Fundamentals of Financial

Management
Unit -1
Introduction

Dr. Gargi Chaudhary

Assistant Professor
Shobhit Institute of Engineering & Technology deemed to – be University Meerut
 MEANING OF FINANCE

• Finance may be defined as the art and science of managing money.

• It includes financial service and financial instruments. Finance also is referred as
the provision of money at the time when it is needed.
• Finance function is the procurement of funds and their effective utilization in
business concerns.
• Definition: According to GUTHMANN and DOUGALL, business finance may be
broadly defined as “the activity concerned with the planning, raising, controlling
and administering the funds used in the business.” Financial decisions refer to
decisions concerning financial matters of a business firm. There are many kinds of
financial management decisions that the firm makers in pursuit of maximizing
shareholder's wealth, viz., kind of assets to be acquired, pattern of capitalization,
distribution of firm's income etc. We can classify these decisions into three major
groups:
•  Investment decisions.
•  Financing decision.
•  Dividend decisions.
•  Working capital decision.
 NATURE OF FINANCE FUNCTION
• In most of the organizations, financial operations are centralized. This results in
economies.
• Finance functions are performed in all business firms, irrespective of their sizes
/legal form of organization.
• They contribute to the survival and growth of the firm.
• Finance function is primarily involved with the data analysis for use in decision
making.
• Finance functions are concerned with the basic business activities of a firm, in
addition to external environmental factors which affect basic business activities,
namely, production and marketing.
• Finance functions comprise control functions also
• The central focus of finance function is valuation of the firm. Finance makes use of
economic tools. From Micro economics it uses theories and assumptions. From
Macro economics it uses forecasting models. Even though finance is concerned
with individual firm and economics is concerned with forecasting of an industry.
 SCOPE OF FINANCIAL MANAGEMENT
• The main objective of financial management is to arrange sufficient finance for
meeting short term and long term needs. A financial manager will have to
concentrate on the following areas of finance function.
• Estimating financial requirements: The first task of a financial manager is to
estimate short term and long term financial requirements of his business. The
amount required for purchasing fixed assets as well as needs for working capital
will have to be ascertained.
• Deciding capital structure: Capital structure refers to kind and proportion of
different securities for raising funds. After deciding the quantum of funds required
it should be decided which type of securities should be raised. A decision about
various sources for funds should be linked to the cost of raising funds.
• Proper use of surpluses: The utilization of profits or surpluses is also an important
factor in financial management. A judicious use of surpluses is essential for
expansion and diversification plans and also in protecting the interests of share
holders. A balance should be struck in using funds for paying dividend and retaining
earnings for financing expansion plans.
3. Selecting a source of finance: An appropriate source of finance is selected after
preparing a capital structure which includes share capital, debentures, financial
institutions, public deposits etc. If finance is needed for short term periods then banks,
public deposits and financial institutions may be the appropriate. On the other hand, if
long term finance is required then share capital and debentures may be the useful.

4. Selecting a pattern of investment: When funds have been procured then a decision
about investment pattern is to be taken. A decision will have to be taken as to which
assets are to be purchased? The funds will have to be spent first on fixed assets and
then an appropriate portion will be retained for working capital and for other
requirements.

5. Proper cash management: Cash management is an important task of finance

manager. He has to assess various cash needs at different times and then make
arrangements for arranging cash. Cash may be required to purchase of raw materials,
make payments to creditors, meet wage bills and meet day to day expenses. The idle
cash with the business will mean that it is not properly used.

6. Implementing financial controls: An efficient system of financial management

necessitates the use of various control devices. They are ROI, break even analysis, cost
control, ratio analysis, cost and internal audit. ROI is the best control device in order to
evaluate the performance of various financial policies
 EVOLUTION OF FINANCE FUNCTION
Financial management came into existence as a separate field of study from
finance function in the early stages of 20th century. The evolution of financial
management can be separated into three stages-
• Traditional stage (Finance up to 1940): The traditional stage of financial
management continued till four decades. Some of the important characteristics of
this stage are: i) In this stage, financial management mainly focuses on specific
events like formation expansion, merger and liquidation of the firm. ii) The
techniques and methods used in financial management are mainly illustrated and
in an organized manner. iii) The essence of financial management was based on
principles and policies used in capital market, equipments of financing and lawful
matters of financial events. iv) Financial management was observed mainly from
the prospective of investment bankers, lenders and others

• Transactional stage (After 1940): The transactional stage started in the beginning
years of 1940‟s and continued till the beginning of 1950‟s. The features of this
stage were similar to the traditional stage. But this stage mainly focused on the
routine problems of financial managers in the field of funds analysis, planning and
control. In this stage, the essence of financial management was transferred to
working capital management.
•.Modern stage (After 1950): The modern stage started in the middle of 1950‟s and
observed tremendous change in the development of financial management with the
ideas from economic theory and implementation of quantitative methods of analysis.
Some unique characteristics of modern stage are: i) The main focus of financial
management was on proper utilization of funds so that wealth of current share
holders can be maximized. ii) The techniques and methods used in modern stage of
financial management were analytical and quantitative. Since the starting of modern
stage of financial management many important developments took place. Some of
them are in the fields of capital budgeting, valuation models, dividend policy, option
pricing theory, behavioral finance etc.
 GOALS OF FINANCE FUNCTION
• Effective procurement and efficient use of finance lead to proper utilization of the
finance by the business concern. It is the essential part of the financial manager.
Hence, the financial manager must determine the basic objectives of the financial
management. Objectives of Financial Management may be broadly divided into two
parts such as: 1. Profit maximization 2. Wealth maximization.
• Profit Maximization Main aim of any kind of economic activity is earning profit. Profit
is the measuring techniques to understand the business efficiency of the concern.
Profit maximization is also the traditional and narrow approach, which aims at,
maximizing the profit of the concern. Profit maximization consists of the following
important features.
• Profit maximization is also called as cashing per share maximization. It leads to
maximize the business operation for profit maximization.
• Ultimate aim of the business concern is earning profit, hence, it considers all the
possible ways to increase the profitability of the concern.
• Profit is the parameter of measuring the efficiency of the business concern. So it
shows the entire position of the business concern.
• Profit maximization objectives help to reduce the risk of the business.
Unfavorable Arguments and Drawbacks for Profit Maximization

The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade
practice, etc.
(iii) Profit maximization objectives leads to inequalities among the stake holders such
as customers, suppliers, public shareholders, etc.

Profit maximization objective consists of certain drawback also:

(i)It is vague: In this objective, profit is not defined precisely or correctly. It creates
some unnecessary opinion regarding earning habits of the business concern.

(ii) It ignores the time value of money: Profit maximization does not consider the time
value of money or the net present value of the cash inflow. It leads certain differences
between the actual cash inflow and net present cash flow during a particular period.

(iii) It ignores risk: Profit maximization does not consider risk of the business concern.
Risks may be internal or external which will affect the overall operation of the business
concern.
 Wealth Maximization
Wealth maximization is one of the modern approaches. The term wealth means
shareholder wealth or the wealth of the persons those who are involved in the
business concern. Wealth maximization is also known as value maximization or net
present worth maximization. This objective is an universally accepted concept in
the field of business . Stockholder's current wealth in a firm = (Number of shares
owned) x(Current Stock Price share)
Favorable Arguments for Wealth Maximization
(i) Wealth maximization is superior to the profit maximization because the main aim
of the business concern under this concept is to improve the value or wealth of the
shareholders.
(ii) Wealth maximization considers the comparison of the value to cost associated with
the business concern. Total value detected from the total cost incurred for the
business operation. It provides extract value of the business concern.
(iii)Wealth maximization considers both time and risk of the business concern.
(iv)Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavorable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea of the business concern but it may
not be suitable to present day business activities.

(ii) Wealth maximization creates ownership-management controversy.

(iii) Management alone enjoy certain benefits.

(iv) The ultimate aim of the wealth maximization objectives is to maximize the profit.

(v) Wealth maximization can be activated only with the help of the profitable position
of the business concern
 TIME VALUE OF MONEY
• You must have heard that a rupee today is worth more than a rupee tomorrow. Do
you know why is it so? Now, let us take an example.
• Sriram's grandfather decided to give a gift of Rs. One lakh at the end of the fifth
year; and gave him a choice of having Rs. 75,000 today. Had you been in Sriram's
place what choice would you have made? Do you accepted Rs. 1,00,000 after five
years or Rs. 75,000 today? What do you say? Rs. 75,000 today is much more
attractive than Rs. 1,00,000 after five years because the present is more certain
than the future. You could invest Rs. 75,000 in the market and earn a return on this
amount. Rs. 1,00,000 at the end of five years would have less purchasing power
due to inflation.
• We hope you got the message that a rupee today is worth more than a rupee
tomorrow. But the matters of money are not so simple.
• The time value of money concept will unravel the mystery of such choices that all
of us face in our daily life. In our day-to-day life, several investment decisions
involve cash flow occurring at different points in time. Therefore, recognition of the
time value of money is very important
 FUTURE VALUE
• Future value (FV) is the value of a current asset at a future date based on an
assumed rate of growth. The future value is important to investors and financial
planners, as they use it to estimate how much an investment made today will be
worth in the future. Knowing the future value enables investors to make sound
investment decisions based on their anticipated needs. However, external
economic factors, such as inflation, can adversely affect the future value of the
asset by eroding its value.
• Determining the FV of an asset can become complicated, depending on the type of
asset. Also, the FV calculation is based on the assumption of a stable growth rate. If
money is placed in a savings account with a guaranteed interest rate, then the FV is
easy to determine accurately.
• To understand the core concept, however, simple and compound interest rates are
the most straightforward examples of the FV calculation.Future value is what a sum
of money invested today will become over time, at a given rate of interest. 2.3
CALCULAT
 CALCULATION OF FUTURE VALUE
There are two types of future value calculations:
• The “future value of a lump sum” is the value of a single deposit, like a bank fixed
deposit over time.
• The “future value of an annuity” is the value of a series of payments, like payment
of insurance premium at regular intervals, over time. The term "annuity" refers to
a series of payments of constant amounts.
The easiest way to calculate future value is to use one of the many free
calculators on the internet, or a financial calculator app such as the HP 12C
Financial Calculator available on Google Play and in the Apple App Store. Most
spreadsheet programs have future value functions as well, but for the purpose of
this course we are going to refer to present value, future value and annuity tables
which are provided in this course. The FV formula assumes a constant rate of
growth and a single up-front payment left untouched for the duration of the
investment. The FV calculation can be done one of two ways, depending on the
type of interest being earned.
 i) Using Simple Annual Interest
• If an investment earns simple interest, then the FV formula is:
FV = P × (1 + R × T) Where, FV= Future Value
• P = Principal amount or Investment Amount
• R = Interest rate
• T = Number of years
• FV= Future value or final amount

• For example, assume a Rs.1,000 investment is held for five years in a savings
account with 10% simple interest paid annually. In this case, the FV of the
Rs.1,000 initial investment is Rs1,000 × [1 + (0.10 x 5)], or Rs.1,500.
 ii) Compounded Annual Interest
• With simple interest, it is assumed that the interest rate is earned only on the initial
investment.
• With compounded interest, the rate is applied to each period’s cumulative account
balance. In the example above, the first year of investment earns 10% × Rs.1,000,
or Rs.100, in interest. The following year, however, the account total is Rs.1,100
rather than Rs.1,000; so, to calculate compounded interest, the 10% interest rate is
applied to the full balance for second-year interest earnings of 10% × Rs.1,100, or
Rs.110
• The formula for the FV of an investment earning compounding interest is: FV = P ×
(1 + R)T Where, P = Principal amount or Investment amount R = Interest rate t =
Number of years
• Using the above example, the same Rs.1,000 invested for five years in a savings
account with a 10% compounding interest rate would have an FV of Rs.1,000 × [(1
+ 0.10)5 ], or Rs.1,610.51.
 Future Value of an Annuity Example
• A common use of future value is planning for a financial goal, such as funding a
retirement savings plan. Future value is used to calculate what you need to save
and invest each year at a given rate of interest to achieve that goal. In general
terms the future value of an Annuity is given has the following formula:

• FVAn = A[(1 + r)n − 1]/r

• Where, FVAn= Future Value of annuity A= Constant Periodic flows r= Interest rate
period n= duration of annuity
 PRESENT VALUE Vs. FUTURE VALUE
• We can also measure the present value of money which is going to be received in
future. Using it, you can calculate the worth of something today when you know its
value in the future. This process is also referred to as "discounting" because, for
any positive rate of return, the present value will be less than what it is worth in
the future.
• The interest rate used to calculate the present value of a future return cash flow is
called the "discount rate." To illustrate present value, let’s look at a example. The
future value of Rs. 1,000 deposited for one year into an account earning an annual
2% interest rate is Rs. 1,020:
FV = 1000 × (1+.02)1 = Rs. 1,020
We also know that the present value of that Rs. 1,020 is Rs. 1,000 because it’s what
we started with. Present value is the mirror image of future value.
 TIME VALUE OF MONEY AND ITS
SIGNIFICANCE
The time value of money is very important to all for financial planning, from the decision you
make to buy or lease an asset to a financial decision to invest in new equipment. The future
value determines the effect of time on money. Using future value and other measures can
help you make sound financial decisions.
From the standpoint of financial management, the importance of time value of money can be
seen as follows:
i) For expansion and growth companies deploy a mix internal funds (equity and retained
earnings) and external funds (debt). The time value of money will assist us in determining
the impact and effect of debt owed by businesses on earning and profits.
ii) Because the future is unknown, the time value of money is essential for managing funds and
generating profits from a corporation
The time value of money is significant because it can aid in financial decision-making. An
investor, for example, has the option of choosing between two projects: Project ‘A’ and
Project ‘B’.The only difference between the two initiatives is that Project ‘A' promises Rs.1
million cash reward in year one, while Project ‘B' promises Rs.1 million cash payout in year
five. If the investor does not grasp the time value of money, both projects may appear to be
equally appealing.In reality, because Project ‘A' has a higher present value than Project ‘B,'
the time value of money mandates that Project ‘A' is more appealing.
 CALCULATION OF TIME VALUE OF MONEY
The Time Value of Money can be calculated in two ways. The following formula can be
used to calculate the present value (PV) of future cash flows:
PV = FV × (1 + r)-n or FV= PV × (1+r)n
Where: PV — Present Value.
FV — Future Value.
r — interest rate.
n — number of periods
Where: PV — Present Value.
FV — Future Value.
r — interest rate.
n — number of periods
Notice the negative sign of the power n which allows us to remove the fractions from the
equation. The following formula allows us to calculate the future value FV) of cash flow
from its present value. FV = PV × (1 + r)n
Where: FV — Future Value. PV — Present Value. r — interest rate. n — number of periods
 Effect of Compounding Periods on Future
Value
• The number of compounding periods used in time value of money estimates can
have a significant impact. If the number of compounding periods is raised to
quarterly, monthly, or daily in the Rs.10,000 example above, the concluding future
value calculations are
• Quarterly Compounding: FV = Rs. 10,0000 × [1 + (10%/4)]4×1 = Rs. 11,038
• Monthly Compounding: FV = Rs. 10,0000 × [1 + (10%/12)]12×1 = Rs. 11,047
• Daily Compounding: FV = Rs. 10,0000 × [1 + (10%/365)]365×1= Rs. 11,052

This demonstrates that the time value of money is determined not just by the
interest rate and time horizon, but also by the number of times the compounding
computations are performed each year.
 In practice, there are two sorts of the time value of money notions,

which are described below :

• iTime Value of Money for a One-Time Payment You invest INR 10000 for
5 years in a bank that offers 10% annual interest. You allow it to grow
cumulatively. After 5 years, you will have accumulated a total value of
Rs.16,110. The question now is whether Rs.10,000 is worth more than
Rs.16,110. This is dependent on the rate of inflation, interest rate, and
risk involved. It is a loss if the inflation rate rises. If the interest rate falls,
then it is a gain.
• ii) Time Value of Money -Doubling the Period To calculate when
the amount of money will double, consider another scenario. The
rule of 72 is used to estimate the doubling period. Doubling period
can be estimated by dividing 72 by interest rate. This is also known
as rate of 72. For example, if you invest Rs. 10,000 for 5 years at an
interest rate of 8%, it will take 9 years to double the present value
of your money
Example-1: Assume a sum of Rs.10,000 is invested for one year at 10%

interest. The future value of that money is :

• FV = Rs. 10,0000 × [1 + (10%/1)1×1 = Rs. 11,000
• The formula can also be altered to get the present-day value of the future
total. For instance, the value of Rs.5,000 to be received after year's time,
compounded at 7% interest, is:
• PV = Rs. 5,0000 [1 + (7%/1)1×1] = Rs. 4,673
• We will use the following example to demonstrate the notion of the time value
of money. We intend to invest in a machine that will provide us with annual
cash flow of Rs. 38,500 for the next ten years. The device will cost Rs. 2,50,000
to purchase, and after its useful life has expired, we will be able to sell it for Rs.
1,40,000.
• Time Value of Money – NPV Calculation (in Rs)