Foundations of Finance

FOUNDATIONS OF FINANCE

1 Introduction

1.1Meaning of Finance

1.2Definition of Finance

1.3Types of Finance

2 Overview

2.1 Scope of Financial Management

2.2 Objectives of Financial Management

2.3 Approaches to Financial Management

2.4 Importance of Financial Management

3 Time Value Of Money

3.1 Concept

3.2 Compound Interest

3.3 Present Value

4 Introduction To The Concept Of Return Of A Single Asset

4.1 Introduction

4.2 Concept and Types of Risk

4.3 Risk and Return of the Portfolio

4.4. Relationship Between The Risk And Return

5 Valuation Of Bonds And Shares

5.1 Valuation of Bonds

5.2 Valuation of Shares

6 Option Valuation

6.1 Factors Affecting Value Of Options

1 Introduction

Business concern needs finance to meet their requirements in the economic world. Any kind of business activity depends on the finance. Hence, it is called as lifeblood of business organization. Whether the business concerns are big or small, they need finance to fulfill their business activities.

In the modern world, all the activities are concerned with the economic activities and very particular to earning profit through any venture or activities. The entire business activities are directly related with making profit. According to the economics concept of factors of production, rent given to landlord, wage given to labour, interest given to capital and profit given to shareholders or proprietors, a business concern needs finance to meet all the requirements. Hence finance may be called as capital, investment, fund etc., but each term is having different meanings and unique characters. Increasing the profit is the main aim of any kind of economic activity.

1.1 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. The concept of finance includes capital, funds, money, and amount. But each word is having unique meaning. Studying and understanding the concept of finance become an important part of the business concern.

1.2 Definition Of Finance

^v       According to Khan and Jain, ―Finance is the art and science of managing money‖.

^v       Webster’s Ninth New Collegiate Dictionary defines finance as ―the Science on study of the management of funds‘ and the management of fund as the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of

banking facilities.

Definition Of Business Finance

According to the Guthumann and Dougall, ―Business finance can broadly be defined as the activity concerned with planning, raising, controlling, administering of the funds used in the business‖.

Corporate finance is concerned with budgeting, financial forecasting, cash management, credit administration, investment analysis and fund procurement of the business concern and the business concern needs to adopt modern technology and application suitable to the global environment.

1.3 Types Of Finance

Finance is one of the important and integral part of business concerns, hence, it plays a major role in every part of the business activities. It is used in all the area of the activities under the different names.

^v        Private Finance

^v        Public Finance

Types of Finance

Private Finance, which includes the Individual, Firms, Business or Corporate Financial activities to meet the requirements.

Public Finance which concerns with revenue and disbursement of Government such as Central Government, State Government and Semi-Government Financial matters.

2 OVERVIEW

Definition

The most popular and acceptable definition of financial management as given by S.C. Kuchal is that ―Financial Management deals with procurement of funds and their effective utilization in the business‖.

Joshep and Massie: Financial management ―is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations.

2.1 Scope Of Financial Management

1. Financial Manage ment and Economics

Economic concepts like micro and macroeconomics are directly applied with the financial management approaches. Investment decisions, micro and macro environmental factors are closely associated with the functions of financial manager. Financial management also uses the economic equations like money value discount factor, economic order quantity etc. Financial economics is one of the emerging area, which provides immense opportunities to finance, and economical areas.

2. Financial Management and Accounting

Accounting records includes the financial information of the business concern. Hence, we can easily understand the relationship between the financial management and accounting. In the olden periods, both financial management and accounting are treated as a same discipline and then it has been merged as Management Accounting because this part is very much helpful to finance manager to take decisions. But nowadays financial management and accounting discipline are separate and interrelated.

3. Financial Management or Mathematics

Modern approaches of the financial management applied large number of mathematical and statistical tools and techniques. They are also called as econometrics. Economic order quantity, discount factor, time value of money, present value of money, cost of capital, capital structure theories, dividend theories, ratio analysis and working capital analysis are used as mathematical and statistical tools and techniques in the field of financial management.

4. Financial Management and Production Management

Production management is the operational part of the business concern, which helps to multiple the money into profit. Profit of the concern depends upon the production performance. Production performance needs finance, because production department requires raw material, machinery, wages, operating expenses etc. These expenditures are decided and estimated by the financial department and the finance manager allocates the appropriate finance to production department. The financial manager must be aware of the operational process and finance required for each process of production activities.

5. Financial Management and Marketing

Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements. The financial manager or finance department is responsible to allocate the adequate finance to the marketing department. Hence, marketing and financial management are interrelated and depends on each other.

6. Financial Management and Human Resource

Financial management is also related with human resource department, which provides manpower to all the functional areas of the management. Financial manager should carefully evaluate the requirement of manpower to each department and allocate the finance to the human resource department as wages, salary, remuneration, commission, bonus, pension and other monetary benefits to the human resource department. Hence, financial management is directly related with human resource management.

2.2 Objectives Of Financial Management

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

^v        Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization.

^v Ultimate aim of the business concern is earning profit, hence, it considers all the possible

ways to increase the profitability of the concern.

^v        Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern.

^v        Profit maximization objectives help to reduce the risk of the business.

Favourable Arguments for Profit Maximization

(i) Main aim is earning profit.

(ii) Profit is the parameter of the business operation.

(iii)Profit reduces risk of the business concern.

(iv)Profit is the main source of finance.

(v) Profitability meets the social needs also.

Unfavourable Arguments for 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.

Drawbacks of Profit Maximization

(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, which involves latest innovations and improvements in the field of the business concern. 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.

Favourable 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.

Unfavourable 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 is nothing, it is also profit maximization, it is the indirect name of the profit maximization.

(iii)Wealth maximization creates ownership- management controversy.

(iv)Management alone enjoys certain benefits.

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

(vi)Wealth maximization can be activated only with the help of the profitable position of the business concern.

2.3 Approaches To Financial Management

Theoretical points of view, financial management approach may be broadly divided into two major parts.

^v   Traditional Approach

^v   Modern Approach

Traditional Approach

Traditional approach is the initial stage of financial management, which was followed, in the early part of during the year 1920 to 1950. This approach is based on the past experience and the traditionally accepted methods. Main part of the traditional approach is rising of funds for the business concern. Traditional approach consists of the following important area.

^v   Arrangement of funds from lending body.

^v   Arrangement of funds through various financial instruments.

^v   Finding out the various sources of funds.

Functions Of Finance Manager

1. Forecasting Financial Require ments

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 day‘s 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.

2.4 Importance Of Financial Management

Financial Planning

Financial management helps to determine the financial requirement of the business concern and leads to take financial planning of the concern. Financial planning is an important part of the business concern, which helps to promotion of an enterprise.

Acquisition of Funds

Financial management involves the acquisition of required finance to the business concern. Acquiring needed funds play a major part of the financial management, which involve possible source of finance at minimum cost.

Proper Use of Funds

Proper use and allocation of funds leads to improve the operational efficiency of the business concern. When the finance manager uses the funds properly, they can reduce the cost of capital and increase the value of the firm.

Financial Decision

Financial management helps to take sound financial decision in the business concern. Financial decision will affect the entire business operation of the concern. Because there is a direct relationship with various department functions such as marketing, production personnel, etc.

Improve Profitability

Profitability of the concern purely depends on the effectiveness and proper utilization of funds by the business concern. Financial management helps to improve the profitability position of the concern with the help of strong financial control devices such as budgetary control, ratio analysis and cost volume profit analysis.

Increase the Value of the Firm

Financial management is very important in the field of increasing the wealth of the investors and the business concern. Ultimate aim of any business concern will achieve the maximum profit and higher profitability leads to maximize the wealth of the investors as well as the nation.

Promoting Savings

Savings are possible only when the business concern earns higher profitability and maximizing wealth. Effective financial management helps to promoting and mobilizing individual and corporate savings.

Nowadays financial management is also popularly known as business finance or corporate finances. The business concern or corporate sectors cannot function without the importance of the financial management.

3 Time Value Of Money

3.1 Concept

Time value of money shows the relation of value of money with time. Time value of money is also value of interest which we have earned for giving money to other for specific period. Value of Rs. 1 which you have today is more valuable than what Rs. 1 you will receive after one year because you can invest today receive Rs. 1 in any scheme and you can earn minimum interest on it. It means today received money is important than tomorrow receivable money. Interest rate is the cost of borrowing money as a yearly percentage. For investors, interest rate is the rate earned on an investment as a yearly percentage.

Time value of money results from the concept of interest. So it now time to discuss Interest.

1. Simple Interest

It may be defined as Interest that is calculated as a simple percentage of the original principal amount. The formula for calculating simple interest is

SI = P0 (i)(n)

Future value of an account at the end of n period FVn = P0+ SI = P0 + P0(i)(n)

3.2 Compound Interest

If interest is calculated on original principal amount it is simple interest. When interest is calculated on total of previously earned interest and the original principal it compound interest. Naturally, the amount calculated on the basis of compound interest rate is higher than when calculated with the simple rate.

FV _n = P_o (1+ i) ⁿ

Where,

i =     Annual rate of interest / Number of payment periods per year

= r/k

So, FV _n = P₀ (1 + r/k)ⁿ

When compounding is done k times a year at an annual interest rate r.

Or

FV_n = P_o (i + FVIF) _in

Where,

Effective Rate of Interest

It is the actual equivalent annual rate of interest at which an investment grows in value when interest is credited more often than once a year. If interest is paid m times in a year it can be found by calculating:

Ei = (1+ i/m) ^m -1

3.3 Present Value

―Present Value‖ is the current value of a ―Future Amount‖. It can also be defined as the amount to be invested today (Present Value) at a given rate over specified period to equal the ―Future Amount‖.

The present value of a sum of money to be received at a future date is determined by discounting the future value at the interest rate that the money could earn over the period. This process is known as Discounting. The present value interest factor declines as the interest rate rises and as the length of time increases.

P_{o =} FV_n /(1+ i) ⁿ

P_{o =} FV_n (1+ i) -ⁿ

Where,

FVn  = Future value n years hence

I        = Rate of interest per annum

n       = Number of years for which discounting is done.

B. Discount (or) present value technique: -

= _{(1+ )}

Present value V_o = Future value (V_n) x DF_in

4 Introduction To The Concept Of Return Of A Single Asset

4.1 Introduction

Risk and Return of the investments are interrelated covenants in the selection any investments, which should be studied through the meaning and definition of risk and return and their classification of themselves in the first part of this chapter and the relationship in between them is illustrated in the second half of the chapter.

Meaning Of Return & Rate Of Return

Return is the combination of both the regular income and capital appreciation of the investments.The regular income is nothing but dividend/interest income of the investments. The capital appreciations of the investments are nothing but the capital gains of the investments i.e. the difference in between the closing and opening price of the investments.

Return symbolized as follows D1 + Pt – Pt – 1 / Pt – 1

These two categories, Earnings yield and Capital gains yield *Earnings Yield = Earnings per share / Market price per share***

4.2Concept And Types Of Risk

^v   The variability of the actual return from the expected return which is associated with the investment/asset known as risk of the investment. Variability of return means that the Deviation in between actual return and expected return which is in other words as variance i.e., the measure of statistics.

^v   Greater the variability means that Riskier the security/ investment. Lesser the variability means that More certain the returns, nothing but Least risky

.

Interest Rate Risk

It is risk – variability in a security's return resulting from the changes in the level of interest rates.

Market Risk

It refers to variability of returns due to fluctuations in the securities market which is more particularly to equities market due to the effect from the wars, depressions etc.

Inflation Risk

Rise in inflation leads to Reduction in the purchasing power which influences only few people to invest due to Interest Rate Risk which is nothing but the variability of return of the investment due to oscillation of interest rates due to deflationary and inflationary pressures.

Business Risk

. Business risk is nothing but Operational risk which arises only due to the presence of the fixed cost of operations.

Financial Risk

Connected with the raising of fixed charge of funds viz Debt finance & Preference share capital. More the application of fixed charge of financial will lead to Greater the financial Risk which is nothing but the Trading on Equity.

Liquidity Risk

Liquidity risk reflects only due to the quality of benefits with reference to certainty of return to receive after some period which is normally revealed in terms of quality of benefits.

Measurement of Risk

Standard Deviation:

^v    Greater the standard deviation - Greater the risk

^v    Does not consider the variability of return to the expected value

^v    This may be misleading - if they differ in the size of expected values

Coefficient of variation = S.D/ Mean

4.3 Risk And Return Of The Portfolio

^v   Portfolio is the Combination of two or more assets or investments.

^v   Portfolio Expected Return is the weighted average of the expected returns of the securities or assets in the portfolio.Weights are the Proportion of total funds in each

security which form the portfolio Wj Kj.

^v   Wj = funds proportion invested in the security.

^v   Kj = expected return for security J.

^v   Benefits of portfolio holdings are bearing certain benefits to single assets.

^v   Including the various types of industry securities - Diversification of assets.

^v   It is not the simple weighted average of individual security.

^v   Risk is studied through the correlation/co-variance of the constituting assets of the portfolio. The Correlation among the securities should be relatively considered to maximize the return at the given level of risk or to minimize the risk.

^v   Correlation of the expected returns of the constituent securities in the portfolio.

It is a Statistical expression which reveals the securities earning pattern in the portfolio as together.

Diversification of the Risk of Portfolio

^v Diversification of the portfolio can be done through the selection of the securities which have negative correlation among them which formed the portfolio. The return of the risky and riskless assets is only having the possibilities to bring down the risk of the portfolio.

^v The risk of the portfolio cannot be simply reduced by way adopting the principle of correlation of returns among the securities in the portfolio. To reduce the risk of the portfolio, the classification of the risk has to be studied, which are as follows:

^v The risk can be further classified into two categories viz Systematic and Unsystematic risk of the securities

Systematic Risk: Which only requires the investors to expect additional return/ compensation to bear the

Unsystematic Risk: The investors are not given any such additional compensation to bear unlike the earlier. The relationship could be obviously understood through the study of Capital Asset Pricing Model (CAPM).

^Ø   Developed by William F. Sharpe

^Ø   Explains the relationship in between the risk and expected / required return

^Ø   Behaviour of the security prices

^Ø   Extends the mechanism to assess the dominance of a security on the total risk and

return

^Ø   Highlights the importance of bearing risk through some premium

^Ø   No transaction costs - No intermediation cost during the transaction

^Ø   No single investor is to influence the market Risk and Return

^Ø   Highest return for given level of risk OrLowest risk for a give n level of return

^Ø   Risk - Expected value, standard deviation

4.4 Relationship Between The Risk And Return

^v   Total Return - Risk free rate of return= Excess return (Risk premium)

^v   Total return = Risk free return + Risk premium

^v   Kj = Rf + bj (Km–Rf)

^v   Bj is nothing but Beta of the security i.e., market responsiveness of the security. It is normally expressed as a b

^v   b = Non Diversifiable risk of asset or Portfolio/ Risk of the Market Portfolio

^v   Risk of the portfolio = after diversification, the risk of the market portfolio is non

^v   diversifiable

5 Valuation Of Bonds And Shares

5.1Valuation Of Bonds

A bond or a debenture is a long-term debt instrument or security. It is issued by business enterprises or government agencies to raise long-term capital. A bond usually carries a fixed rate of interest. It is called as coupon payment and the interest rate is called as the coupon rate. The coupon payment can be either annually or semi-annually.

Where:

Interest 1 to n = Interests in periods 1 to n.

Unless otherwise mentioned, the maturity value of the bond is the face value.

When the required rate of return is equal to the coupon rate, the bond value equals the par value.

When the required rate of return is more than the coupon rate, the bond value would be less than its par value. The bond in this case would sell at a discount.

When the required rate of return is less than the coupon rate, the bond value would be more than its par value. The bond in this case would sell at a premium.

5.2 Valuation Of Shares

Factors Which Influence The Value Of Shares

The factors which influence the value of shares can be broadly classified into two groups- internal and external factors. They are stated below-

(i)                Internal factors

^v  Earning capacity of assets

^v  Return on investments

^v  Profit after tax

^v  Profit available to equity shareholders

^v  Earnings per share

^v  Dividend per share or Rate of dividend.

(ii) External Factors

^v  General economic condition of the country.

^v  Political and social environment.

^v  International economic scenario.

^v  International political environment.

METHODS OF VALUATION OF SHARES

The methods of valuation depend on the purpose for which valuation is required. Generally, there are three methods of valuation of shares:

1.Net Assets Method of Valuation of Shares

Under this method, the net value of assets of the company is divided by the number of shares to arrive at the value of each share. For the determination of net value of assets, it is necessary to estimate the worth of the assets and liabilities. The goodwill as well as non-trading assets should also be included in total assets.

Value per Share= (Net Assets-Preference Share Capital)/Number of Equity Shares

2. Yield or Market Value Method of Valuation Of Shares

The expected rate of return in investment is denoted by yield. The term "rate of return" refers to the return which a shareholder earns on his investment. Further it can be classified as

(a) Rate of earning and (b) Rate of dividend. In other words, yield may be earning yield and dividend yield.

a. Earning Yield

Value per Share = (Expected rate of earning/Normal rate of return) X Paid up value of equity share

Expected rate of earning = (Profit after tax/paid up value of equity share) X 100

b. Dividend Yield

Expected rate of dividend = (profit available for dividend/paid up equity share capital) X 100 Value per share = (Expected rate of dividend/normal rate of return) X 100

3. Earning Capacity Method Of Valuation Of Shares

Under this method, the value per share is calculated on the basis of disposable profit of the company. The disposable profit is found out by deducting reserves and taxes from net profit.

Value per share = Capitalized Value/Number of Shares

6 Option Valuation

An option is a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation, to perform a specified transaction with another party (the option issuer or option writer) according to the specified terms. The owner of a property might sell another party an option to purchase the property any time during the next three months at a specified price.

There are two options which can be exercised:

^v   Call option, the right to buy is referred to as a call option.

^v    Put option, the right to sell is referred as a put option.

There are two types of options: the European options, which can be exercised only at expiration, and the American options, which may be exercised any time prior to expiration.

The American option offers greater flexibility and hence its value, in general, is greater than the European one.

At this point, we are examining options on stocks that are not paying any dividends. When a stock pays a dividend then the value of the stock drops on the ex dividend date. This predictable drop in the price of a stock will have an effect on the price of the options on that stock.

6.1 Factors Affecting Value Of Options

•   Price – value of the call option is directly proportionate to the change in the price of the underlying.

•  Time – as options expire in future, time has an effect on the value of the options.

•   Interest rates and Volatility – in case where the underlying asset is a bond or interest rate, interest rate volatility would have an impact on the option prices.

Properties of Option Values

1. The minimum value of an option is zero.

This is because an option is only a choice, not an obligation. The value of an option cannot be negative, because you do not have to do anything to get rid of it. The option will always have a zero, or a positive value.

2. The maximum value of a call option is equal to the value of the underlying asset.

This makes a lot of economic sense. An option allows you to buy a given asset at a certain exercise price. The most valuable option will be the one that allows you to acquire the asset at no cost, and the value of this option will be equal to the value of the underlying asset.

3. The total value of an option is the sum of its intrinsic value and its time premium.