LECTURE NOTES ON FINANCIAL MANAGEMENT

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LECTURE NOTES ON FINANCIAL MANAGEMENT MBA I YEAR II SEMESTER (JNTUA-R15) Mr. P. PRATHAP KUMAR ASST.PROFESSOR DEPARTMENT OF MANAGEMENT STUDIES CHADALAWADA RAMANAMMA ENGINEERING COLLEGE CHADALAWADA NAGAR, RENIGUNTA ROAD, TIRUPATI (A.P) - 51750 CREC, Dept of MBA Page 1 THE FINANCE FUNCTION INTRODUCTION: In our present day economy, Finance is defined as the provision of money at the time when it is required. Every enterprise, whether big, medium or small needs finance to carry on its operations and to achieve its targets. In fact, finance is so indispensable today that it is rightly said to be the life blood of an enterprise. 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 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. Finance can be classified into two major parts: 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. Definition: Finance may be defined as the provision of money at the time when it is required. Finance refers to the management of flow of money through an organization.  According to WHEELER, business finance may be defined as “that business activity which is concerned with the acquisition and conservation of capital CREC, Dept of MBA Page 4 funds in meeting the financial needs and overall objectives of the business enterprise.”  According to GUTHMANN and DOUGALL, business finance may be broadly defined as “the activity concerned with the planning, raising, controlling and administering the funds used in the business.” NATURE OF FINANCE FUNCTION: The finance function is the process of acquiring and utilizing funds of a business. Finance functions are related to overall management of an organization. Finance function is concerned with the policy decisions such as like of business, size of firm, type of equipment used, use of debt, liquidity position. These policy decisions determine the size of the profitability and riskiness of the business of the firm. Prof. K.M.Upadhyay has outlined the nature of finance function as follows: i) In most of the organizations, financial operations are centralized. This results in economies. ii) Finance functions are performed in all business firms, irrespective of their sizes / legal forms of organization. iii) They contribute to the survival and growth of the firm. iv) Finance function is primarily involved with the data analysis for use in decision making. v) Finance functions are concerned with the basic business activities of a firm, in addition to external environmental factors which affect basic business activities, namely, production and marketing. vi) Finance functions comprise control functions also vii) The central focus of finance function is valuation of the firm. Finance is something different from Accounting as well as Economics but it uses information of accounting for making effective decisions. Accounting deals with recording, reporting and evaluating the business transactions, whereas Finance is termed as managerial or decision making process. Economics deals with evaluating the allocation of resources in economy and also related to costs and profits, demand and supply and production and consumption. Economics also consider those transactions which involve goods and services either in return of cash or not. Economics is easy to understand when divided into two parts. 1. Micro Economics: It is also known as price theory or theory of the firm. Micro economics explains the behavior of rational persons in making decisions related to pricing and production. 2. Macro Economics: Macro Economics is a broad concept as it takes into consideration overall economic situation of a nation. It uses gross national product (GNP) and useful in forecasting. CREC, Dept of MBA Page 5 In order to manage problems related to money principles developed by financial managers, economics, accounting are used. Hence, finance makes use of economic tools. From Micro economics it uses theories and assumptions. From Macro economics it uses forecasting models. Even though finance is concerned with individual firm and economics is concerned with forecasting of an industry. SCOPE OF FINANCIAL MANAGEMENT: The main objective of financial management is to arrange sufficient finance for meeting short term and long term needs. A financial manager will have to concentrate on the following areas of finance function. 1. Estimating financial requirements: The first task of a financial manager is to estimate short term and long term financial requirements of his business. For that, he will prepare a financial plan for present as well as for future. The amount required for purchasing fixed assets as well as needs for working capital will have to be ascertained. 2. Deciding capital structure: Capital structure refers to kind and proportion of different securities for raising funds. After deciding the quantum of funds required it should be decided which type of securities should be raised. It may be wise to finance fixed assets through long term debts. Even here if gestation period is longer than share capital may be the most suitable. Long term funds should be employed to finance working capital also, if not wholly then partially. Entirely depending on overdrafts and cash credits for meeting working capital needs may not be suitable. A decision about various sources for funds should be linked to the cost of raising funds. 3. Selecting a source of finance: An appropriate source of finance is selected after preparing a capital structure which includes share capital, debentures, financial institutions, public deposits etc. If finance is needed for short term periods then banks, public deposits and financial institutions may be the appropriate. On the other hand, if long term finance is required then share capital and debentures may be the useful. 4. Selecting a pattern of investment: When funds have been procured then a decision about investment pattern is to be taken. The selection of an investment pattern is related to the use of funds. A decision will have to be taken as to which assets are to be purchased? The funds will have to be spent first on fixed assets and then an appropriate portion will be retained for working capital and for other requirements. CREC, Dept of MBA Page 6 5. Proper cash management: Cash management is an important task of finance manager. He has to assess various cash needs at different times and then make arrangements for arranging cash. Cash may be required to purchase of raw materials, make payments to creditors, meet wage bills and meet day to day expenses. The idle cash with the business will mean that it is not properly used. 6. Implementing financial controls: An efficient system of financial management necessitates the use of various control devices. They are ROI, break even analysis, cost control, ratio analysis, cost and internal audit. ROI is the best control device in order to evaluate the performance of various financial policies. 7. Proper use of surpluses: The utilization of profits or surpluses is also an important factor in financial management. A judicious use of surpluses is essential for expansion and diversification plans and also in protecting the interests of share holders. The ploughing back of profits is the best policy of further financing but it clashes with the interests of share holders. A balance should be struck in using funds for paying dividend and retaining earnings for financing expansion plans. FINANCE FUNCTION – AIM The objective of finance function is to arrange as much funds for the business as are required from time to time. This function has the following objectives. 1. Assessing the Financial requirements. The main objective of finance function is to assess the financial needs of an organization and then finding out suitable sources for raising them. The sources should be commensurate with the needs of the business. If funds are needed for longer periods then long-term sources like share capital, debentures, term loans may be explored. 2. Proper Utilization of Funds: Though raising of funds is important but their effective utilisation is more important. The funds should be used in such a way that maximum benefit is derived from them. The returns from their use should be more than their cost. It should be ensured that funds do not remain idle at any point of time. The funds committed to various operations should be effectively utilised. Those projects should be preferred which are beneficial to the business. 3. Increasing Profitability. The planning and control of finance function aims at increasing profitability of the concern. It is true that money generates money. To increase profitability, sufficient funds will have to be invested. Finance Function should be so planned that the concern neither suffers from inadequacy of funds nor wastes more funds than required. A proper control should also be exercised so that scarce resources are not frittered away on uneconomical operations. The cost of acquiring funds also influences profitability of the business. CREC, Dept of MBA Page 7 4. Maximizing Value of Firm. Finance function also aims at maximizing the value of the firm. It is generally said that a concern's value is linked with its profitability. ROLE OF FINANCIAL MANAGEMENT IN CONTEMPORARY SCENARIO: Sources of finance Finance  Equity shares markets  Debentures Capital  Commercial banks markets  Insurances Repayments, interest and dividends money  govt markets funds CFO Net cash flows investments Investments in fixed and currents asstes Due to recent trends in business environment, financial managers are identifying new ways through which finance function can generate great value to their organization. 1. Current Business Environment: The progress in financial analytics is because of development of new business models, trends in role of traditional finance department, alternations in business processes and progress in technology. Finance function in this vital environment emerged with enormous opportunities and challenges. 2. New Business Model: At the time when internet was introduced, three new e- business models have evolved. They are business-to-business (B2B), business-to- CREC, Dept of MBA Page 8 customer (B2C) and business-to-employees (B2E) future of financial analytics can be improved with the help of this new model of business. Traditionally, financial analytical is emphasizing on utilization of tangible assets like cash, machinery etc, whereas some companies are mainly focused on intangible assets which are not easy to evaluate and control. Hence financial analytics solved this problem by: i) Recognizing the complete performance of organization. ii) Determining the source through which value of intangible assets can be evaluated and increased. iii) Predict the trends in market. iv) The abilities of information system is encouraged. v) Minimizes the operating costs and enterprise-wide investments are effectively controlled and upgrade the business processes. 3. Changing Role of the Finance Department: The role of finance function has been changing simultaneously with the changes in economy. These changes are mainly due to Enterprise Resource Planning (ERP), shared services and alternations in its reporting role. In the field of transaction processing, the role of financial staff has been widened up because of automated financial transactions. Now financial executives are not just processing and balancing transactions but they are focusing on decision- making processes. International organizations are facilitating their customers by providing financial information and facility to update both finance and non-finance functions from any place around the world. It resulted in the department of decision support in the organization. Finance professionals are held responsible for supplying suitable analytical tools and methods to decision makers. i) Business Processes: With the evolution of business processes, queries regarding business are becoming more complicated. In order to solve, it requires analytics with high level of data integration and organizational collaboration. In the last few decades, organizations are replacing function based legacy systems with new methods like ERP, BRP etc., in order to get accurate and consistent financial and non- financial information. In 1990’s organizations were applying some modern systems like supply chain management, Customer Relationship Management (CRM) and many others to encourage their transactions. Overall organizations were building strong relations with customers. CREC, Dept of MBA Page 9 ii) Technology: With the developments in technology, ERP, internet, data warehousing have also improved. Internet helps in increasing the sources of acquiring financial data, whereas ERP vendors are building their own financial analytics which helps I n evaluating the performance, planning and estimating, management and statutory reporting and financial consolidation. Till now, data warehousing solutions used to emphasize on developing elements of analytical infrastructure such as data stores, data marts and reporting applications but in future these data ware housings provide advances analytical abilities to data stores. iii) Integrated Analytics: To survive in this competitive environment, organizations must have advanced level of integrated financial analytics. Integrated financial analytics are useful for organizations to evaluate, combine and share information inside and outside the organization. Hence, with the progress in role of finance function, the financial analytics are used in organizations effectively. EVOLUTION OF FINANCE FUNCTION: Financial management came into existence as a separate field of study from th finance function in the early stages of 20 century. The evolution of financial management can be separated into three stages: 1. Traditional stage (Finance up to 1940): The traditional stage of financial management continued till four decades. Some of the important characteristics of this stage are: i) In this stage, financial management mainly focuses on specific events like formation expansion, merger and liquidation of the firm. ii) The techniques and methods used in financial management are mainly illustrated and in an organized manner. iii) The essence of financial management was based on principles and policies used in capital market, equipments of financing and lawful matters of financial events. iv) Financial management was observed mainly from the prospective of investment bankers, lenders and others. 2. Transactional stage (After 1940): The transactional stage started in the beginning years of 1940’s and continued till the beginning of 1950’s. The features of this stage were similar to the traditional stage. But this stage mainly focused on the routine problems of financial managers in the field of funds analysis, planning and control. In this stage, the essence of financial management was transferred to working capital management. CREC, Dept of MBA Page 10 3. Modern stage (After 1950): The modern stage started in the middle of 1950’s and observed tremendous change in the development of financial management with the ideas from economic theory and implementation of quantitative methods of analysis. Some unique characteristics of modern stage are: i) The main focus of financial management was on proper utilization of funds so that wealth of current share holders can be maximized. ii) The techniques and methods used in modern stage of financial management were analytical and quantitative. Since the starting of modern stage of financial management many important developments took place. Some of them are in the fields of capital budgeting, valuation models, dividend policy, option pricing theory, behavioral finance etc. GOALS OF FINANCE FUNCTION Effective procurement and efficient use of finance lead to proper utilization of the finance by the business concern. It is the essential part of the financial manager. Hence, the financial manager must determine the basic objectives of the financial management. Objectives of Financial Management may be broadly divided into two parts such as: 1. Profit maximization 2. Wealth maximization. Share holders BOD CFO 1. Profit Maximization Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring techniques CREC, Dept of MBA Page 11 to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization consists of the following important features. 1. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization. 2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern. 3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern. 4. Profit maximization objectives help to reduce the risk of the business. Favorable Arguments for Profit Maximization The following important points are in support of the profit maximization objectives of the business concern: (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. Unfavorable Arguments for Profit Maximization The following important points are against the objectives of profit maximization: (i) Profit maximization leads to exploiting workers and consumers. (ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc. (iii) Profit maximization objectives leads to inequalities among the sake holders such as customers, suppliers, public shareholders, etc. Drawbacks of Profit Maximization Profit maximization objective consists of certain drawback also: (i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern. (ii) It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period. CREC, Dept of MBA Page 12 (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. 2. 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 Favorable Arguments for Wealth Maximization (i) Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders. (ii) Wealth maximization considers the comparison of the value to cost associated with the business concern. Total value detected from the total cost incurred for the business operation. It provides extract value of the business concern. (iii) Wealth maximization considers both time and risk of the business concern. (iv) Wealth maximization provides efficient allocation of resources. (v) It ensures the economic interest of the society. Unfavorable Arguments for Wealth Maximization (i) Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities. (ii) Wealth maximization 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 enjoy 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. CREC, Dept of MBA Page 13 S.NO. PROFITMAXIMIZATION WEALTH MAXIMIZATION WELFARE MAXIMIZATION 1) Profits are earned Wealth is maximized, so that Welfare maximization is maximized, so that firm wealth of share-holders can be done with the help of micro can over-come future risks maximized. economic techniques to which are uncertain. examine a locative distribution. 2) Profit maximization is a In wealth maximization In welfare maximization, yards stick for calculating stockholders current wealth is social welfare is evaluated efficiency and economic evaluated in order to maximize by calculating economic prosperity of the concern. the value of shares in the activities of individuals in market. the society. 3) Profit is measured in terms Wealth is measured in terms of Welfare can be measured in of efficiency of the firm. market price of shares. two ways, either by pare to efficiency or in units or dollars. 4) Profit maximization Wealth maximization involves Wealth maximization involvesproblemof problems related to involves problem of uncertainty because profits maximizing shareholder’s combining the utilities of are uncertain. wealth or wealth of the firm different people. PROFIT VS. WEALTH VS. WELFARE AGENCY RELATIONSHIP AND COST: The relationship that exists in an organization between share holders and management known as agency relationship. Agency relationship results when a principal hires an agent to perform part of his duties. In this type of relationship there is a chance of conflicts to occur between the principal and the agent. This conflict is termed as agency problem. The costs incurred by stockholders in order to minimize agency problem and maximize the owner’s wealth are called agency costs. The two primary agency relationship exists in a business concern are: 1) Shareholders Vs Bondholders 2) Manager Vs Share holders 1) Agency conflict-I (Shareholders Vs Bondholders): Shareholders are the real owners of the concern, they pay fixed and agreed amount of interest to bondholders till the duration of bond is finished but bondholders have a proceeding claim over the assets of the company. Since equity investors are the owners of the company they possess a residual claim on the cash flows of the company. Bondholders are the only sufferers if decisions of the company are not appropriate. CREC, Dept of MBA Page 14 When a company invest in project by taking amount from bondholders and if the project is successful, fixed amount is paid to bondholders and rest of the profits are for shareholders and suppose if project fails then sufferers will be the bondholders as their money have been invested. 2) Agency conflict-II (Managers Vs Shareholders): Profits generated from investments in projects can be utilized for reinvestment or provided back to shareholders as dividends. If dividends are increased, it may leads to decrease in the resources which are under the manager’s control and also strict its growth. As managers are evaluated on the basis of growth they might go for unproductive projects which cannot generate appropriate returns, which make the shareholders feel shocked. This is the main cause of conflicts between managers and shareholders. THE NEW DEBATE ON MAXIMIZING VS SATISFYING: A principal agent relationship exists between management and owners of the company. The real owners of the company are shareholders and whereas management engaged for making decisions on behalf of share holders. Conflicts are common in every relationship, they arise when objectives of agents does not match with objectives of principal. Sometimes, managers are considered to be the satisfiers rather than maximizer’s of share holder’s wealth, when managers satisfy the objectives of shareholders considerably and also satisfies their own objectives. Such a behavior of management is well in short term but it is not suitable in long, medium term for some companies. It give rise to two critical conditions: 1) The competitive market for the shareholder’s funds 2) The competitive market for management jobs The share holders of the company which is listed in stock exchange can evaluate the performance of management by comparing the share price performance of similar companies. If share price performance is not good, then it is clear that management is only satisfying and not working for maximizing shareholders wealth. It leads to the situation in which share holders sell off their shares and purchase shares of maximizing companies. It ultimately leads to the undesirable takeover. Hence, the competitive market for shareholder’s funds ensures support to the maximizing objective. Another way for managers to continue his objectives are possible with job promotions. It is believed by managers that performing their duties well leads to promotion and applies; it is a competitive market for managerial jobs. Hence, satisfying managers are replaced with maximizing managers. Because of above conditions, satisfying behavior of management is not suitable in long and medium term. It is difficult for companies which are not listed in stock exchange to evaluate share price performance. CREC, Dept of MBA Page 15 MAXIMIZING VS SATISFYING As share holders are the real owners of the organization, they appoint managers to take important decisions with the objective of maximizing share holder’s wealth. Though organizations have many more objectives, but maximizing stock price is considered to be an important objective of all for many firms. 1) Stock price maximization and social welfare: It is advantageous for society, if firm maximize its stock price. But, firm must not have any intentions of forming monopolistic market, creating pollution and avoiding safety measures. When stock prices are maximized, it benefits society by: i) To greater extent the owners of stock are society: In past, ownership of stock was with wealthy people in society. But now, with the tremendous growth of pension funds, life insurance companies and mutual funds, large group of people in society have ownership of stock either directly or indirectly. Hence, when stock price is increased, it ultimately improves the quality of life for many people in society. ii) Consumers benefit: It is necessary to have effective low-cost businesses which manufacture good quality of goods and services at the cheapest cost possible to maximize stock price. Companies which are interested in maximizing stock price must satisfy all requirements of customers, provide good services and innovate new products finally; it must increase its sales by creating value for customers. Some people believe that firms increase the prices of goods while maximizing stock price. But it is not true; in order to survive in competitive market firms does not increase prices otherwise they may lose their market share. iii) Employees benefit: In past years, it was an exception that decreases in level of employees lead to increase in stock price, but now a successful company which can increase stock price can develop and recruit more employees which ultimately benefits the society. Successful companies take advantage of skilled employees and motivated employees are an important source of corporate success. 2) Managerial Actions to Maximize Shareholder’s Wealth: In order to identify the steps taken by managers to maximize shareholder’s wealth, the ability of the organization to generate cash must be known. Cash flows can be determined in three ways, they are: i) Unit Sales: In first determinant, managers can increase the level of their sales either by satisfying customers or by luck, but which will not continue in long run. ii) After Tax Operating Margins: In second determinant, managers can generate cash flows by increasing operating profit which is not possible in competitive environment or by decreasing direct expenses. iii) Capital Requirements: In third determinant, managers can increase cash flows by decreasing assets requirements which ultimately results in increase of stock price. CREC, Dept of MBA Page 16 Investment and financing decisions have an impact on level, timing and risk of the cash flow of firm and finally on stock price. It is necessary for manager to make decisions which can maximize the stock price of the firm. 3) Maximizing Earnings Per Share is Beneficent or Not: In order to maximize stock price, many analyst focus on cash flows by evaluating the performance of the company and also focus of EPS as an accounting measure. Along with cash flow, EPS also plays an important role in identifying stockholder’s value. RISK RETURN TRADE-OFF The Risk-Return Trade-Off is an essential concept in finance theory. Risk implies the changes in expected return like sales, profits or cash flow and it also includes probability that problem. Risk analysis is a procedure of calculating and examining the risk which is related to financial and investment decision of the company. Finance managers must focus on expected rate of return by comparing the level of risks involved in investment decision. When it is expected that rate of return will be high then it involves high level of risk and vice versa. INVESTMENT DECISIONS - CAPITAL BUDGETING RISK - WORKING CAPITAL MANAGEMENT MARKET FINANCING DECISIONS VALUE OF -CAPITAL STRUCUTURE THE FIRM RETURN DIVIDEND DECISIONS -DIVIDEND POLICY (RISK–RETURN TRADE OFF) The decisions which involve risk-return trade off are explained below: 1) Capital Budgeting Decisions: Capital budgeting decision is important, as it involves proper allocation of funds. These decisions are made considerably for long period of time in order to get benefits in future. While taking capital budgeting decision, finance manager needs to evaluate the cost of capital and risk involved in it. Finance manager must have complete knowledge about the techniques used for evaluating such as Net Present Value (NPV), IRR, discounted cash flow, etc. Finance manager must have the capability of combining risk with returns in order to evaluate the potential of investment appropriately. CREC, Dept of MBA Page 17 2) Capital Structure Decisions: Capital structure decisions play an important role in designing the capital structure which is suitable for the company. It is the duty of finance manager to develop an optimum capital structure which involves less amount of cost of capital, less amount of risk but which can generate huge amount of returns. While developing capital structure, finance managers must also consider the financial and operating leverages of the firm. 3) Dividend Decisions: Dividend decision is also important for organization to design the dividend policy. Dividend policy involves the amount of profits to paid as dividend to shareholders or reinvested in the organizations. Shareholders emphasize on getting higher amount of dividend, whereas management of company tries to maintain profits to face uncertainties in future. The dividend policy of the firm mainly depends of profitability. 4) Working Capital Decisions: Working capital management is an addition of fixed capital investment. Working capital management is an important element of every organization, as it helps in continuing the business processes. Decisions related to working capital are known as working capital decisions. The essential elements of working capital are cash, accounts receivable and inventory. Each element of working capital involves some kind of risk in it. Hence, it is clear that each every decision related to finance involves risk-return trade-off. So, it is the responsibility of finance managers to consider both risk and return, while making these decisions. PROFIT MAXIMIZATION VS WEALTH MAXIMIZATION PROFIT MAXIMIZATION Profit earning is the main aim of every economic activity. A business being an economic institution must earn profit to cover its costs and provide funds for growth. No business can survive without earning profit. Profit is a measure of efficiency of a business enterprise. Profits also serve as a protection against risks which cannot be ensured. The accumulated profits enable a business to face risks like fall in prices, competition from other units, adverse government policies etc. (i) When profit-earning is the aim of business then profit maximization should be the obvious objective. (ii) Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise, thus, profit maximization if justified on the grounds of rationality. (iii) Economic and business conditions do not remain same at all the times. There may be adverse business conditions like recession, depression, severe competition etc. A business will be able to survive under unfavorable situation, only if it has some past earnings to rely upon. Therefore, a business should try to earn more and more when situations favorable. CREC, Dept of MBA Page 18 (iv) Profits are the main sources of finance for the growth of a business. So, a business should aim at maximization of profits for enabling its growth and development. (v) Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit maximization also maximizes socio-economic welfare. WEALTH MAXIMIZATION Wealth maximization is the appropriate objective of an enterprise. Financial theory asserts that wealth maximization is the single substitute for a stockholder’s utility. When the firm maximizes the stockholder’s wealth, the individual stockholder can use this wealth to maximize his individual utility. It means that by maximizing stockholder’s wealth the firm is operating consistently towards maximizing stockholder’s utility. Stockholder’s current wealth in a firm = (Number of shares owned) x (Current Stock Price Share) Symbolically, 𝑊 = 0 0 DIFFERENCE BETWEEN PROFIT AND WEALTH MAXIMIZATION Goal Objective Advantages Disadvantages Profit Large amount of profits -Easy to calculate profits. -Emphasizes the short term. maximization -Easy to determine the link -Ignores risk or uncertainty. between financial decisions -Ignores the timing of and profits. returns. -Requires immediate resources. Stockholder Highest market value of -Emphasizes the long term. -Offers no clear relationship wealth common stock -Recognizes risk or between financial decisions maximization uncertainty. and stock price. -Consider stockholders -Can lead to management return. anxiety and frustration. CREC, Dept of MBA Page 19 𝑁𝑃 UNIT – 2 CREC, Dept of MBA Page 20 THE INVESTMENT DECISION (CAPITAL BUDGETING) INTRODUCTION The word Capital refers to be the total investment of a company of firm in money, tangible and intangible assets. Whereas budgeting defined by the “Rowland and William” it may be said to be the art of building budgets. Budgets are a blue print of a plan and action expressed in quantities and manners. Investment decision is the process of making investment decisions in capital expenditure. A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over period of time exceeding one year. The main characteristic of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the expenditure are realized at different points of time in future. The examples of capital expenditure: 1. Purchase of fixed assets such as land and building, plant and machinery, good will, etc. 2. The expenditure relating to addition, expansion, improvement and alteration to the fixed assets. 3. The replacement of fixed assets. 4. Research and development project. MEANING The process through which different projects are evaluated is known as capital budgeting. Capital budgeting is defined “as the firm’s formal process for the acquisition and investment of capital. It involves firm’s decisions to invest its current funds for addition, disposition, modification and replacement of fixed assets”. DEFINITION Capital budgeting (investment decision) as, “Capital budgeting is long term planning for making and financing proposed capital outlays.” - Charles T.Horngreen “Capital budgeting consists in planning development of available capital for the purpose of maximizing the long term profitability of the concern” – Lynch “Capital budgeting is concerned with the allocation of the firm source financial resources among the available opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent streams of earning from a project, with the immediate and subsequent streams of expenditure”. G.C. Philippatos CREC, Dept of MBA Page 21 NEED AND IMPORTANCE OF CAPITAL BUDGETING 1. Huge investments: Capital budgeting requires huge investments of funds, but the available funds are limited, therefore the firm before investing projects, plan are control its capital expenditure. 2. Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore financial risks involved in the investment decision are more. If higher risks are involved, it needs careful planning of capital budgeting. 3. Irreversible: The capital investment decisions are irreversible, are not changed back. Once the decision is taken for purchasing a permanent asset, it is very difficult to dispose of those assets without involving huge losses. 4. Long-term effect: Capital budgeting not only reduces the cost but also increases the revenue in long-term and will bring significant changes in the profit of the company by avoiding over or more investment or under investment. Over investments leads to be unable to utilize assets or over utilization of fixed assets. Therefore before making the investment, it is required carefully planning and analysis of the project thoroughly. CAPITAL BUDGETING PROCESS Capital budgeting is a complex process as it involves decisions relating to the investment of current funds for the benefit to the achieved in future and the future is always uncertain. However the following procedure may be adopted in the process of capital budgeting: CREC, Dept of MBA Page 22

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