future cash flows, minus the $1 million investment.

The calculation could be more complicated if the equipment was expected to

have any value left at the end of its life, but in this example, it is assumed to
be worthless.
Step 2: NPV of Future Cash Flows

Here, cash flow is constant, i.e. $ 25,000 and

initial investment is $ 1,000,000

In this case, the NPV is positive; the equipment should be purchased.

Step 2: NPV of Future Cash Flows
Assume the monthly cash flows are earned at the end of the month, with the
first payment arriving exactly one month after the equipment has been
purchased.

This is a future payment, so it needs to be adjusted for the time value of money.

NPV of the first five payments:

Internal Rate of Return (IRR):
✓ IRR, or internal rate of return, is a metric used in financial analysis to
estimate the profitability of potential investments.
✓ It is the discount rate that makes the NPV of an investment zero.
Internal Rate of Return (IRR):

Assume a company is reviewing two projects.

Management must decide whether to move forward
with one, both, or neither. Its cost of capital is 10%.
The cash flow patterns for each are as follows:

Project A Project B
Initial Outlay = $5,000 Initial Outlay = $2,000
Year one = $1,700 Year one = $400
Year two = $1,900 Year two = $700
Year three = $1,600 Year three = $500
Year four = $1,500 Year four = $400
Year five = $700 Year five = $300
Internal Rate of Return (IRR):
The company must calculate the IRR for each project. The initial outlay
(period = 0) will be negative. Solving for IRR is an iterative process using the
following equation:

$0 = Σ CFt ÷ (1 + IRR)t

$0 = (initial outlay * −1) + CF1 ÷ (1 + IRR)1 + CF2 ÷ (1 + IRR)2 + ...

+ CFX ÷ (1 + IRR)X
where:
CF = net cash flow
IRR = internal rate of return
t = period (from 0 to last period)

Using the above examples, the company can calculate IRR for each project as:
Internal Rate of Return (IRR): Project A
Project A
Initial Outlay = $5,000
Year one = $1,700
Year two = $1,900
Year three = $1,600
Year four = $1,500
Year five = $700

$0 = $1,700 /(1 + IRR)1 + $1,900/(1 + IRR)2 + $1,600/(1 + IRR)3 +

$1,500/(1 + IRR)4 + $700/(1 + IRR)5 −($5,000)

IRR Project A = 16.61 %

Internal Rate of Return (IRR): Project B
Project B
Initial Outlay = $2,000
Year one = $400
Year two = $700
Year three = $500
Year four = $400
Year five = $300

$0 = ($400 ÷ (1 + IRR)1 + $700 ÷ (1 + IRR)2 + $500 ÷ (1 + IRR)3 +

$400 ÷ (1 + IRR)4 + $300 ÷ (1 + IRR)5 − ($2,000)

IRR Project B = 5.23 %

Given that the company’s cost of capital is 10%, management should proceed
with Project A and reject Project B.
Modified Internal Rate of Return (MIRR)
✓ The modified internal rate of return (MIRR) assumes that positive cash flows are
reinvested at the firm's cost of capital and that the initial outlays are financed
at the firm's financing cost.

✓ By contrast, the traditional internal rate of return (IRR) assumes the cash flows
from a project are reinvested at the IRR itself.

✓ The MIRR, therefore, more accurately reflects the cost and profitability of a
project.
Modified Internal Rate of Return (MIRR):
Example
Assume that a two-year project with an initial outlay of $195
and a cost of capital of 12% will return $121 in the first year
and $131 in the second year. To find the IRR of the project so
that the net present value (NPV) = 0 when IRR = 18.66%:
Modified Internal Rate of Return (MIRR):
Example

To calculate the MIRR of the project, assume that the

positive cash flows will be reinvested at the 12% cost
of capital. Therefore, the future value of the positive
cash flows when t = 2 is computed as:

$121×1.12 + $131 = $266.52

Modified Internal Rate of Return (MIRR):
Example
Next, divide the future value of the cash flows by the present value
of the initial outlay, which was $195, and find the geometric return
for two periods. Finally, adjust this ratio for the time period using
the formula for MIRR, given:

Thus, the IRR gives an overly optimistic picture of the potential of the project,
while the MIRR gives a more realistic evaluation of the project.
Key Finance Functions

3. Financing Decision-Making
Key Finance Functions

3. Financing Decision-Making

This involves decisions on how to fund operations and growth, including equity,
debt, or internal financing.

Example : A company decides whether to raise funds through issuing new shares
or taking a loan.

Key terms that requires in Financing Decision Making are:

1) Cost of Debt (after tax)
2) Cost of Equity
3. Financing Decision-Making

Cost of Debt (after tax):

✓ The Cost of Debt (after tax) represents the effective rate that a company
pays on its borrowed funds, taking into account the tax deductions on
interest expenses.

✓ Since interest payments on debt are tax-deductible, the after-tax cost of

debt is lower than the nominal (pre-tax) interest rate.

✓ It is a crucial component in calculating a company's Weighted Average Cost

of Capital (WACC)

✓ It is also used to evaluate the cost efficiency of financing through debt.

Cost of Debt (after tax): Example
Formula:
Cost of Debt (After Tax)=Rd×(1−Tc)
Where:
•Rd = Cost of debt (pre-tax interest rate)
•Tc = Corporate tax rate

Let's consider a company with the following details:

Cost of debt (pre-tax interest rate) Rd : 6%
Corporate tax rate Tc : 30%

Solution:
Cost of Debt (After Tax) = 𝑅𝑑×(1−𝑇𝑐)
Cost of Debt (After Tax) = 0.06×(1−0.30) = 0.06×0.70 = 0.042 or 4.2%

So, the after-tax cost of debt for this company is 4.2%.

This means that after accounting for tax deductions, the effective interest rate the company
pays on its borrowed funds is 4.2%.
Cost of Equity (using CAPM):
✓ The Cost of Equity represents the return that investors require for investing in
a company’s equity, considering the risk relative to the risk-free rate and the
overall market.

✓ The Capital Asset Pricing Model (CAPM) is a widely used method to calculate
the Cost of Equity.

✓ It estimates the expected return on equity by incorporating the risk-free rate,

the stock's beta (which measures its volatility relative to the market), and the
expected market return.
Cost of Equity (using CAPM):
Formula

𝑅𝑒 = 𝑅𝑓+𝛽(𝑅𝑚−𝑅𝑓)
Where:
Re = Cost of equity
Rf = Risk-free rate (e.g., return on government bonds)
𝛽 = Beta of the stock (a measure of its volatility relative to the market)
Rm = Expected market return
(Rm - Rf) = Market risk premium
Cost of Equity (using CAPM): Example
Let's consider a company with the following details:
Risk-free rate 𝑅𝑓: 3%
Beta of the stock 𝛽: 1.2
Expected market return 𝑅𝑚: 8%

Market risk premium: 𝑅𝑚−𝑅𝑓= 0.08−0.03 = 0.05

Cost of Equity 𝑅𝑒 = 𝑅𝑓 + 𝛽(𝑅𝑚−𝑅𝑓)
Cost of Equity 𝑅𝑒 = 0.03+1.2×(0.08−0.03)
Cost of Equity 𝑅𝑒=0.03+1.2×0.05=0.03+0.06=0.09 or 9%

So, the Cost of Equity for this company, using the CAPM, is 9%.
This means that investors require a 9% return on their investment in the company’s
equity, given the company's risk profile compared to the overall market.
Key Finance Functions:

4. Liquidity Management
4. Liquidity Management
✓ This ensures that the organization has enough cash flow to meet its short-term
obligations.

✓ Liquidity management refers to the strategies and processes used by a

company to ensure it has sufficient cash flow to meet its short-term
obligations and operating expenses.

✓ Effective liquidity management involves maintaining an optimal balance

between having enough liquid assets to cover immediate needs while investing
surplus cash to generate returns.
Current Ratio
✓ One common measure of liquidity is the Current Ratio.

✓ The current ratio formula is a financial metric used to evaluate a company’s

ability to pay its due debts within a year.

✓ A ratio 1.2 or 2 or higher is generally considered good, indicating that the

company is utilizing its assets efficiently.

✓ a low current ratio, less than 1 doesn’t necessarily mean the company is
bankrupt. However, it indicates that the company does not have sufficient
assets to pay off its short-term debt and is not in a desirable position.

✓ It provides investors and analysts insight into how effectively a business can use
its current assets to meet its current liabilities and other payables.
Current Ratio : (Example)

Formula:

Current Ratio = Current Assets/Current Liabilities

Here is an example of Amazon Inc., where the company

provided the current assets and liabilities data in its annual
report for the financial year ending on December 31, 2021.
Balance Sheet of Amazon
Current Ratio : (Example)
From the balance sheet, one can find that the company’s
current assets were worth $161,580, and the current
liabilities were $142,266.
Let’s find the company’s ratio by implementing the current ratio formula.

Current assets: $161,580

Current liabilities: $142,266

Solution:
Current Ratio = Current Assets/Current Liabilities
Current Ratio = $161,580/$142,266
Current Ratio = 1.14
Current Ratio : (Example)

Thus, Amazon’s Current Ratio for 2021 is 1.14.

▪ A low current ratio (values less than 1) can indicate that a firm struggles to
meet current obligations.

▪ However, it can also reflect the organization’s ability to borrow against

good prospects to meet current obligations.

▪ Strong businesses that can turn inventory faster than due dates on their
accounts payable may also have a current ratio of less than one.
Quick Ratio

✓ The Quick Ratio is a liquidity metric used to evaluate a company's ability to

meet its short-term obligations using its most liquid assets.

✓ The quick ratio excludes inventory from current assets, as inventory might
not be easily converted to cash within a short period. However, the current
ratio includes all current assets,

✓ The quick ratio provides a rigid measure of a company's short-term liquidity.

Quick Ratio (Example)
Let us take the latest annual report of Apple Inc. to explain the quick
ratio calculation. As per the annual report for the year ended on Sep 29,
2018, the following information is available:

Based on the given information, Calculate the quick ratio for Apple Inc. for the
year ending Sep 29, 2018.
Balance Sheet of Apple Inc.
Quick Ratio (Example)

Solution:
Out of the above-mentioned current assets, only cash and cash equivalents,
marketable securities, net accounts receivable, vendor non-trade receivables, and
other current assets can be considered quick assets.

Quick Ratio formula is:

Quick Ratio = (Cash and Cash Equivalents +

Marketable Securities + Accounts Receivable +
Net Accounts Receivable + Vendor Non-Trade
Receivables + Other Current Assets) / Total
Current Liabilities
 Quick Ratio (Example)

Quick Ratio = ($25,913 Mn + $40,388 Mn + $23,186 Mn + $25,809 Mn + $12,087 Mn) / $116,866

Mn
Quick Ratio = 1.09
Therefore, the QR for Apple Inc. for the year ending Sep 29, 2018, stood at 1.09, indicating a moderate
liquidity position.
Key Finance Functions:

5. Risk Management
Key Finance Functions:

5. Risk Management

✓ Financial risk management involves identifying, analyzing, and mitigating

financial risks.
✓ It identifies the potential downsides in any investment decision and decides
whether to accept the risks or take measures to mitigate them.

✓ Financial risk management is a continuing process as risks can change over time.
Value at Risk (VaR)
✓ Value at Risk (VaR) is a statistic, used in risk management to predict the
greatest possible losses over a specific time frame.

✓ VaR is determined by three variables: period, confidence level, and the size
of the possible loss.

✓ There are three methods of calculating Value at Risk (VaR) including the
historical method, the variance-covariance method, and the Monte Carlo
simulation.
Value at Risk (VaR)
The formula for calculating VaR depends on the approach used (e.g., historical
simulation, variance-covariance, or Monte Carlo simulation).
A simple and common method is the variance-covariance approach, assuming
normally distributed returns:

Where:
𝑍𝛼 = Z-score corresponding to the confidence level (e.g., 1.65 for 95% confidence, 2.33
for 99% confidence)
𝜎 = Standard deviation of the portfolio's returns
𝑡 = Time period over which the VaR is calculated (e.g., 1 day, 10 days)
Value at Risk (VaR) : Example
Let's consider a portfolio with the following details:
▪ Standard deviation of daily returns (𝜎): 2%
▪ Confidence level: 95%
▪ Time period (𝑡): 1 day

First, find the Z-score for a 95% confidence level. For a 95% confidence level, 𝑍𝛼Z
α is approximately 1.65.
Value at Risk (VaR) : Example

▪ So, the 1-day VaR at a 95% confidence level is 3.3%.

▪ This means that there is a 95% chance that the portfolio will not lose more
than 3.3% of its value in a single day.
▪ If the portfolio value is $1,000,000, the maximum expected loss over one day
would be:

This means there is a 95% confidence that the portfolio will not lose more than
$33,000 in one day.
Key Finance Functions:

6. Capital Structure Management

Key Finance Functions:

6. Capital Structure Management

✓ This involves optimizing the mix of debt and equity financing to minimize the
cost of capital.

✓ For example, A company adjusts its debt-equity ratio to reduce the cost of
capital while maintaining financial stability.

Key terms used in capital structure management are:

1) Debt-to-Equity Ratio
2) Weighted Average Cost of Capital (WACC)
Debt-to-Equity Ratio:
✓ The Debt-to-Equity Ratio (D/E) is a financial leverage ratio that compares a
company's total liabilities to its shareholders' equity.

✓ It indicates the relative proportion of debt and equity used to finance a

company's assets.

✓ A higher ratio suggests more leverage and higher financial risk, as the
company relies more on debt to fund its operations.

✓ Whereas, a lower ratio indicates less leverage and potentially lower

financial risk.

The formula for the Debt-to-Equity Ratio is:

Debt-to-Equity Ratio: Example
Suppose a company has a long term debt of $30 million,
Equity of $20 million, Assets of $60 million.
This would imply that the liabilities other than debt are
60-20-30 = $10 million
Now if we need to find the Debt to Equity ratio, some analysts may only use the
given amount of long term debt that is, the $30 million, while some might
also include the liabilities other than debt and therefore use $40 million as
debt.

Thus, total liabilities will be sum of long term debt and liabilities.

Dept-to-Equity Ratio = (debt + liabilities)/Equity

Dept-to-Equity Ratio = (30 + 10)/20 = 40/20
Dept-to-Equity Ratio = 2
Weighted Average Cost of Capital
(WACC)
✓ The Weighted Average Cost of Capital (WACC) is a financial metric that
represents the average rate of return a company expects to pay its investors
for financing its assets.

✓ It takes into account the proportion of debt and equity in a company's capital
structure.

✓ WACC is used to determine the minimum return that a company must earn on
its existing assets to meet the expectations of its investors.
Formula for WACC:

WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)

Where:
E = Market value of the company's equity
D = Market value of the company's debt
V = Total market value of the company (E + D)
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate
WACC: Example
Let's say a company has the following values:

Market value of equity (E) = $10,000

Market value of debt (D) = $5,000
Cost of equity (Re) = 10%
Cost of debt (Rd) = 5%
Corporate tax rate (Tc) = 30%

First, calculate the total market value of the company (V):

V = E + D = $10,000 + $5,000 = $15,000

Then, calculate the WACC:

WACC = (10,000/15,000) * 0.10 + (5,000/15,000) * 0.05 * (1 - 0.30)
WACC = (0.67) * 0.10 + (0.33) * 0.05 * 0.70
WACC = 0.067 + 0.01155
WACC = 0.07855 or 7.86%

Therefore, the Weighted Average Cost of Capital (WACC) for this company
is 7.86%.