Fundamental of Financial Management B.com 5th Sem Notes
UNIT - 1
INTRODUCTION
Contents of the Chapter :Nature, scope and objective of Financial Management, Time value of money, Risk and return (including Capital Asset Pricing Model), Valuation of securities - Bonds and Equities.
Also Read: Fundamentals of financial management complete notes
SHORT TYPE QUESTIONS & ANSWERS
1. What do you understand by Financial Management.
Ans: Financial management is concerned with those managerial decisions which result in the acquisition and financing of long term and short-term assets of a firm. It, there fore, deals with the situations which call selection of specific assets and specific liabilities, as also with the problems of size and growth of an enterprise. An analysis of these decisions is based upon expected inflows and outflows of funds and their effects on the stated managerial objectives.
Raymond Schultz and Robert Schultz have said that the subject of financial management is extremely broad and complex. The difficulty is compounded by the fact that it can be approached in a variety of ways in a descriptive, theoretical, analytical and applicative wary.
2. Mention five nature of financial management.
Ans: Five nature of financial management are :
(i) An indispensable organ of business management.
(ii) Continuous process.
(iii) Less descriptive and more analytical..
(iv) Different from accounting function.
(v) Centralized nature of finance function.
3. Write three functions of financial management.
Ans: Three functions of financial management
(i) Recurring Finance Functions.
(ii) Non-Recurring Finance Functions.
(iii) Routine Functions.
4. Briefly mention the scope of financial management.
Ans: A priori definitions of the scope of financial manage fall into three groups. One view is that finance is Concerned with cash. At the other extreme is the relatively narrow definition that financial management is concerned with sailing administering funds for an enterprise. The third approach is that it is an integrate part of overall management part of overall management rather than a staff specially can corned with fund raising operations. In this connection, Ezra Solomon says that in this broader view, the central issue of financial policy is the wise use of funds. One apparently straight forward approach is to define the scope of financial management as something which embraces those areas in which the finance officer or treasurer operators.
5. Mention five roles of finance manager.
Ans: Five Roles of Finance Manager are:
(i) Estimating financial requirements. (ii) Preparation of financial plan..
(iii) Balanced Capital structure.
(iv) Liquidity of the firm.
(v) Profitability of the firm.
6. Mention five importance of financial management.
Ans: Five importance of financial management are:
(i) Basis of success of the enterprise.
(ii) Optimum allocation and utilisation of resources.
(iii) Central focal point of decision-making.
(iv) Measurement of performance and efficiency.
(v) Basis of planning, Co ordination and control.
7. Write five limitation of financial management.
Ans: Five limitation of Financial Management are:
(i) It is difficult to know the financial effects of various managerial decisions.
(ii) Based on financial records.
(iii) Lack of knowledge of related subjects.
(iv) Lack of objectivity.
(v) Developing subject.
8. Explain the limitations of financial management.
Ans: The role of financial management is increasing continuously and i a part of top management. But it has some limitations which are as follows:
(i) Based on financial records : Certain techniques of financial analysis and performance measurement are based on accounting records o As the financial accounts are concerned with the past, the decisions based f on those records may be faulty.
(ii)Lack of objectivity: There is a lack of objectivity in financial management. The decisions of financial management are affected by the personal views and feelings of the personal managers and when the effect is more it can lead to bad results.
(iii) Lack of knowledge of related subjects: The objectives of financial management can be fulfilled only when the financial managers have knowledge about management, management accounting, statistics, economics etc. If they do not have adequate knowledge, they cannot take right decisions.
(iv) Expensive: It is quite expensive to build an effective financial management. So, the small business organisation are not able to bear the burden.
(v) Developing subject: It is not a fully developed subject and development is still going on. The specialists are not agreeing on certain views and theories. The standards of financial analysis are also changing.
Gauahti University Fundamental of Financial Management Unit-1 Introduction B.com 5th Sem Notes
9. Write Short Notes on:
(a) Profit maximization:
Ans: Profit maximisation is used as a standard of financing decisions. According to this approach, a firm should undertake all those activities which add to its profits and eliminate all others which reduce its profits. This objective highlights the fact that all the decisions-financing, dividend and investment, should result in profit maximisation.
(b) The wealth maximization
Ans: The wealth maximisation approach has been recognised for the evaluation of performance of a business undertaking. It is also known as value maximisation or maximisation of net present worth. According to this approach, financial management should take such decisions which increase the net present value of the firm.
(c) Value maximization:
Ans: Value maximization may be defined as the managerial function involved in the appreciation of the long-term market value of an organization. The total value of an organization is comprised of all the assets, such as equity, debt, preference shares, and warrant. The total value of an organization increases when the value of its shares increases in the market.
10. Give an example of TVM.
Ans: The relevance of TVM depends on how much returns you can generate from the capital available. Money has immense growth potential and the more you delay employing this potential, the more you lose the chance to earn on it.
For instance, if a friend or lender gives you two options - to take Rs. 10,000 today or to take Rs, 10,500 next year. Now, even if this promise is from someone or an entity you trust implicitly, chances are more that the second option is a raw deal. With more and more schemes ranging from low-risk to high-risk-tax-saving FDs, ELSS et. - there is a high chance that you can make at least 7% on this sum, which is Rs. 10,700. But if the interest rate offered is less than 5%, then you may consider taking the money next year. So, it depends on the possible returns as per the RBI guidelines or the market.
11. What is Present Value and Future Value?
Ans. Present Value is the same as Time Value. It is the money you have currently that is equal to a future one-time disbursal or several part payments-discounted by a suitable rate of interest. Future Value is the sum of money that any saving scheme with a compounded interest will build to by a pre-decided future date. It applies to both lumpsum as well as recurring investments like SIP.
12. What Is the Capital Asset Pricing Model?
Ans. The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.
13.What is the formula for calculating the expected return of an
asset?
Ans. ERI-Rf +ái (ERm "Rf)
Where: ERI expected return of investment
Rf = risk-free rate
âi = beta of the investment
(ERM "Rf)= market risk premium
14. What is the expected return of the security using the CAPM formula?
Ans: Expected return=Risk Free Rate + [Beta x Market Return Premium]
Expected return 2.5% + [1.25 x 7.5% ]
Expected return = 11.9%
15. Why CAPM is Important?
Ans: The CAPM formula is widely used in the finance industry. It is vital in calculating the weighted average cost of capitalWACCWACC is a firm's Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt. (WACC), as CAPM computes the cost of equity.
WACC is used extensively in financial modelingWhat is Financial ModelingFinancial modeling is performed in Excel to forecast a company's financial performance. Overview of what is financial modeling, how & why to build a model.. It can be used to find the net present value (NPV) of the future cash flows of an investment and to further calculate its enterprise valueEnterprise Value (EV)Enterprise Value, or Firm Value, is the entire value of a firm equal to its equity value, plus net debt, plus any minority interest and finally its equity value.
16. Define the concept of Risk.
Ans: A person making an investment expects to get some returns from the investment in the future. However, as future is uncertain, the future expected returns too are uncertain. It is the uncertainty associated with the returns from an investment that introduces a risk into a project. The expected return is the uncertain future return that a firm expects to get from its project.
The realized return, on the contrary, is the certain return that a firm has actually earned. The realized return from the project may not correspond to the expected return. This possibility of variation of the actual return from the expected return is termed as risk. Risk is the variability in the expected return from a project. In other words, it is the degree of deviation from expected return. Risk is associated with the possibility that realizet returns will be less than the returns that were expected. So, wher realizations correspond to expectations exactly, there would be no risk
17. Discuss the elements of risk.
Ans: Various components cause the variability in expected returns, which are known as elements of risk. There are broadly two groups of elements classified as systematic risk and unsystematic risk.
Systematic Risk: Business organizations are part of society that is dynamic. Various changes occur in a society like economic, political and social systems that have influence on the performance of companies and thereby on their expected returns. These changes affect all organizations to varying degrees. Hence the impact of these changes is system-wide and the portion of total variability in returns caused by such across the board factors is referred to as systematic risk. These risks are further subdivided into interest rate risk, market risk, and purchasing power risk.
Unsystematic Risk: The returns of a company may vary due to certain factors that affect only that company. Examples of such factors are raw material scarcity, labour strike, management ineffi-ciency, etc. When the variability in returns occurs due to such firm-specific factors it is known as unsystematic risk. This risk is unique or peculiar to a specific organization and affects it in addition to the systematic risk. These risks are subdivided into business risk and financial risk.
18. What are "Equities and Bonds"?
Ans: Equities and Bonds are two of the most traded asset classes and are often combined together as part of a well-diversified portfolio. When buying equity in a company, the investor becomes a shareholder and can participate in the distribution of profits. When buying a bond, the investor becomes a creditor to the issuer and is entitled to a fixed interest along with the ultimate repayment of the principal. Equities (also known as stocks) are shares issued by companies and trade on an exchange. On the other hand, bonds (also known as fixed income) could be issued by companies or sovereigns and could be traded either publicly, over the counter (OTC), or privately.
19. What are Equities?
Ans: In practice, when buying shares in a business the investor becomes one of the many co-owners of the company and usually has the right to vote at Annual General Meetings and other corporate strategy proposals (depending on the type of share owned). The benefit of being a shareholder is that the share price of the company may rise in value and the investor could sell making a profit (capital appreciation). Also, the investor may be entitled to participate in the distribution of company profits in the form of dividends or share buy backs. However, the downside of investing in equities is that there is no guarantee for future profits or that the investor could be able to redeem the amount invested. In addition, if the company goes into liquidation, shareholders are among the last to be repaid in the hierarchy of creditors.
LONG TYPE QUESTIONS & ANSWERS
1. Explain the limitations of financial management.
Ans: The role of financial management is increasing continuously and is a part of top management.
But it has some limitations which are as follows:
(i) Based on financial records: Certain techniques of financial analysis and performance measurement are based on accounting records. As the financial accounts are concerned with the past, the decisions based on those records may be faulty.
(ii) Lack of objectivity: There is a lack of objectivity in financial management. The decisions of financial management are affected by the personal views and feelings of the personal managers and when the effect is more it can lead to bad results.
(iii) Lack of knowledge of related subjects: The objectives of financial management can be fulfilled only when the financial manager have knowledge about management, management accounting, statistics economics etc. If they do not have adequate knowledge, they canne take right decisions.
(iv) Expensive: It is quite expensive to build an effective financial management. So, the small business organisation are not able to bear the burden.
(v) Developing subject: It is not a fully developed subject and development is still going on. The specialists are not agreeing on certain views and theories. The standards of financial analysis are also changing.
2. Define Financial management. What are the characteristics of financial management?
Ans: Financial management is mainly concerned with the proper management of funds:
According to Ezra Soloman: "Financial Management is concerned with the efficient use of an important economic resource, namely capital fund" According to Howard and Lipton: "Financial Management is the application of planning and control function to the finance function".
According to modern approach, the finance function plays an important role in business management. So the role of finance manager becomes quite important.
The following are the characteristics of financial management:
(i) An indispensable organ of business management: In modern approach the financial management is an important part of business management and the finance manager is an active member of group of high level of management. As finance is linked to all business activities, financial management plays an important role in business decisions.
(ii) Continuous process: In modern days financial management has become a continuous process and for the successful running of business, the role of finance manager is quite important.
(iii) Different from accounting function: Many people consider the finance function to be same as accounting function because many terms and records are same, but finance function is different from accounting function. In accounting function the collection of financial and related statistics is done while in finance function these are used for the analysis and decision making.
(iv) Wide scope: The scope of financial management is quite wide. The function of financial management is to find the sources for short term and long-term requirements, their distribution and optimum use. Financial management is responsible for Accounts, Audit, Cost Accounts, Business Budget, Management of Materials, Cash and Credit.
(v) Helpful in decisions of top-management: According to modern theory the financial manager helps the top management in decision making. The finance manager presents the reports to the high level of management on financial performance of the enterprise.
(vi) Measurement of performance: In the modern times the business performance is measured on the basis of financial results. The finance manager has to manage the liquidity, and profitability functions and for this he has to divide the profit and risk property. Then he can get the desired level of performance.
(vii) Coordination with other departments: The finance manager cannot do his work effectively without coordination with other departments of the enterprise. The work of every department affects the financial results, so the non-cooperation of any department disturbs the expected results.
(vili) Applicable to all types of organisation: Financial Management is applicable in all organisations whether it is manufacturing organisation or service organisation, small or big organisation. It is also applicable to non-profit organisations.
3. Briefly describe the goals of financial management.
Ans: The goal of financial management should be to achieve the objectives of the business owners i.e. share holders. It is generally argued that the goal of finance function should be maximisation of profits. However, there is disagreement over this goal.
There are two basic goals in business to be achieved through finance function They are:
(i) Profit Maximisation,
(ii)Wealth Maximisation.
(i) Profit Maximisation: Profit earning is the main aim of every economic activity. Traditionally, the business has been considered as an economic institution and profit has been accepted as the valid criterion of measuring its efficiency. Therefore this is a natural objective that the
profit should be maximised. The following reasons are being given for the suitability of profit maximisation:
(a) Profit maximisation is justified on the ground of rationality:
If a person does some economic activities with patience then his ultimate objective is to maximise his utility. Utility can easily be measured in terms of profit. So on the basis of rationality it is considered right to maximise profit.
(b) Indicator of economic efficiency: The profit is an indicator of economic efficiency of the enterprise whereas the loss is an indicator of economic inefficiency.
(c) Efficient allocation and utilisation of resources: The efficient allocation and utilisation of resources is done on the basis of profit. The financial management puts the less profitable utilisation into more profitable utilisation which increases the efficiency of the enterprise.
(d) Source of incentive: The profit is a major source of incentive in business. For earning of more profit, one firm tries to become more profitable than the other firm.
(e) Maximisation of social benefit: Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit maximisation also maximises socio-economic welfare. However, profit maximisation objective has been criticised on many grounds because of its limitations:
(a) It is a vague concept: The term 'profit' is vague as it does not clarify what exactly does it mean. For example, which profit are to be maximised-short run or long run, rate of profit or the amount of profit, profit before tax or after tax or distributable profit.
(b) It is a short-run concept: The profit concept ignores the long run going concern concept and concentrates on the short-run view. Some capital expenditures which are not profitable today may yield revenues in future. But this is ignored by profit concept.
4.Discuss the functions of financial management.
Or
Discuss the scope/elements/areas of finance function.
Ans: The finance manager in a big enterprise has to perform such important functions which are known to be Finance Functions. According to the modern scholars the contents of finance functions can be discussed under three broad groups as under:
A. Recurring finance functions
B. Non-recurring finance functions
C. Routine functions.
A. Recurring finance functions: It means all such financial activities
that are carried out regularly or frequently for the efficient conduct of a firm. The contents of recurring finance functions are as follows:
(a) Planning for funds: The initial task of the finance manager in a new or going concern is to formulate plans for the company. Planning for funds involve two activities:
(i) Estimation of fund requirements: The finance manager has to estimate the quantum of fund requirements and its duration. While determining fund requirements the finance manager must keep in aind various considerations like the purpose of the business, economic and business conditions, future investment programmes, state regulations etc. (ii) Determination of sources: After estimating total fund requirements, the finance manager decides as to how these requirements will be met. The finance manager has to decide the various sources where from the required funds are to be raised.
(b) Organising of funds: The next important function of the finance manager is the or administration of funds.
Three activities are involved in it:
(i) Raising of funds: The finance manager has to arrange the issue of prospectus for the security issues, in case of public limited companies.
In order to ensure quick sale of securities, he may approach the brokers or underwriters, who deal in securities. If the company decides to borrow fund from financial institutions the finance manager has to negotiate with the appropriate authorities.
(ii) Allocation of funds: The finance manager should take into consideration some factors while allocating funds such as immediate requirements, overall management plans, profit prospects etc. The finance manager has to strike a balance in allocating funds among fixed assets and current assets.
(iii) Allocation of income: Allocation of income is the exclusive responsibility of the finance manager. He must be very careful in deciding what portion of earnings should be distributed as dividend and how much to retain for future growth or expansion..
(iv) Controlling of funds: The finance manager has to control the usage of funds in business. He is to see whether the funds are raised or utilised as per plans and budgets or if there is any deviation. He can apply various tools or techniques to control the usage of funds such as budgetary control, ratio analysis, break even analysis etc.
B. Non-Recurring Finance Functions: Non-recurring finance functions refers to these financial activities that are performed by a financial manager very infrequently. These functions are not found in the ordinary routine of the financial manager. Some non-recurring finance functions are:
(i) Preparation of financial plan at the time of promotion of the company.
(ii) Financial readjustments at the time of financial crisis or liquidation of a company.
(ii) Valuation of the firm at the time of merger, or amalgamation of two or more companies.
C. Routine functions: In this category these functions are included which are of routine in nature. These are performed by lower level employees like accountant, cashier and typist.
Gauahti University Fundamental of Financial Management B.com 5th Sem Notes
5. What are the importance of financial management?
Ans: The importance of financial management has increased day by day in the business world due to three important reasons:
(i) Increase in size and number of corporation.
(ii) Wide distribution of corporate ownership.
(ii) Divorce between ownership and management.
The importance of financial management can be discussed under the following heads:
(i) Basis of planning, coordination and control: The financial management gives the basis of planning, coordination and control in the enterprise. The financial planning is done on the basis of financial forecasting. In this case coordination among various departments and budgetary control are essential.
(ii) Basis of the success of the enterprise: The success of an enterprise depends wholly on effective financial management. The effective financial I management can turn an enterprise which is running in loss into a profit making organisation.
(iii) Centrol focal point of decision-making: In the past, the business managers used to make the decisions on the basis of intuition. But, today most of the decisions are taken on the basis of financial analysis and comparison.
(iv) Measurement of performance and efficiency: Whatever work is done in the enterprise, its measurement of efficiency is done on the basis of finance. For this work, certain new techniques have been developed in financial management. (v) National importance: The per capita national income can be increased by effectiveness of financial management. Inefficient management of public investment is a big reason for slow economic development.
(vi) Optimum allocation and utilisation of resources: A good finance manager can make possible the optimum allocation and utilisation of resources and through this works they help in increasing the wealth of the firm.
(vii) Useful for various groups: The financial management is quite useful for business managers, shareholders, financial institutions, politicians, etc. Even economists, sociologists, students of commerce and management, all have been benefitted from this subject.
6. Discuss the nature of financial management.
Ans: According to modern approach, the finance function plays an important role in business management. So the role of finance manager becomes quite important. According to modern approach the following are the characteristics of financial management:
(a) An indispensable organ of Business management: When the traditional approach was in use, the finance manager was considered quite unimportant in the management of business but in modern approach the financial management is an important port of business management and the finance manager is an active member of group of high level of management. The question of finance is attached to all business activities, therefore, finance manager plays an important role in business decisions.
(b) Continuous process: The process of financial management was not a continuous process in traditional approach, rather this process was used only on occupancy of special events and when the problem was solved, it again became slow, But in modern approach it is a continuous process and for the successful renaming of business, the role of finance manager is quite important.
(c)Less descriptive and more analytical: The traditional financial management was more descriptive and less analytical while the modern financial management is more analytical and less descriptive. Today the statistical and mathematical models have been developed by which the best alternative can be easily chosen under given internal and external conditions.
(d) Different from accounting functions: many people consider the finance function to be same as accounting function because many terms and records are same, but finance function is different from accounting function. In accounting function the collection of financial and related statistics is done while in finance function these are used for the analysis and decision-making.
(e) Centralized nature of finance function: In different areas of modern business management, the finance function is centralized Decentralization of production distribution and management of works is possible but in finance function this is not possible on practical ground.
(f) Wide scope: The scope of financial management is quite wide. The function of financial management is to find the sources for short term and long term requirements, their distribution and optimum use, optimum use. Financial management is responsible for Accounts, Audit, Cost Accounts, Business Budget, management of Materials, Cash and Credit.
(g) Helpful in decisions of top management: According to modern theory the finance management helps the top management in decision making. The finance manager presents the reports to the high level of management on financial performance of the enterprise.
(h) Measurement of performance: In the modern times the business performance is measured on the basis of financial results. The finance manager has to manage the liquidity and profitability functions and fir this he has to divide the profit and risk property. Then he can get the desired level of performance.
(i) Co-Ordination with other departments of the enterprise : The Finance manager Cannot do his work effectively. Without co ordination with other department of the enterprise. The work of every department disturbs the expected results.
(j) Financial planning control and follow up: According to modern approach the following are included in financial management like obtaining of resources and planning of their use, control according to the budgets, search of deviations and improvement of work by feedback.
(k) Applicable to all types of organization: Financial management is applicable in all organization whether it is manufacturing organization or service organization or sole proprietorship organization. It is also applicable in non-profit organization.
Gauahti University Fundamental of Financial Management B.com 5th Sem Notes
7. Discuss the scope of financial management.
Ans: Scope of financial management means the various decisions to be taken by a financial manager in a corporate enterprise for achievement of business Objectives.
The decisions taken by a financial manager may be discussed under two broad groups:
(a) Long-term Financial Decisions: Such decisions have long term effects on the value of the enterprise. It is, therefore, necessary to consider the likely cost and benefits of the various decisions. Long-term financial decisions may be of four types:
(b) Fund Requirement Decision: This is the most important function performed or delusion taken by the finance manager. A careful estimate has to be made about the total funds required by the enterprise, taking into account both the fixed and working capital requirements. This is done by forecasting the physical activities of the enterprise.
(c) Capital Budgeting Decision: It is concerned with the allocation of a given amount of capital to fixed assets of the business. It is also known as capital expenditure decision. In making the capital budgeting decision selection of projects should be carefully done. Certain methods are employed to judge the profitability of the decision e.g. pay back method, average rate of return method, internal rate of return method etc.
(d) Capital structure Decision: The financial manager in a corporate enterprise must decide the proportion of equity capital and debt capital i,e, the Debt-Equity Ratio. He must obtain an optimal or balanced capital structure where overall. Cost of capital is the minimum and the value of firm is maximum.
(e) Dividend Decision: The next crucial financial decision is the dividend decision. This decision is involved with two policies, i.e. dividend policy and reserve policy. The dividend pay out ratio-determines the amount of earnings retained in the business. The dividend policy must be such that it increases the market value of shares.
(f) Short-term Financial Decision: The job of the financial manager is not just limited to the long term financial decision. He should take short term financial decisions which includes investment decisions on current assets such as cash, inventories, debtors, receivables etc. The investment in current assets will depend on the credit and inventory policies perused by the enterprise. Investment in current assists affects the firms profitability, liquidity and solvency.
8. Describe the evolution of financial management.
Ans: Before the start of 20th century, the study of finance was included under economies, but after the start of 20th century due to merging of small industries to form big industries led to the problem of arrangement of finance in front of business managers. Because of special contribution of finance in solving of these problems, it began to be studied as a separate subject. Mostly big undertakings were organized on they corporation from, due to which books on corporation finance were published. In Corporation finance books, we find a detailed description of capital structure. classification of securities and conditions of financial contracts. That is why the Business finance was descriptive subject. The names of Green, Mede, Darling and Lion are better Known as developers of the subject.
Before the recession of thirties great importance was given for obtaining of finance through different type of securities and from different financial institutions. In the 1930's development of radio, chemical, steel and motor car industries took place rapidly and the importance of national advertisement, new distribution system and high profits increased. Due to recession of thirties, the liquidity problem arise in many business enterprises. The businessmen have problem in obtaining of finance from banks and other financial institutions for their day to day requirements. Therefore, in order to fulfill their demand of liquidity they had to sell the manufactured stock quickly and in more quantity but due to decrease in prices, the finance available was not adequate. Thus changes took place in financial management of a firm. More importance was given to financial planning and control. The protective policy was developed for business institutions by finance managers in order to protect them from closing of business and declaring themselves insolvent. More attention was paid to
the problems arising out of financial crisis in the life of the business firms. In 1950's after the second world war, the reorganization of industries led to different problems in procuring of money from capital markets for the peaceful requirements. In the fifth decade of 20th century the financial experts had give importance to the selection of such a financial structure that could bear the burden of post was pressures and adjustments.
The traditional approach of Business finance, which originated in 1920, was extremely popular till 1950, After 1950 certain changes took place due to which the importance of traditional approach declined and the new approach of business finance developed. In the sixth decade of 20th century, on the one hand there was increase in business activities in America and on the other hand frustrated stock exchanged and money market conditions were there In thes circumstances, cash analysis was given more importance than profi analysis. The financial exports were given the responsibility to control the cash flow in such a way that the firm could achieve its objectives an du dates. Now the financial arrangement of day-to-day activities of the firm was given more importance than institutional and external finance. Cast forecast, Cash Budget, Receivables management, Purchase Analysis and Inventory control were given special place in financial management.
9. Discuss the arguments in favour of the profit maximization approach.
Ans. The following arguments are advanced in favour of this approach:
(i) Measurement of Performance: Profit is a test of economic efficiency of a business. It is a yardstick by which the economic performance of a business can be judged.
(ii) Efficient Allocation and Utilisation of Resources : Profit maximization leads to efficient allocation and utilisation of scarce resources of the business because sources tend to be directed to uses from less profitable projects to more profitable projects.
(iii) Maximisation of Social Welfare: Profitability is essential for fulfilling the goal of social welfare also. Maximization of profits leads to the maximization of social welfare.
(iv) Source of Incentive: Profit acts as a motivator or incentive which induces a business organisation to work more efficiently. If profit motive is withdrawn the pace of development will be reduced.
(v) Helpful in Facing Adverse Business Conditions: Economic and business conditions go on changing from time to time. There may be adverse business conditions like recession, severe competition etc. Under adverse circumstances a business will be able to survive only if it has some past earnings to rely upon. Hence, a business should maximize its profits when the circumstances are favourable.
(vi) Helpful in the Growth of the Firm: Profits are the major source of finance for the growth of a firm.
10. Discuss the points of criticism against the profit maximization approach.
Ans: Following are the points given below:
(i) Ambiguous: One practical difficulty with this approach is that the term profit is vague and ambiguous. Different people take different meanings of term profit. For example, profit may be short-term or long term, it may be before tax or after tax, and it may be total profit or rate of profit. Similarly, it may be returned on total capital employed or total assets or shareholders' funds and so on.
(i) Ignores the Time Value of Money: This approach ignores the time value of money, i.e., it does not make a distinction between profits earned over the different years. It ignores the fact that the value of one rupee at present is greater than the value of the same rupees received after one year. Similarly, the value of profit earned in the first year will be more in comparison to the equivalent profits earned in later years.
(iii) Ignores Risk Factor: This approach ignores the risk associated with the earnings. If the two firms have the same total expected earnings, but if earnings of one firm fluctuate considerably as compared to the other, it will be more risky. Investors in general, have a preference for a lower income with less risk in comparison to high income with greater risk. But this approach does not pay any attention to the risk factor.
(iv) Ignores Future Profits: The business is not solely run with the objective of maximising immediate profits. Some firms place more importance on growth of sales. They are willing to accept lower profits to achieve stability provided by a large volume of sales.
(v) Ignores Social Obligations of Business: This approach ignores the social obligations of business to various social groups like workers, consumers, society, Government etc. A firm cannot exist for long when interests of social groups are ignored because these groups contribute to its smooth run.
(vi) Neglects the Effects of Dividend Policy on Market Price of the Shares: Under this approach the firm may not think of paying dividends because retaining profit in the business may satisfy the goal of maximising the earning per share.
11. Why wealth maximization approach is superior to the profit maximization approach.
Ans: It has the following advantages in its favour:
(i) It uses cash flows instead of accounting profits which avoids the ambiguity regarding the exact meaning of the term profit.
(ii) It gives due importance to the time value of money by reducing the future cash flows by an appropriate discount or interest rate. If higher risk and longer time period are involved, higher rate of discount or interest will be used to find out the present value of future cash benefits. The discount or interest rate will be lower for the projects which involve low risk.
(iii) It gives due importance to payment of regular dividends - In this approach financial decisions are taken in such a way that the shareholders receive the highest combination of dividends and increase in the market price of the shares.
(iv) It gives due importance to risk factor and analyses risk and uncertainty so that the best course of action can be selected out of different alternatives.
(v) It gives due importance to social responsibilities of the business.
(vi) It takes into consideration long-run survival and growth of the firm.
12. What are the objectives of financial statement?
Ans: Objectives of Financial Management: The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be -
(i) To ensure regular and adequate supply of funds to the concern.
(ii) To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders.
(iii) To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost. (iv) To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved.
(v) To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.
13. What is time value of money?
Ans: Time value of money (TVM) is the idea that money that is available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received. One of the most fundamental concepts in finance is that money has a time value attached to it. In simpler terms, it would be safe to say that a dollar was worth more yesterday than today and a dollar today is worth more than a dollar tomorrow.
Future Present
=
Money Money
This chapter is a practical approach to the time value of money. We fully understand that today's technology provides multiple calculators and applications to help you derive both present value and future value of money. If you do not take the time to comprehend how these calculations are derived, you may make critical financial decisions using inaccurate data (because you may not be able to recognize whether the answers are correct or incorrect). There are five (5) variables that you need to know:
(i) Present value (PV): This is your current starting amount. It is the money you have in your hand at the present time, your initial investment for your future.
(ii) Future value (FV): This is your ending amount at a point in time in the future. It should be worth more than the present value, provided it.is earning interest and growing over time.
(iii) The number of periods (N): This is the timeline for your investment (or debts). It is usually measured in years, but it could be any scale of time such as quarterly, monthly, or even daily.
(iv) Interest rate (I): This is the growth rate of your money over the lifetime of the investment. It is stated in a percentage value, such as 8% or.08.
14. What is the Basic TVM Formula?
Ans: Based on your financial circumstances at the time, the TVM formula can vary to some extent. Example, in the case of annuity (income) or perpetuity (until death) pension payments, the general formula can have more components. But as a whole, the basic TVM formula is as shown r in the image.
FV PV x[1+ (I/N)] (NT) FV is Future value of money,
where,
PV is Present value of money,
I is the interest rate.
15. What are the advantages and disadvantages of Capita ?
Ans: Advantages of the CAPM:
(i) CAPM takes into account only the systematic or market risk of not the security's only inherent or systemic risk. This factor eliminates the vagueness associated with an individual security's risk, and only the general market risk, which has a degree of certainty, becomes the primary factor. The model assumes that the investor holds a diversified portfolio, and hence the unsystematic risk is eliminated between the stock holdings
(ii) It is widely used in the finance industry for calculating the cost of equity and ultimately for calculating the weighted average cost of capital, which is used extensively to check the cost of financing from various sources. It is seen as a much better model to calculate the cost of equity than the other present models like the Dividend growth model (DGM)
(iii) It is a universal and easy to use model. Given the extensive presence of this model, this can easily be utilized for comparisons between stocks of various countries. Disadvantages of CAPM:
(i) The capital asset pricing model is hinged on various assumptions. One of the assumptions is that a riskier asset will yield a higher return. Next, the historical data is used to calculate Beta. The model also assumes that past performance is a good measure of the future results of a stock's functioning. However, that is far from the truth.
(ii) The model also assumes that the risk-free return will remain constant over the course of the stock investment. If the return on the government treasury securities rises or falls, it will change the risk-free return and potentially the calculation of the model. It is not taken into account while calculating the CAPM.
(iii) The model assumes that the investors have access to the same information and have the same decision-making process with respect to the risks and returns associated with the securities. It assumes that for a given return, the investors will prefer low-risk securities to high-risk securities. For a given risk, the investors will prefer higher returns to lower returns. Although this is a general guideline, some of the more extravagant investors might not be in agreement with this theory.
16. Discuss the Components of CAPM.
Ans: Following are the components of CAPM: (1) Risk-free return (Rrf): Risk-Free Rate of Return is the value assigned to an investment that guarantees a return with zero risks. Investments in US securities are considered to have zero risks since there is a minimal chance of the government defaulting. Generally, the value of the risk-free return is equivalent to the yield on a 10-year US government bond.
(ii) Market Risk Premium (Rm - Rrf): Market Risk Premium is the expected return an investor receives (or expects to receive in the future) from holding a risk-laden portfolio instead of risk-free assets. The premium rate allows the investor to make a decision on if the Investment in the securities should take place, and if yes, the rate that he will earn beyond the risk-free return offered by government securities.
(iii) Beta : The Beta is a measure of the volatility of a stock with espect to the market in general. The fluctuations that will be caused in stock due to a change in market conditions is denoted by Beta. For example, if the Beta of a stock is 1.2, it would cause a 120% change du to any change in the general market. The opposite is the case for Bes less than 1. For Beta, which is equal to 1, the stock is in sync with th changes in the market.
17. Discuss the limitations of the CAPM.
Ans: Limitations of the Capital Asset Pricing Model: Apart from the assumptions directly related to the factors around the stock and the capital asset pricing model calculation formula, there is a list of genera assumptions that the model takes, which are worth looking into.
(i) Only the returns and risks involved in the securities are the decision making factors for an investor. There is no accountability of the long term growth or qualitative factors around a stock that could influence the investor to take an alternative step.
(ii) There is perfect competition in the market, and no single investor can influence the prices or the returns of a stock. There is no limit on the short-selling of a stock; neither is their control on the divisibility of the purchase and selling units.
(iii) There are nil taxes with regards to the returns earned or any borrowing costs with respect to the amount that is additionally utilized to earn interest on the investment. Finally, the model assumes that the investor is risk-averse, and he is supposed to act as a rational being and maximize his utility.
18. What is Measurement of risk? Discuss the two approaches followed in it.
Ans: Quantification of risk is known as measurement of risk.
Two approaches are followed in measurement of risk:
(i) Mean-variance approach, and
(ii) Correlation or regression approach.
Mean-variance approach is used to measure the total risk, i.e. sum of systematic and unsystematic risks. Under this approach the variance and standard deviation measure the extent of variability of possible returns from the expected return and is calculated as:
19. Define the concept of Return.
Ans: Return can be defined as the actual income from a project as well as appreciation in the value of capital. Thus there are two components in return the basic component or the periodic cash flows from the investment, either in the form of interest or dividends; and the change in the price of the asset, com-monly called as the capital gain or loss. The term yield is often used in connection to return, which refers to the income component in relation to some price for the asset. The total return of an asset for the holding period relates to all the cash flows received by an investor during any designated time period to the amount of money invested in the asset. It is measured as: Total Return = Cash payments received + Price change in assets over the period /Purchase price of the asset. In connection with return we use two terms realized return and expected or predicted return. Realized return is the return that was earned by the firm, so it is historic. Expected or predicted return is the return the firm anticipates to earn from an asset over some future period.
Gauahti University Fundamental of Financial Management B.com 5th Sem Notes
20. Describe a Bond.
Ans: A bond is defined as a long-term debt tool that pays the bondholder a specified amount of periodic interest over a specified period of time. In financial area, a bond is an instrument of obligation of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest and/or to recompense the principal at a later date, called the maturity date. Interest is generally payable at fixed intervals such as semi-annual, annual, and monthly. Sometimes, the bond is negotiable, ie the ownership of the instrument can be relocated in the secondary market. This means that once the transfer agents at the bank medallion stamp the bond, it is highly liquid on the second market.
It can be established that Bonds signify loans extended by investors to companies and/or the government. Bonds are issued by the debtor, and acquired by the lender. The legal contract underlying the loan is called bond indenture. Normally, bonds are issued by public establishments, credit institutions, companies and supranational institutions in the major markets. Simple process for issuing bonds is through countersigning. When a bond issue is underwritten, one or more securities firms or banks, forming a syndicate, buy the whole issue of bonds from the issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is organised by book runners who arrange the bond issue, have direct contact with depositors and act as consultants to the bond issuer in terms of timing and price of the bond issue. The book runner is listed first among all underwriters participating in the issuance in the tombstone ads commonly used to announce bonds to the public. The book-runners' willingness to underwrite must be discussed prior to any decision on the terms of the bond issue as there may be limited demand for the bonds.
On the contrary, government bonds are generally issued in an auction. In some cases both members of the public and banks may bid for bonds. In other cases, only market makers may bid for bonds. The overall rate of return on the bond depends on both the terms of the bond and the price paid. The terms of the bond, such as the coupon, are fixed in advance and the price is determined by the market.
21. What are the key features of a bond?
Ans: Key Features of Bonds:
(i) The par (or face or maturity) value is the amount repaid (excluding interest) by the borrower to the lender (bondholder) at the end of the bond's life.
(i) The coupon rate decides the "interest" payments. Total annual amount = coupon rate x par value.
(iii) A bond's maturity is its remaining life, which drops over time. Original maturity is its maturity when it is issued. The firm promises to repay the par value at the end of the bond's maturity.
(iv) A sinking fund involves principle repayments (buying bonds) prio to the issue's maturity.
(v) Exchangeable bonds can be converted into a pre-specified number of shares of stock. Characteristically, these are shares of the issuer's common stock.
(vi) The call provision permits the issuer to buy the bonds (repay the loan) prior to maturity for the call price. Calling may not be allowed in the first few years.
Also Read: Fundamentals of financial management complete notes
Fundamentals of Financial Management Unit Wise Notes 😄
👉UNIT 5. working Capital Decision
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