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FINANCE FUNCTIONS

Financing decisions
Investment decisions BENEFITS OF FINANCIAL PLANNING
Liquidity decisions A financial plan is at the core of value creation process. A successful value
Dividend decisions creation process can effectively meet the benchmarks of investors expectations.
FINANCING DECISIONS: Financing decisions relate to the composition of relative Financial planning ensures effective utilization of the funds. To manage shortage
proportion of various sources of finance. The sources could be: of funds, planning helps the firms to obtain funds at the right time, in the right
(a) Shareholders Fund: Equity Share Capital, Preference Share Capital, quantity, and at the least cost as per the requirements of finance emerging
Accumulated Profits. opportunities. Surplus is deployed through well-planned treasury management.
(b) Borrowing from outside agencies: Debentures, Loans from Financial Institutions. Ultimately, the productivity of assets is enhanced.
Financing decisions relate to the acquisition of such funds at the least cost. In order Effective financial planning provides firms the flexibility to change the
to calculate the specific cost of each type of capital, recognition should be given to composition of funds that constitute its capital structure in accordance with the
two dimensions of cost: changing conditions of the capital market.
Explicit Cost Financial planning helps in formulation of policies and instituting procedures for
Implicit Cost elimination of wastages in the process of execution of strategic plans.
An investor in a companys shares has two objectives for investing: Financial planning helps in reducing the operating capital of a firm. Operating
Income from capital appreciation (capital gains on sale of shares at market capital refers to the ratio of capital employed to the sales generated. Maintaining
price) the operating capability of the firm through the evolution of scientific replacement
Income from dividends schemes for plant and machinery and other fixed assets will help the firm in
INVESTMENT DECISIONS reducing its operating capital. Along with fixed assets such as plant and equipment,
To survive and grow, all organizations have to be innovative. Innovation demands working capital is considered a part of operating capital.
managerial proactive actions. Proactive organizations continuously search for GUIDELINES FOR FINANCIAL PLANNING
innovative ways of performing the activities of the organization. Innovation is wider Never ignore the cardinal principle that fixed asset requirements must be met
in nature. It could be: from the long-term sources.
Expanding by entering into new markets. Make maximum use of spontaneous source of finance to achieve highest
Adding new products to its product mix. productivity of resources.
Performing value added activities to enhance customer satisfaction. Maintain the operating capital intact by providing adequately out of the current
Adopting new technology that would drastically reduce the cost of production. periods earnings. Give due attention to the physical capital maintenance or
Rendering services or mass production at low cost or restructuring the operating capability.
organization to improve productivity. Never ignore the need for financial capital maintenance in units of constant
There are two critical issues to be considered in these decisions. They are: purchasing power.
Evaluation of expected profitability of the new investments. Employ current cost principle wherever required.
Rate of return required on the project. Give due weightage to cost and risk in using debt and equity.
The Rate of Return required by an investor is normally known as the hurdle rate or Keeping the need of finance for expansion of business, formulate plough back
the cut off rate or the opportunity cost of capital. policy of earnings.
DIVIDEND DECISIONS Exercise thorough control over overheads.
Dividends are payouts to shareholders. Dividends are paid to keep the Seasonal peak requirements to be met from short-term borrowings from banks.
shareholders happy. Dividend decision is a major decision made by the finance A strategic financial plan of a firm spells out its corporate purpose,
manager. scope, objectives, and strategies. As a financial manager, one must:
Dividend is that portion of profits of a company which is distributed among its Sensitize the strategic planning group to the financial implications of various
shareholders according to the resolution passed in the meeting of the Board of choices
Directors. This may be paid as a fixed percentage on the share capital contributed Ensure that the chosen strategic plan is financially feasible
by them or at a fixed amount per share. The dividend decision is always a problem Translate the plan that is finally adopted into a long-range financial plan
before the top management or the Board of Directors as they have to decide how Coordinate the development of the budget
much profits should be transferred to reserve funds to meet any unforeseen STEPS IN FINANCIAL PLANNING
contingencies and how much should be distributed to the shareholders. Establish corporate objectives
The following issues need adequate consideration in deciding on dividend policy: o Qualitative and quantitative objectives
Preferences of shareholders Do they want cash dividend or capital gains? o Short-term, medium-term, and long-term objectives
Current financial requirements of the company. Formulate strategies
Legal constraints on paying dividends. Assign responsibilities
Striking an optimum balance between desire of shareholders and the companys
Forecast financial variables
funds requirements.\
The main reasons why a stable dividend is preferred are: Develop plans
(a) A regular and stable dividend payment may serve to resolve uncertainty in the Create flexible economic environment
minds of shareholders, and it creates confidence among shareholders. IMPORTANTANCE OF FORECASTING OF FINANCIAL STATEMENTS
(b) Many investors are income conscious and favor a stable dividend. Following are some basic points that would help you to understand the importance
(c) Other things being in balance, the market price invariably vary with the rate of of financial forecasting before we study the methods of forecasting and income
dividend declared by the company on its equity shares. The value of shares of a statement/balance sheet.
company that has a stable dividend policy does not fluctuate as much, even if the Financial forecasting is the process of estimating future business performance
earnings of the company fluctuate now and then. (sales, costs, earnings).
(d) A stable dividend policy encourages investments from institutional investors. Corporations and companies employ forecasting to do financial planning which
In this way, stability and regularity of dividends not only affects the market price of includes an assessment of their future financial needs.
shares but also increases the general credit of the company that pays the company Forecasting is also important for production planning, human resource planning,
in the long run. Dividend decisions are thus highly significant. etc.
LIQUIDITY DECISIONS Forecasting is also used by outsiders to value companies and their securities.
The liquidity decision is concerned with the management of the current assets, METHODS OF FORECASTING INCOME STATEMENT
which is a pre-requisite to long-term success of any business firm. This is also Percent of sales method or constant ratio method
called as working capital decision. The main objective of the current assets Expense method
management is the trade-off between profitability and liquidity, and there is a conflict Combination of the above two
between these two concepts. If a firm does not have adequate working capital, it PERCENT OF SALES METHOD
may become illiquid and consequently fail to meet its current obligations thus This is the most basic method of forecasting a financial statement. It assumes that
inviting the risk of bankruptcy. certain expenses, assets, and liabilities maintain a constant relationship to the level
The important elements of liquidity decisions are: of sales.
Formulation of inventory policy Basically, this method assumes that future relationship between various elements of
Policies on receivable management cost to sales will be similar to their historical relationships. These cost ratios are
Formulation of cash management strategies generally based on the average of previous two or three years. For example, cost of
Policies on utilization of spontaneous finance effectively goods sold may be expressed as a percentage of sales.
BUDGETED EXPENSE METHOD
Expenses for the planning period are budgeted on the basis of anticipated behavior
of various items of cost and revenue. The value of each item is estimated on the
basis of expected developments in the future period for which the pro forma P&L
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account is being prepared. It calls for greater effort on the part of management 1. Investment Decisions
since they have to define the likely happenings. This also demands effective 2. Financing Decisions
database for 3. Dividend Decisions
reasonable budgeting expenses. 4. Financial Analysis, Planning and Control Decisions
COST THEORY a) Investment Decisions;
Under this theory, the total amount of capitalization for a new company is the sum Investment decisions are made by investors and investment managers.
of: Investors commonly perform investment analysis by making use of fundamental
Cost of fixed assets analysis, technical analysis, screeners and gut feel.
Cost of establishing the business Investment decisions are often supported by decision tools. The portfolio theory is
Amount of working capital required often applied to help the investor achieve a satisfactory return compared to the risk
MERITS OF COST APPROACH taken.
It helps promoters to estimate the amount of capital required for incorporation of b) Financing Decisions;
company, conducting market surveys, preparing detailed project report, procuring What are the three types of financial management decisions? For each type of
funds, procuring assets both fixed and current, running a trial production, and decision, give an example of a business transaction that would be relevant.
successfully producing, positioning, and marketing its products or rendering of There are three types of financial management decisions: Capital budgeting,
services. Capital structure, and Working capital management.
If done systematically, it will lay the foundation for successful initiation of the Capital budgeting is the process of planning and managing a firm's long-term
working of the firm. investments. The key to capital budgeting is size, timing, and risk of future cash
DEMERITS OF COST APPROACH flows is the essence of capital budgeting. For example, yesterday I received a call
If the firm establishes its production facilities at inflated prices, the productivity of from our manager over our Sand & Gravel Operations. He is looking into buying a
the firm will become less than that of the industry. new crusher (to crush stone into gravel and sand). I helped him today evaluate the
Net worth of a company is decided by the investors and the earnings of a return on investment for this opportunity. It quite a lot of work, but we determined
company. Earning capacity based on net worth helps a firm to arrive at the total that buying the new crusher would bring in 60,000 more tons of production/sales
capital in terms of industry-specified yardstick (operating capital based on within the 1st year of owning the machine.
benchmarks in that industry). Cost theory fails in this respect. Capital Structure refers to the
FACTORS AFFECTING FINANCIAL PLANNING c) Dividend Decisions
Nature of the industry The Dividend Decision is a decision made by the directors of a company. It relates
Size of the company to the amount and timing of any cash payments made to the company's
Status of the company in the industry stockholders. The decision is an important one for the firm as it may influence its
capital structure and stock price. In addition, the decision may determine the
Sources of finance available
amount of taxation that stockholders pay.
The capital structure of a company There are three main factors that may influence a firm's dividend decision:
Matching the sources with utilization Government policy Free-cash flow
Flexibility Dividend clienteles
Government policy Information signaling
1. Nature of the industry:- Here, we must consider whether it is a capital Under this theory, the dividend decision is very simple. The firm simply pays out, as
intensive of labor intensive industry. This will have a major impact on the total dividends, any cash that is surplus after it invests in all available positive net
assets that the firm owns. present value projects.
2. Size of the company: - The size of the company greatly influences the Why wealth maximization is superior to profit maximization in todays
availability of funds from different sources. A small company normally finals it context? Justify you answer?
difficult to raise funds from long term sources at competitive terms. On the Superiority of Wealth Maximization over Profit Maximization:
other hand, large companies like Reliance enjoy the privilege of obtaining 1. It is based on cash flow, not based on accounting profit.
funds both short term and long term at attractive rates. 2. Through the process of discounting it takes care of the quality of cash flows.
3. Status of the company in the industry:- A well established company enjoying a Distant uncertain cash flows into comparable values at base period facilitates
good market share, for its products normally commands investors confidence. better comparison of projects. There are various ways of dealing with risk
Such a company can tap the capital market for raising funds in competitive associate with cash flows. These risk are adequately considered when present
term for implementation new projects to exploit the new opportunity emerging values of cash of any project.
from changing business environment. 3. In todays competitive business scenario corporate play a key role. In company
4. Sources of finance available:- Sources of finance could be group into debt and from of organization, shareholders own the company but the management of
equity. Debt is cheap but risky whereas equity is costly. A firm should aim at the company rests with the board of directors. Directors are elected by
optimum capital structure that would achieve the least cost capital structure. A shareholders and hence agents of the shareholders. Company management
large firm with a diversified product mix may manage higher quantum of debt procures funds for expansion and diversification from Capital Markets. In the
because the firm may manage higher financial risk with a lower business risk. liberalized set up-, the society expects corporate to tap the capital market
Selection of sources of finances us closely linked to the firms capacity to effectively for their capital requirements. Therefore to keep the investors happy
manage the risk exposure. through the performance of value of shares in the market, management of the
5. The capital structure of a company:- Capital structure of a company is company must meet the wealth maximization criterion.
influenced by the desire of the existing management of the company to remain 4. When a firm follows wealth maximization goal, it achieve maximization of
control over the affairs of the company. The promoters who do not like to lose market value of share. When a firm pact wealth maximization goal, it is
their grip over the affairs of the company normally obtain extra funds for growth possible only when procedures quality goods at low cost. On this account
by issuing preference shares and debentures to outsiders. society gains became of the society welfare.
6. Matching the sources with utilization:- The product policy of any good financial 5. Maximization of wealth demands on the part of corporate to develop new
plan is to match the term of the source with the term of investment. To finance products or render new services in the most effective and efficient manner.
fluctuating working capital needs, the firm resorts to short term finance. All This helps the consumers all it will bring to the market the products and
fixed assets-investment are to be finance by long term sources. It is a cardinal services that consumers need.
principal of financial planning. 6. Another notable features of the firms committed to the maximization of wealth
7. Flexibility:- The financial plan of company should possess flexibility so as to is that to achieve this goal they are forced to render efficient service to their
effect changes in the composition of capital structure when ever need arises. If customers with courtesy. This enhance consumer and hence the benefit to the
the capital structure of a company is flexible, it will not face any difficulty in society.
changing the sources of funds. This factor has become a significant one today 7. From the point of evaluation of performance of listed firms, the most
because of the globalization of capital market. remarkable measure is that of performance of the company in the share
8. Government Policy:- SEBI guidelines, finance ministry circulars, various market. Every corporate action finds its reflection on the market value of
clauses of Standard Listing Agreement and regulatory mechanism imposed by shares of the company. Therefore, shareholders wealth maximization could be
FEMA and Department of Corporate Affairs (Govt of India) influence the considered a superior goal compared to profit maximization.
financial plans of corporate today. Management of public issues of shares 8. Since listing ensures liquidity to the shares help by the investors shareholders
demands the companies with many status in India. They are to be compiled can reap the benefits arising from the performance of company only when they
with a time constraint. sell their shares. Therefore, it is clear that maximization of the net wealth of
What are the 4 finance decisions taken by a finance manager. shareholders.
Modern approach of financial management provides a conceptual and analytical
framework for financial decision making. According to this approach there are 4
major decision areas that confront the Finance Manager these are:-

2
share prices risk.. Such behaviors are expected to increase the share price of
whose shares are being purchased and lowering the shares price of those share
which are being sold. This switching operation will continue till the market price of
identical firms becomes identical.
Proposition II: The expected yield on equity is equal to discount rate (capitalization
rate) applicable plus a premium.
Q1. A. What is the cost of retained earnings? Ke = Ko + [ ( Ko Kd ) D/S ]
Cost of Retained Earnings Proposition III: The average cost of capital is not affected by the financing decisions
Cost of retained earnings (ks) is the return stockholders require on the companys as investment and financing decision are independent.
common stock.
There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach
a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first estimate
the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day
Treasury-bill rate as well as the expected rate of return on the market (rm).
The next step is to estimate the companys beta (bi), which is an estimate of the How to estimate cash flows? What are the components of incremental cash
stocks risk. Inputting these assumptions into the CAPM equation, you can then flows?
calculate the cost of retained earnings Estimation of cash flows
Estimating the cash flows associated with the project under consideration is the
most difficult and crucial step in the evaluation of an investment proposal. It is the
result of the team work of many professionals in an organization.
1. Capital outlays are estimated by engineering department after examining all
aspects of production process.
2. Marketing department on the basis of market survey forecasts the expected
b) Bond-Yield-Plus-Premium Approach sales revenue during the period of accrual of benefits from project executions.
This is a simple, ad hoc approach to estimating the cost of retained earnings. 3. Operating cost is estimated by cost accountants and production engineers.
Simply take the interest rate of the firms long-term debt and add a risk premium 4. Incremental cash flows and out flows statement is prepared by the cost
(typically three to five percentage points): accountant on the basis of details generated in the above steps. The ability of
ks = long-term bond yield + risk premium the firm to forecast the cash flows with reasonable accuracy lies at the root of
ks = D1 + g; the implementation of any capital expenditure decision.
P0 Investment (Capital budgeting) decision required the estimation of incremental cash
where: flow stream the life of the investment. Incremental cash flow are estimated on after
D1 = next years dividend tax basis.
g = firms constant growth rate 1. Initial Cash outlay (Initial investment): Initial cash outlay to be incurred is
P0 = price determined after considering any post tax cash inflows if any. In replacement
c) Discounted Cash Flow ApproachAlso known as the dividend yield plus growth decision existing old machinery is disposed of and new machinery incorporating
approach. Using the dividend-growth model, you can rearrange the terms as the latest technology is installed in its place. On disposed of existing old
follows to determine ks machinery the firm has a cash inflow. This cash inflow has to be computed on
Explain Miler and Modigliani Approach to capital structure theory? post tax basis. The net cash out flow (total cash required for investment in
Miller and Modigliani Approach capital assets minus post tax cash inflow on disposal on the old machinery being
Miller and Modigliani criticize that the cost of equity remains unaffected by leverage replaced by a new one) therefore is the incremental cash outflow. Additional net
up to a reasonable limit and Ko being constant at all degrees of leverage. They working capital required on implementation of new project is to be added to initial
state that the relationship between leverage and cost of capital is elucidated as in investment.
NOI approach. The assumptions for their analysis are: 2. Operating Cash inflows: Operating cash inflows are estimated for the entire
Perfect capital markets: Securities can be freely traded, that is, investors are economic life of investment. Operating cash inflows constitute a stream of
free to buy and sell securities( both shares and debt instruments), there are no inflows and outflows over the life of the project. Here also incremental inflows
hindrances on the borrowings, no presence of transaction costs, securities and outflows attributable to operating activities are considered. Any saving in
infinitely divisible, availability of all required information at all times. cost on installation of new machinery in the place of the old machinery will have
Investors behave rationally, that is, they choose that combination of risk and to be accounted to on post tax basis. In this connection incremental cash flows
return that is most advantageous to them. refer to the change in cash flows on implementation of a new project over the
Homogeneity of investors risk perception that is all investors have the same existing position.
perception of business risk and returns. 3. Terminal Cash inflows: At the end of the economic life of the project, the
Taxes: There is no corporate or personal income tax. operating assets installed now will be disposed off. It is normally known as
Dividend pay-out is 100%, that is, the firms do not retain earnings for future salvage value of equipment. These terminal cash inflows are computed on post
activities. tax basis.
Basic propositions: The following three propositions can be derived based on the What are the steps involved in capital rationing?
above assumptions: Steps involved in Capital Rationing are:
Proposition I: The market value of the firm is equal to the total market value of 1. Ranking of different investment proposals
equity and total market value of debt and is independent of the degree of leverage. 2. Selection of the most profitable investment proposals
The basic argument for proposition I is that equilibrium is restored in the market by Ranking of different investment proposal
the arbitrage mechanism. Arbitrage is the process of buying security at lower price The various investment proposals should be ranked on the basis of their
in one market and selling it in another market at higher price bringing about profitability. Ranking is done on the basis of NPV. Profitability index or IRR in the
equilibrium. This is a balancing act. Miller and Modigliani perceive that the investors descending order.
of firm whose value is higher will sell their share and in return buy shares of the firm Profitability index as the basis of Capital Rationing
whose value is lower. They will earn the same return at lower outlay and lower the The following details are