Factors Affecting Business Risk Of A Firm

The business risk of a firm is measured by the variability in operating income of the firm. Larger variability in operating income denotes larger business risk. The firm's business risk changes over time and it varies from firm to firm. Some factors affecting business risk of a firm are as follows: 

1. Variability In Demand

The operating income of the firm fluctuates widely if variability in demand for firm's product is larger. Thus, a firm with larger variability in demand is more exposed to business risk.

2. Variability In Selling Price

A firm's product does not sell at constant price. The selling price of the firm's product may be volatile because of alternative demand and supply conditions, nature of competitions and so on. Thus, larger the variability in selling price wider will be the fluctuations in operating income leading to higher business risk.

3. Uncertainty Of Input Costs

Cost of input keeps on changing over time, affecting the total cost of output. The total operating cost of the firm widely fluctuates if the uncertainty associated to input cost is larger. This exposes the firm to high business risk.

4. Ability To Price Adjustment

When there is an increase in input costs, the selling price must also increase to maintain the stability in firm's operating income. However, the speed with which selling price is adjusted in response to the change in input costs, depends on price adjustment capacity of the firm.Thus, higher the firm's ability to price adjustment, lower will be the business risk.

5. Speed Of Technological Changes

The firm should adapt to changing technology over the years. If the speed of technological changes is greater and the firm is not able to adapt to changing technology, demand for firm's product will be adversely affected. The level of business risk associated to such firm is larger.

6. Extent Of Fixed Operating Costs

If larger portion of the firm's costs are fixed, the firm has to make larger sales to meet the fixed costs. At lower sales level such firm is not able to meet the fixed cost. There larger fixed cost exposes the firm to larger degree of business risk.

Concept And Meaning Of Business Risk

Business risk is defined as the riskiness on the firm's stock provided that the firm has used no debt capital. It is the risk inherent in operation of the business. A firm's business risk arises because of uncertainty associated  to projection of return in invested capital (ROIC). ROIC is calculates as below.

ROIC = NOPAT/Capital

In this equation, NOPAT is the net operating profit after tax, which is calculated as net income available to common stockholders plus after-tax interest payment. Capital includes both debt and equity. We assume for simplicity that the firm has used no preferred stock capital. If a company uses no debt capital, its interest expenses will be zero and the capital consists only common equity. Therefore, return on invested capital with zero debt os calculated as below.

ROIC = Net income/Common equity

This equation gives same result as to that of return on equity (ROE), if company has used debt capital, In such a case, the business risk is simply indicated by standard deviation, which measures the variability associated to firm's ROE assuming no debt financing used.

Concept Of Financial Forecasting

Financial forecasting is a process of projecting future financial requirements of a firm. Financial manager is concerned with the futurity of financial performance. Financial forecasting, an integral part of finance manager's job, is an act of deciding in advance the quantum of funds requirements of the firm and the time pattern of such requirements. In the process of financial forecasting, financial manager is supposed to develop projected financial statements. Efficient financial forecasting enables a financial manager to plan for future financing requirements and to identify the appropriate sources of funds to satisfy the financing needs. An efficient financial forecasting should consists of the following activities:

1. Setting up projected income statement and balance sheet so that the effect of operating plan on firm's future profit and other indicator of financial performance can be analyzed.

2. Determining need of financing to support firm's growth in sales and other investment opportunities.

3. Forecasting appropriate sources of financing that can be generated internally as well as externally.

4. Setting up proper mechanism of control relating to allocation and utilization of funds.

Sales Forecasting Methods

There are several methods of sales forecasts. Some of them are as follows:

1. Sales persons
A firm can employ its sales persons to provide a close forecast of sales. These sales person are employed at many places where firm's products are offered. They collect market information personally from customers, collect customer's response to the firm's product and thus provide an estimate if likely sales that the firm can achieve in the future.

2. Customer Survey
It is a formal process of sales forecasts applied by the firm on the basis of survey of customers in many places. Firm employs some survey people to visit many customers of many places and takes the response of existing as well as prospective customers on the basis of direct interview and questionnaire.Existing and prospective customers are asked to give their opinion verbally or in written format about the product offered by the firm. On the basis of opinion survey of customers, these survey people provide an estimate of future sales.

3. Time Series Model
Time series model is a mathematical model of sales forecasts. This model assumes that level of sales varies according to change in time period. A time series model states that the relationship between two variables, one of them being the time period and another being sales. A series of time period is regarded as independent variable and the level of sales over several time periods is used as dependent variable. Under this method, past sales data are arranged chronologically and statistical analysis of these chronological sales data is made to forecast the level of sales in some future date. Here the sales level is regarded as a function of time period. The time series model is stated as below:

Yt = f(t)

Where, 'Yt' represents the value of sales in time 't'.

4. Econometric Model
Econometric model is an important model used in sales forecasting. This method assumes that sales of firm are influenced by many factors such as level of inventory, advertisement expenses, cost of production, cost of quality control, research and development expenditure and so on. Sales are regarded as dependent variable and all other factors under considerations are regarded as independent variables. Once these variables are identified, they are into the following model to provide a forecast of sales.

Y = a+b1X1+b2X2+b3X3+...........+bnXn+e

Y = Estimated sales
X1,X2,X3 = value of independent variables influencing sales
b1,b2,b3 = the coefficient of respective independent variables
a = the intercept constants
e = standard random error term.

Concept Of Sales Forecast And Factors To Be Considered For Sales Forecasting

Concept Of Sales Forecast

Financial forecasting is a significant part of financial planning process. The financial forecasting begins with sales forecast. Sales forecast is a forecast of firm's future sales both in terms of volume and value. The sales forecast always begins with analyzing the historical trends in sales over the past periods. It also takes to consideration the future economic prosperity if given line of business. To determine the forecasted sales growth, the firm must rely on competitive market conditions, customers' tastes and preferences, change in technology and future possibilities of market expansion. Nowadays, several statistical methods like regression analysis, time series analysis, econometric models are used to consider all these factors in providing sales forecasts.

Factors To Be Considered For Sales Forecasting

Some factors that should be considered while developing sales  forecast are as follows:

1. Provide a projection of divisional sales based on historical growth and combine the divisional sales forecasts to provide a approximate corporate sales forecast.

2. Forecast the level of economic activity in each market area of the firm along with the change in population and their economic growth.

3. Estimate the market share of the firm that is expected in each market area depending on the firm's production and distribution capacity, capacity of competitors, possibility of new product and so on.

4. Forecast the effect of future rate of inflation in the consumer's purchasing power and price of products.

5.Consider the effect of advertisement campaigns, price discounts, credit terms and so on.

6. Provide the ultimate forecasts of sales for each division in aggregate and on an individual product basis.

The accurate sales forecast must be as accurate as possible. If it is overly optimistic, the firm may have idle plant capacity and unnecessary investment in inventories. If the sales forecast is overly pessimistic, it may result into loosing the customers because of failure to meet demand. Both of these conditions result into low profit margin, low return on assets, low return on equity and decline in market price of share. Therefore, accurate sales forecast is significant to improve profitability of the firm. 

Financial Planning Process

A firm's financial plan largely involves the forecast and use of various types of budgets. These budgets are prepared for every key area of firm's activities such as production, marketing, research and development, purchase and so on. The major steps involved in financial planning are as follows:

1. Project financial statements and use these projections to analyze the effects of the operating plan on projected profits and various financial ratios. The projections can also be used to monitor operations after the plan has been finalized and put into effect.

2. Determine the funds needed to support periodic plan which includes funds for plant and equipments, inventories, receivables,new product development, research and developments and for other major activities.

3. Forecast availability of funds over the planning horizon. This involves estimating the funds to generate internally as well as those to be obtained from external sources.

4. Establish and maintain a system of control to govern the allocation and use of funds within the firm.

5. Develop procedures for adjusting the basic plan, if the economic forecast upon which the plan was based do not materialize.

6. Establish a performance based management compensation system.

Concept And Objectives Of Financial Plan

Concept Of The Financial Plan

The financial plan refers to the projection of future financial course of action to be carried for efficient execution of operating plans and effective accomplishment of corporate objective. Financial plan begins with the preparation of strategic plans that in turn guides the formulation of operating plans and budgets. Financial plan provides road map for guiding, coordinating and controlling firm's financial action in order to achieve the objectives. 

Therefore, a plan that spells out future course of action, budgets and capital expenditures required for execution of operating plans is known as financial plan.

Objectives Of The Financial Plan

Most corporate organizations spend significant time and labor in preparing the financial plan as it enables a firm:
* To identify significant actions to be taken in various aspects of firm's finance functions.

* To develop various options in the field of finance functions, which can be exercised as condition change.

* To state clearly the relationship between present and future financial decision.

* To systematize the interaction required between investment and financing decision.

* To ensure that the strategic plan of the firm is financially viable.

* To provide standard against which future financial performance is compared.

Concept Of The Cost Of Money And Factors Affecting It

Concept Of The Cost Of Money

The cost of money refers to the price paid for using the money, whether borrowed or owned. Every sum of money used by corporations bears cost. The interest paid on debt capital and the dividends paid on ownership capital are examples of the cost of money. The supply of and demand for capital is the factor that affects the cost of money. In addition, the cost of money is affected by the following factors as below:

Factors Affecting The Cost Of Money

1. Production Opportunities

Production opportunities refer to the profitable opportunities for investment in productive assets. Increase in production opportunities in an economy increases the cost of money. Higher the production opportunities more will be the demand for money which leads to higher cost of money.

2. Time Preference For Consumption

Time preference for consumption refers to the preference of consumers for current consumption as opposed to future consumption. The cost of money also depends on whether the consumers prefer  to consume in current period or in future period.  If the consumers prefer to consume in current period, they spend larger portion of their earnings in current consumption. It leads to the lower saving. Lower saving reduces the supply of money causing the cost of money increase. Therefore, as much as the consumers give high preference to current consumption, the cost of money will increase and vice versa.

3. Risk

Risk refers to the chance of loss. In the context of financial markets, risk means the chance that investment would not produce promised return. The degree of risk perceived by investors and the cost of money has positive relationship. If an investor perceives high degree of risk from a given investment alternative, he or she will demand higher rate of return, and hence the cost of money will increase.

4. Inflation

Inflation refers to the tendency of prices to increase over periods. The expected future rate of inflation also affects the cost of money, because, it affects the purchasing power of investors. Increasing in rate of inflation results in decline in purchasing power of investors. The investors will demand higher rate of return to commensurate against decline in purchasing power because of inflation.

Classification Or Types Of Financial Institutions

In financial market there are many types of financial institutions or intermediaries exist for the flow of funds. Some of them involve in depositary type of transactions whereas other involve in non-depositary type of transactions. The type of financial institutions can be divided into two types as follows:

1. Depository Institutions

The depository types of financial institutions include banks, credit unions, saving and loan associations and mutual saving banks

* Commercial banks

Commercial banks are those financial institutions, which help in pooling the savings of surplus units and arrange their productive uses. They basically accepts the deposits from individuals and institutions, which are repayable on demand. These deposits from individuals and institutions are invested to satisfy the short-term financing requirement of business and industry.

* Credit Unions

Credit unions are cooperative associations where large numbers of people are voluntarily associated for savings and borrowing purposes. These individuals are the members of credit unions as they make share investment along with deposits. The saving generated from these members are used to lend the members of the union only.

* Saving And Loan Associations

Saving and loan associations are the financial institutions involved in collecting funds of many small savers and lending these funds to home buyers and other types of borrowers.

* Mutual Saving Banks

Mutual saving banks are more or less similar to saving and loan associations. They primarily accepts savings of individuals and they are lent to the home users and consumers on a long-term basis.

2. Non-depository Institutions

Non-depository types of financial institutions are not banks in real sense. They make contractual arrangement and investment in securities to satisfy the needs and preferences of investors. The non-depository institutions include insurance companies, pension funds, finance companies and mutual funds.

* Insurance Companies

Insurance companies are the contractual saving institutions which collect periodic premium from insured party and in return agree to compensate against the risk of loss of life and properties. 

* Pension/Provident Funds

Pension funds are financial institutions which accept saving to provide pension and other kinds of retirement benefits to the employees of government units and other corporations. Pension funds are basically funded by corporation and government units for their employees, which make a periodic deposit to the pension fund and the fund provides benefits to associated employees on the retirement. The pension funds basically invest in stocks, bonds and other type of long-term securities including real estate. 

* Finance Companies

Finance companies are the types of financial institutions that engage in satisfying individual credit needs, and perform merchant banking functions. In other words, finance companies are non-bank financial institutions that tend to meet various kinds of consumer credit needs. They involve in leasing, project financing, housing and other kind of real estate financing.

* Mutual Funds

Mutual funds are open-end investment companies. They are the associations or trusts of public members and invest in financial instruments or assets of the business sector or corporate sector for the mutual benefit of its members. Mutual funds are basically a large public portfolio that accepts funds from members and then use these funds to buy common stocks, preferred stocks, bonds and other short-term debt instruments issued by government and corporation. 

Concept And Meaning Of Financial Institutions

Financial institutions are organizations that deals with transaction of financial claims and financial assets. They issue financial claims against themselves for cash and use the proceeds from this issuance to purchase primarily the financial assets of others. Financial institutions primarily collect saving from people, business and government by offering accounts and by issuing securities. The savings are lent to the user of the funds. They also work as the intermediaries between issuer of securities and the investing public. Thus, financial institutions are the specialized firms that facilitate the transfer of funds from savers to borrowers. They offer accounts to the savers and in turn the money deposited are used to buy the financial assets issued by other forms.  Similarly, they also issue the financial claims against themselves and the proceeds are used to buy the securities of other firms. Since financial claims simply represent the liability side of balance sheet for an organization, the key distinction between financial institution and other types of organizations involves what is on the assets side of the balance sheet.

For example, a typical commercial bank issues financial claims against itself in the form of debt (for instance, checking and saving accounts) and equity; and so does a typical manufacturing firm. However, structure of assets held by a commercial bank reveals that most of the bank's money is invested in loans to individuals, corporations, and government as well. On the other hand, typical manufacturing firm invest primarily in real assets. Accordingly, banks are classified as financial institutions and manufacturing firms are not. Besides commercial banks, other example of financial institutions are finance companies, insurance companies, credit unions, pension funds, mutual funds savings and loan associations, and so on.

Types Of Financial Markets

Financial markets can be divided into different types. One way to classify the financial markets is to distinguish between primary market and secondary market. Another classification is based on life span of the securities traded in the market. They are money market and the capital market.

1. Primary Market
When securities are issued for the first time, they are traded in primary market. In other words, it is the market in which corporations raise new capital. All proceeds from the issue in this market go to issuing corporation. In issuing securities, the corporation could take the services of investment bankers and securities dealers. They assist issuing corporations selling securities in the market.

2. Secondary Market
A secondary market is the market for already existing securities, where trading between investors to investors take place. The original issuer has no role in secondary markets, and the proceeds from securities transactions do not go to the issuer.
An active secondary market is crucial for any securities once they are sold off in primary market. The existence of secondary market facilitates trading among investors to investors, thus adding to the liquidity of securities. Investors are motivated to buy securities in primary market only if the secondary markets for the securities exist.

3. Money Market
Money market deals with trading of securities with less than one year of life span. It is the market for borrowing and lending for relatively short period of time, usually less than one year. Government, corporations and individuals requiring short-term loan are major participants of money market. Government issues treasury bills to meets its need of short-term funds. Corporations could issue commercial papers or take loan on short-term basis fro banks to satisfy their short-term need of funds. Other money market instruments include bankers' acceptance, certificate of deposits, promissory notes, bills of exchange and any others with less than one year of life. These money market instruments are actively traded in primary as well as secondary market.

4. Capital Market
Capital market is the market for long-term (more than one year) securities. All long-term securities issued by corporations and government such as common stock, preferred stock, corporate bonds, government bonds are the instruments of capital market. These capital market instruments are also traded in both primary as well as secondary market. Capital market instruments are not as liquid as money market instruments because of longer maturity. However, the existence of secondary market adds to the liquidity of these instruments.

Concept And Meaning Of Financial Markets

Financial Markets

Financial environment consists of financial markets, financial institutions, financial instruments ans services. Financial markets are the place where transaction of financial instruments and services are take place. Financial markets exists in order to bring buyer and seller of securities and financial services together. They are the mechanism that exists in order to facilitate the exchange of financial assets, thus adding to the liquidity of financial assets. Financial markets facilitate the flow of savings generated from one sector of economy to another, where there is the demand for funds. People and organizations that need to borrow money are brought together with those having surplus funds in the financial markets.

In financial markets, the corporate managers could raise funds by issuing securities or borrowing from banks. Financial markets help in bringing suppliers and borrowers together with the help of financial intermediaries directly or indirectly. Lenders or suppliers of funds exchange money for other financial assets that tend to provide a better future return.

The development of financial markets in any economy determines the degree of success of financial activities. Because financial markets add to the liquidity of financial securities, investors are generally interested to buy those securities for which a market exists.

Relationship Of Corporate Finance With Related Discipline

Finance is concerned with the acquisition and use of the firm's financial resources. It is an integral part of the overall management. Therefore, it should be studied along with other disciplines. It is because finance derives heavily the conceptual and analytic foundations from other disciplines particularly from economics and accountancy.

1. Relationship With Economics
The relationship between corporate finance and economics can be viewed from two basic aspects of economics macroeconomics and microeconomics.
Macroeconomics is concerned with broad aspects of an economy such as output, employment and income. Every business firm operates within the economy. It is imperative for financial managers to understand the broad economic framework. He must also be alert about the consequences of varying levels of economic activities, and recognize and understand the effect of monetary policy on the cost and availability of funds. The financial managers should evaluate various financing and investment alternatives in a macroeconomic framework.
Microeconomics is concerned with the economic issues relating to individual firms operating within the economy. It deals with the economic problems related to individual firms. Many principles associated to microeconomics such as demand and supply analysis, profit maximization strategies, pricing theories have practical application in finance. In this sense, finance is regarded as applied microeconomics. The principle of marginal analysis technique of microeconomics is widely used in finance for decision making.

2. Relationship With Accounting
The relationship between finance and accounting is quite close. Accounting is basically concerned with collecting, presenting and processing necessary financial data, whereas finance is concerned with decision-making. The financial manager, as per the requirements, recasts the statements prepared by accountants, generates additional data, and makes decisions on subsequent analysis.

3. Relationship To Other Disciplines
Besides its direct relationship to economics and accounting, finance is also related to other disciplines, such as mathematics production and quantitative techniques . In fact, it draws heavily on mathematics and quantitative techniques. The use of several quantitative and mathematical techniques have been extremely useful for solving complex financial problems of a firm.

Superior Decision Criterion Of Wealth Maximization Objective Of A Firm

Shareholder wealth maximization should be the basic goal of any corporation. The justification for this goal are as follows:

1. Wealth Maximization Objective Recognizes The Time Value Of Money
Time value of money is an important concept in financial decision making. Wealth maximization goal recognizes this concept. According to this concept, all cash flows generated over the life of the project are discounted back to present value using required rate of return as discount rate, and the decision is based on the present value of future returns.

2. Consideration Of Risk
Wealth maximization objective also considers the risks associated to the streams of future cash flows. The risk is taken care of by using appropriate required rate of return to discount the future streams of cash flows. Higher the risk, higher will be the required rate of return and vice versa. 

3.Efficient Allocation Of Resources
Shareholders wealth maximization objective provides guideline for firm's decision making and also promotes an efficient allocation of resources in the economic system. Resources are generally allocated taking into consideration the expected return and risk associated to a course of action. The market value of stock itself reflects the risk return trade-off associated to any investor in the capital market. In other words, shareholder wealth , maximization considers the riskiness of the income stream. Therefore, if a firm makes financing decisions considering market price of share maximization, it will raise necessary capital only when the investment ensures the economic use of capital. In the absence of pursuing the goal of shareholders wealth maximization, there is danger of sub-optimal allocation of  resources in an economy that leads to inadequate capital formation and low rate of economic growth.

4. Residual Owners
Shareholders are residual claimants in earnings and assets of the company. Therefore, if shareholders wealth is maximized, then all others with prior claim than shareholders could be satisfied.

5. Emphasis On Cash Flow
Wealth maximization objective uses cash flows rather than accounting profit as the basic input for decision making. The use of cash flows is less ambiguous because it represents means profit after tax plus non-cash outlays to all.  

Concept Of Wealth Maximization Objective Of The Firm

The wealth maximization objective is almost universally accepted goal of a firm. According to this objective, the managers should take decisions that maximize the shareholders' wealth. In other words, it is to make the shareholders as rich as possible. Shareholders' wealth is maximized when a decision generates net present value. The net present value is the difference between present value of the benefits of a project and present value of its costs. A decision that has a positive net present value creates wealth for shareholders and a decision that has a negative net present value destroys wealth of shareholders. Therefore, only those projects which have positive net present value should be accepted. For example, suppose a firm invests $ 10,000 in a project that generates net cash flow $ 3,000 each year for five years. If the firm requires 10% return on its capital, the net present value of the project is $ 1,372. Project like this should be accepted because the net present value accruing from the project belongs to shareholders, hence increases their wealth. Investors pay higher price for shares of a company which undertakes projects with positive net present value. As a result, wealth maximization is reflected in the market price of shares. Based on this logic, stock price maximization is   equivalent to shareholders wealth maximization. It is because, market price of firm's stock takes into account present and expected earnings per share; the timing, duration, and risk of these earnings; the dividend policy of the firm; and other factors that bear on the market price of the stock. Stock price maximization is considered superior goal to profit maximization goal.

Criticisms Or Drawbacks Of Profit Maximization Objectives

Although profit maximization objective is widely known objective of a firm, some theorists have raised doubts on the validity of this objective. They have criticized the profit maximization objective on the following grounds:

1. The profit maximization objective ignores the timing of returns. It equates a dollar received today with a dollar received in the future. In fact, $ 100 today is valued more than $ 100 received after one year. It is because the money received in earlier period may be reinvestable to earn more.

2. The critics of profit maximization objective argue that it ignores the risk associated with stream of cash flow of the project. For example, the total profit from two projects may be same but the profit from one project may be fluctuating widely than the profit from the other project. The firm with wider fluctuation in profit is riskier. This fact is ignored by profit maximization objective.

3. The profit maximization objective has greater relevance to a perfectly competitive firm than to a monopoly firm. Critics argue that a monopoly firm would be earning super normal profit more or less automatically.

4. Today large-scale corporate type of organizations exist. Different stakeholders such as owners, managers, customers, creditors, and employees are directly connected with the organization. The interest of each member in this organizational collusion cannot be achieved with the sole objective of profit maximization.

5. The profit maximization objective of the firm has greater relevance to short-run. In long-run, a firm cannot survive with this objective.

6. If all firms keep profit maximization as the primary objective, they may commit unfair practice to maximize profit.

Concept Of Profit Maximization Objective Of The Firm

Profit Maximization Objective Of The Firm

In the conventional theory of the firm, the principle objective of a business firm is to maximize profit. Under the assumptions of given taste and technology, price and output of a given product under competition are determined with the sole objective of maximization of profit.

Profit maximization refers to the maximization of dollar income of the firm. Under profit maximization objective, business firms attempt to adopt those investment projects, which yields larger profits, and drop all other unprofitable activities. In maximizing profits, input-output relationship is crucial, either input is minimized to achieve a given amount of profit or the output is maximized with a given amount of input. Thus, this objective of the firm enhances productivity and improves the efficiency of the firm.

The conventional theory of the firm defends profit maximization objective on the following grounds:

* In a competitive market only those firms survive which are able to make profit. Hence, they always try to make it as large as possible. All other objectives are subjected to this primary objective.

* Profit maximization objective is a time-honored objective of a firm and evidence against this objective is not conclusive or unambiguous.

* Though not perfect, profit is the most efficient and reliable measure of the efficiency of a firm.

* Under the condition of competitive market, profit can be used as a perfermance evaluation criterion, and profit maximization leads to efficient allocation of resources.

* Profit maximization objective has been found extremly accurate in predicting certain aspect of firm's behaviour and trends; as such the behaviour of most firms are directed towards the objective of profit maximization.

Routine Finance Functions

Routine finance functions are those financial functions which generally do not require managerial involvement to carry out. Routine finance functions are performed for the effective execution of managerial finance functions. These functions are carried out by the people at lower levels. Routine finance functions include the following tasks as follows:

1. Supervision of cash receipts and cash payment

2. Custody and safeguarding cash balances and valuable papers such as securities, insurance policies, certificates of property, contract paper etc.

3. Taking care of mechanical details regarding all new outside financing employed by the firm.

4. Maintaining records of firm's activities which have financial implications 

5. Timely reporting to facilitate financial manager

The financial manager's involvment in these functions are only limited to the extent of setting up rules and regulations and procedures, establishing standards for the employment of personnel and evaluating the performance to ensure that rules are properly followed.

Managerial Finance Functions Or The Functions Of Financial Manager

Managerial finance functions are functions that require managerial skills in their planning, execution and control. The managerial finance functions are as follows:

1. Investment Decision

Investing decision is the managerial decision regarding investment in long-term proposals. It includes the decision concerned with acquisition, modification and replacement of long-term assets such as plant, machinery, equipment, land and buildings. Long term assets require huge amount of capital outlay at the beginning but the benefits are derived over several periods in the future. Because the future benefits are not known with certainty, long-term investment proposals involve risks.The financial manager should estimate the expected risk and return of the long-term investment and then should evaluate the investment proposals in terms of both expected returns and risk. The financial manager accepts the proposal only if the investment maximizes the shareholders wealth.

2. Financing Decision

Financing decision which is also known as capital structure decision, is concerned with determining the sources of funds and deciding upon the proportionate mix of funds from different sources. It calls for raising of funds from different sources maintaining appropriate mix of capital. The sources of long-term funds include equity capital and debt capital. A particular combination of debt and equity may be more beneficial to the firm than any others. The financial manager should decide an optimal structure of debt and equity capital.

3. Dividend Decision

Dividend decision is the decision about the allocation of earnings to common shareholders. It is concerned with deciding the portion of earnings to be allocated to common shareholders. The net income after paying preference dividends belongs to common shareholders. The financial manager has three alternatives regarding dividend decision:
* Pay all earnings as dividend
* Retain all earnings for reinvestment
* Pay certain percentage of earning and retain the rest for reinvestment.
The financial manager must choose among the above alternatives. The choice should be optimum in the sense that it should maximize the shareholders wealth. While taking dividend decisions, the financial manager should consider the preferance of shareholders as well as the investment opportunities available to the firm.

4. Working Capital Decision

Working capital decisions refers to the commitment of funds to current assets and deciding on their financing pattern. It refers to the current assets investment and financing decision. Investment in current assets affects firm's profitability and liquidity. More investment in current assets enhances liquidity. Liquidity refers to the capacity to meet short-term obligation of the firm. At the same time more investment in current assets negatively affects the profitability because current assets earn nothing or they earn much less than their cost of capital. Similarly, less investment in current assets negatively affects the firm's liquidity and the firm may lose its profitable opportunities. So, a financial manager should achieve a proper trade-off between liquidity and profitability which requires maintaining optimal investment in current assets.

Functions Of Finance Or Finance Functions

Generally, finance functions are carried on to achieve the goals of the firm. Finance functions are mainly viewed from two approaches; 'raising of funds' and 'raising and allocation of funds'. The first approach confines the finance functions to the procurement of funds only and ignores the use of funds. It was the major finance function at the early stage of the development of finance. The second approach is comprehensive and universally accepted. Nowadays, we follow the second approach. Alternatively, finance functions may be viewed on the basis of level of managerial attention required to get them performed. On this basis, finance functions may be classified as managerial finance functions and routine finance functions as below.

1. Managerial finance functions
* Investment decisions
* Financing decisions
* Dividend decisions
* Working capital decisions

2. Routine finance functions
* Supervision of cash receipts and disbursement
* Safeguarding of cash balances
* Custody and safeguarding of valuable documents like securities and insurance policies
* Taking care of mechanical details of financing
* Record keeping of the financial performance of the firm
* Reporting to the top management
* Supervision of fixed assets and current assets.

Concept And Meaning Of Corporate Finance

Business firms and government organizations do need to implement various programs to achieve their goals. Implementing programs require resources such as natural resources, human resources and financial resources. Effectiveness in the management of financial resources is key to optimize the use of natural and human resources.In the case of individual, management of financial resources or funds is known as personal finance. The same is called by public finance in government organizations. Corporate finance is used to refer to the management of funds in the context of business firm. Thus, finance as a discipline is classified into three domains: public finance, business finance and personal finance. Public finance is the management of funds for governments: both local government and central government. Traditionally, it deals with the management of revenue and expenditure of government. Personal finance refers to the management of funds of and individual. 
Generally, business finance, corporate finance and financial management, and managerial finance are used as synonym of each other. At the early stage of the development of finance as a separate discipline, academics and practitioners used business finance. Later on, they used corporate finance instead of business finance. The rationale behind the use of corporate finance was the dominance of corporate form of business organization in the business world. Traditionally, corporate finance used to focus only on the procurement of funds required to set up a company or corporation and expansion of its activities. Accordingly, the responsibility of the financial manager was limited only to estimate the financial requirements of a corporation and raise funds to meet the projected financial requirement.

Now, corporate finance is not limited to the fund raising activities; it has widened to cover the acquisition, financing and management aspects of a corporation's assets. This approach to the concept of corporate finance is known as modern concept. 
In short, corporate finance is the study of the ways to address the following issues in a firm.
1. What long-term investments should a firm take on ?
2. Where the firm will get the long-term fund to pay for investment ?
3.How the firm will manage its everyday financial activities such as collecting from customers and paying to suppliers.
4. How the firm should go about deciding upon payment to stockholders ?

Therefore, corporate finance deals with acquisition and financing management of a firm's assets that leads to shareholders wealth maximization.

Concept Of Stock Repurchase

Repurchase of stock refers to the buyback by the firm of outstanding shares of its common stock in the market place. There may be several motives for a stock repurchases. Some of the motives may be to obtain shares to be used in acquisitions, to have shares available for employee stock option plans, to achieve gain in the book value of equity when shares are selling below their book value, to retire outstanding shares and so on. Repurchase of stock for retirement of outstanding shares is considered to be similar to the payment of cash dividends. As an alternative to paying cash dividends, a firm may distribute its income by repurchasing its own stock.

Stock repurchase can substitute the cash dividend as a way to distribute funds to stockholders. When common stock is repurchased for retirement, the underlying motive is to distribute excess cash to the stockholders. Stock repurchase programs undertaken by any firm has been more popular these days. The basic advantage of stock repurchase for retirement is that they enhance shareholder value. It is because as long as earnings remain constant, the repurchase of shares reduces the number of outstanding shares, raising the earnings per share and market price per share.

In addition to maximizing shareholders' wealth, stock repurchase may result into tax benefit for certain shareholders. The repurchase of stock substitutes dividends for capital gain which may be taxed at lower rate or later rate (when stocks are sold). The retirement of common stock by the repurchase can be regarded as a reverse dilution, because it results into increase in earning per share and market price per share with a reduction in number of share outstanding.

Concept Of Reverse Stock Splits

The company may want to reduce the number of share outstanding if its share price falls substantially. Number of share is reduced by reverse stock split. The reduction of the number of outstanding share increases both the par value per share and market price per share. Reverse stock split also increases earning per share and dividend per share. It is just opposite of stock splits.


Suppose, total shareholder's account of a firm is as follows:

A. Common stock (10,000 Shares @ $ 10).........................= $ 100,000
B. Additional paid in capital...................................................= $ 100,000
C. Retained earnings..............................................................= $ 300000
Total shareholder's equity....................................................= $ 500,000

Now let us assume that the firm announced 2-for-5 reverse stock split, which results into decrease in number of outstanding shares from 10,000 shares to 4,000 shares (i.e. 10,000 shares x 2/5) and increase in the par value from $10 per share to $ 25 per share ( i.e. $10 x 5/2). This keeps the value of common stock constant at $ 100,000 ( i.e. 4,000 x $25). Thus, total shareholder's equity account of the firm after 2-for-5 reverse stock splits appear as:

A. Common stock (4,000 shares @ $25 each).......................= $ 100,000
B. Additional paid in capital .....................................................= $ 100,000
C. Retained earnings ................................................................= $ 300,000
Total shareholder's equity (A+B+C)......................................= $ 500,000.

Concept Of Stock Splits And Its Value To Shareholders

A stock split is similar to a stock dividend in economic sense. When a company announces stock splits, it results into an increase in number of outstanding shares with a proportionate decrease in par value and market price of the stocks. Therefore, firms with exceptionally high market prices split their stocks in order to bring the market price within reasonable limits. As a result, small investors can purchase the company's share. With a stock split, total value of the shares of common stock outstanding remains unchanged along with no change in paid-in capital and retained earnings.

Suppose, a firm has the following total shareholder's equity account before stock split:

A. Common stock ( 4000 shares @ $10)...................=$ 40,000
B. Additional paid-in capital........................................= $ 20,000
C. Retained earnings ....................................................= $ 90,000
Total shareholder's equity (A+B+C)...........................= $ 150,000

If the firm announces 2-for-1 stock splits, it results into an increase in outstanding shares from 4,000 shares to 8,000 shares (i.e 4,000 shares x2) and reduction in the par value from $ 10 per share to $ 5 per share (i.e. $10 x 1/2). This keeps the value of common stock constant at $ 40,000 (i.e 8,000 shares x $ 5). Total shareholder's equity accounts of the firm after 2-for-1 stock splits announcement appears as:

A. Common stocks ( 8,000 shares @ $ 5 each)....................= $ 40,000
B. Additional paid in capital.....................................................= $ 20,000
C. Retained earnings................................................................= $ 90,000
Total shareholder's equity (A+B+C)......................................= $ 150.000

Unlike in stock dividend, stock split does not involve transfer of funds from retained earnings to paid-in capital and common stock accounts.
Stock splits do not change the proportionate ownership of the company. Therefore, stock splits has no economic value to the investors or shareholders. When the number of shares held by shareholders increases, because of stock splits, the market price of the stock should decrease proportionately to remain the total value of common stock unchanged.

Concept Of Stock Dividend And Its Value To Investors

A stock dividend refers to the dividend paid to existing stockholders in the form of additional shares of common stock. Unlike cash dividends it does not result into the cash outflows. The purpose of stock dividend is to conserve cash in the firm, so that it can be used in new projects. It involves simple book keeping transfer from retained earnings to the capital stock account. The stock dividend does not affect the equity position of stockholders; rather it represents a recapitalization of a company which takes place in the form of transfer of certain amount from firm's retained earnings to capital stock account.

Suppose a firm has following total shareholder's equity account before a 20 percent stock dividend announcement:
A. Common stock (100,000 shares of $ 10 par) .........= $ 1,000,000
B. Additional paid in capital.............................................= $ 200,000
C. Retained earnings........................................................= $ 1,800,000
Total shareholder's equity(A+B+C)..............................= $ 3,000,000

If the firm announces 20% stock dividends, the firm has to issue additional 20,000 shares in common stock. To illustrate the effect of stock dividend on total shareholder's equity accounts, let us assume that current market price of the stock is $ 40. So, amount of stock dividend will be $ 800,000 (i.e. $40 x 20,000 shares). The total amount of dividend is transferred to common stock account and additional paid-in capital from retained earnings. Since par value of common stock is $ 10 a total of $ 200,000 (i.e. $10 x 20,000 shares) is transferred to common stock account and rest $ 600,000 (i.e $ 30 x 20,000 shares) is added to paid-in capital. Thus, the total amount of shareholder's equity remains the same. total shareholder's equity account after 20% stock dividend appears as follows:

A. Common stock( 120,000 Shares of $ 10 par)...............= $1,200,000
B. Additional paid-in capital.................................................= $ 800,000
C. Retained earnings.............................................................= $ 1,000,000
Total shareholder's equity (A+B+C)..................................= $ 3,000,000

Stock dividend generally has no economic significance as it only results into change in capitalization keeping total equity position constant. Stock dividend simply results into an increase in outstanding shares of common stock. In the above example, with a 20% stock dividend, there is an increase in outstanding shares of common stock from 100,000 shares to 120,000 shares.

Factors Affecting Dividend Policy Of A Firm

A firm's dividend policy is influenced by the large numbers of factors. Some factors affect the amount of dividend and some factors affect types of dividend. The following are the some major factors which influence the dividend policy of the firm.

1. Legal requirements

There is no legal compulsion on the part of a company to distribute dividend. However, there certain conditions imposed by law regarding the way dividend is distributed. Basically there are three rules relating to dividend payments. They are the net profit rule, the capital impairment rule and insolvency rule.

2. Firm's liquidity position

Dividend payout is also affected by firm's liquidity position. In spite of sufficient retained earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash.

3. Repayment need

A firm uses several forms of debt financing to meet its investment needs. These debt must be repaid at the maturity. If the firm has to retain its profits for the purpose of repaying debt, the dividend payment capacity reduces.

4. Expected rate of return

Expected rate of return also affects the dividend policy of the business firm If a firm has relatively higher expected rate of return on the new investment, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividend.

5. Stability of earning

If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with relatively fluctuating earnings.

6. Desire of control

When the needs for additional financing arise, the management of the firm may not prefer to issue additional common stock because of the fear of dilution in control on management. Therefore, a firm prefers to retain more earnings to satisfy additional financing need which reduces dividend payment capacity.

7. Access to the capital market

If a firm has easy access to capital markets in raising additional financing, it does not require more retained earnings. So a firm's dividend payment capacity becomes high.

8. Shareholder's individual tax situation

For a closely held company, stockholders prefer relatively lower cash dividend because of higher tax to be paid on dividend income. The stockholders in higher personal tax bracket prefer capital gain rather than dividend gains.

Dividend Payment Procedures Of A Firm

The dividend payment procedures of a firm can be outlined as follows:

1. Declaration Date

The board of directors of the company announces that a specified amount of dividend will be paid to the stockholders. It is paid to the stockholders who will be on the record on the company's record at some particular future date. The date on which directors meet and announce dividend is called declaration date. Generally, the dividend is announced as a percentage on the par value of the stock. However, in some cases, it can be the absolute amount as $ 2 dividend per share.

2. Date Of Record

Along with the dividend announcement, the board of directors also specifies a date of record. For example, if the board of directors meets on June10, 2010, and declares a 10 % cash dividend to the stockholders of record on September 15; the July 10 is called declaration date and the September 15 is called date of record. The company prepares a list of stockholders from the stock transfer book at the close of business on the date of record. All the stockholders of the record date are entitled to receive dividend as declared by the board. The new stockholders would receive dividend if the shareholders' name is recorded in the shareholders' registered on or before the date of record. But, if the company were notified of the transfer after the date of record, the old owner of the stock would receive the dividends.

3. Ex-dividend Date

There can be delay of several days from the time a transfer takes place to the time the firm is informed of the transfer. Therefore, shares transferred on, say September 12, would not generally recorded on the company's book. In normal practice, the buyer and seller of the stocks have four business days to settle the transactions prior to the date of record. For example, if the date of record is September 15, the transaction must take place before September 11 to entitle the new holder to receive dividend. Thus, the date when the right to the dividend leaves the stock for new owner is called ex-dividend date. In our example if stock is bought on or after September 11, the new shareholder is not entitled to receive dividend. As a result of this, we normally expect that stock price will decline exactly by the amount of dividend per share on the ex-dividend date.

4. Payment Date

At the time of dividend announcement, the board of directors also specifies the date on which the payment of dividend is actually made and it is called the payment date. On this date the company actually pays the dividend to all the stockholders of the date of record.

Concept And Meaning Of Dividend Policy

Dividend refers to the portion of net income paid out to shareholders. It is paid in cash and/or stock for making investment and bearing risk. Dividend decision of the firm is yet another crucial area of financial management as it affects shareholders wealth and value of the firm. The percentage of earning paid out in the form of cash dividend is known as dividend payout ratio. A company may retain some portion of its earnings to finance new investment. The percentage of retained in the firm is called retention ratio. Dividend policy is an integral part of the firm's financing decision as it provides internal financing. Dividend policy is concerned with determining the proportion of firm's earnings to be distributed in the form of cash dividend and the portion of earnings to be retained. A firm has three alternatives regarding the payment of cash dividends:
1. It can distribute all of its earnings in the firm of cash dividends,

2. It can retain all of its earnings for reinvestment,

3. It can distribute a part of earnings as dividend and retain the rest for reinvestment purpose.

When dividends are paid to the stockholders the firm's cash is reduced. A firm may decrease its dividend payout and use the retained funds to expand its capacity, to pay off some of its debt or to increase investment. In this way, the firm's dividend policy is closely related with the firm's investment and financing decisions.
Determining the part of earnings to be distributed as dividends is a key decision that affects the value of firm's common stock in the market place. Similarly, the retained earnings are considered to be the most convenient internal source available for financing corporate growth. Thus, every corporate firm should establish and implement an effective dividend policy that leads the firm to stockholders wealth maximization.
It should be recognized that a firm's dividend payout ratio depends on many factors. For example, it may be affected by the volatility in firm's cash flows and changing investment needs over time. If the firm's cash flow is volatile, it may prefer to set a minimum level of regular cash dividends that can be maintained even at low profits. Similarly, if the firm has profitable investment opportunity it prefers to retain more amount by reducing dividend payout ratio.

Significance Of The Concept Of Time Value Of Money

Time value of money is a widely used concept in literature of finance. Financial decision models based on finance theories basically deal with maximization of economic welfare of shareholders. The concept of time value of money contributes to this aspect to a greater extent. The importance or significance of the concept of time value of money could be stated as below:

Investment Decision

Investment decision is concerned with the allocation of capital into long-term investment projects. The cash flow from long-term investment occur at different point in time in the future. They are not comparable to each other and against the cost of the project spent at present. To make them comparable, the future cash flows are discounted back to present value.
The concept of time value of money is useful to securities investors. They use valuation models while making investment in securities such as stock and bonds. These security valuation models consider time value of cash flows from securities.

Financing Decision

Financing decision is concerned with designing optimum capital structure and raising funds from least cost sources. The concept of time value of money is equally useful in financing decision, especially when we deal with comparing the cost of different sources of financing. The effective rate of interest of each source of financing is calculated based on time value of money concept. Similarly, in leasing versus buying decision, we calculate the present value of cost of leasing and cost of buying. The present value of costs of two alternatives are compared against each other to decide on appropriate source of financing.

Besides, the concept of time value of money is also used in evaluating proposed credit policies and the firm's efficiency in managing cash collection under current assets management.

Concept Of Time Value Of Money

The concept of tome value of money suggests that the money received at different point of time has different value. The financial manager must appreciate this fact and understand why they are different and how they are made comparable.

Time value of money is a concept to understand the value of cash flows occurred at different point of time. If we are given the alternatives whether to accept $ 100 today or one year fro now, then we certainly accept $ 100 today. It is because there is a time value to money. Every sum of money received earlier has reinvestment opportunity. For example, if we deposited $ 100 in saving account at 5% annual rate of interest, it will increase to $ 105 at the end of one year. Money received at present is preferred even if we do not have reinvestment opportunity. The reason is that the money that we receive in future has less purchasing power than the money that we have at present due to the inflation. What happens if there is no inflation? Still, money received at present is preferred, it is because most of us have a fundamental behavior to prefer current consumption to future consumption. Thus, i) The reinvestment opportunity or the earning power of the money, ii) the risk of inflation, and iii) an individual's preference for current consumption to future consumption are the reasons for the time value of money.

The concept of time value of money is useful in addressing our real life problems relating to planning for future family expenditure. For instance, if we need $ 50,000 after the retirement from job in 15 years, the amount we need to deposit at interest every year from now until the retirement is conveniently determined by using the time value of money concept.

Many financial decisions of the firm require a consideration regarding time value of money. The corporate manager must always concentrate on maximizing shareholders wealth. Maximizing shareholders wealth, to a larger extent, depends on the timing of cash flows from investment alternatives. In this regard, time value of money concept deserves serious considerations on all financial decisions.

Determinants Of Investment In Receivables

The size of investment in receivables is influenced by number of factors. Among them two factors, the volume of credit sales, and the average length if time between sales and collection are important.
To illustrate, suppose National Enterprise, a newly established firm makes a credit sales of $ 5000 per day and its customers are allowed 15 days of credit. At the start of business i.e. in the first day, it sold $ 5000 on credit so that its end-of-day accounts receivables stand $ 5000 in the firm's book. During the second day, it sold another $ 5000 on credit increasing the book receivables to $10,000. If it goes on granting a credit of $ 5000 per day for 15 days, its account receivable will increase to $ 75,000 at the end of 15th day. However in 16th day it will make another $ 5000 credit sales, but payments for sales made on first day will reduced receivables by $ 5000, so that total account receivable will remain constant at $ 75000 in 16th day and the each day thereafter throughout the year. The average account receivable the firm must carry during the year is, therefore $ 75000.
Account receivable = Credit sales per day X Average length of collection period
= $ 5000 X 15 days = $ 75000.

Above illustration shows that the change in credit sales or change in collection period or both will affect the investment in account receivable. However in turn, the volume of credit sales and collection is affected by several factors such as industrial norms, credit standards, credit terms, collection policy, payment habits of customers, nature of business, size of enterprise, cost of investment in receivables and so on. Therefore, the financial manager must be able to look in depth and analyze the impact of these factors in volume of sales and the cost-benefit trade off associated to credit decisions.

Costs Of Maintaining Receivables And Their Calculation

Maintaining receivables bears cost. It includes cost of investment in receivables, bad debt losses, collection expenses and cash discount. Costs related with receivables and their calculation are as follows:

1. Cost Of Investment In Receivables
This is the opportunity cost of funds being tied up in receivables, which would otherwise have not been incurred if all sales were in cash. The cost of investment in receivable is calculated as:
Cost of receivables = Investment in receivables X Opportunity costs
investment in receivables = (FC+ VC)/Days in year) X DSO
Where, FC = Fixed Cost, VC = Variable Cost and DSO = Days sales outstanding.

2. Bad Debt Losses
This is the loss due to default customers. Extension of credit to low quality-rate customers results into increase in bad debt losses. Bad debt losses are calculated as a percentage on sales as shown in equation below:

Bad debt losses = Annual credit sales X Percentage default customer

3. Collection Expenses
This is the cost incurred for operating and managing the collection and credit department of a firm. This includes the administrative cost of credit department, salary and commission paid to collection staff, cost paid for telephone and communication and so on.

4. Cash Discount
It is the cost incurred to induce the customer for early payments of their accounts. A firm can offer cash discount to its customers to reduce the average collection period, bad debt losses, and the cost of investment in receivables. The discount cost is calculated as cash discount percentage multiplied by sales to discount customers as given below:

Discount Cost = Annual credit sales X Percentage discount customer X Percentage cash discount