UNIT I

LECTURE NOTES ON
BBA 305 FINANCIAL MANAGEMENT
By: DR.SWASTIKA TRIPATHI

INTRODUCTION
The financial function is that managerial activity which is concerned with the planning and
controlling of the firm’s financial resources. It was a branch of economics till 1890, but as a separate
discipline, it is of recent origin. Still, it has no unique body of knowledge of its own, and draws
heavily on economics for its theoretical concepts even today.
The subject of the finance function is of immense interest to both academicians and
practising managers. It is of great interest to academicians because the subject isstill developing,
and there are still certain areas where controversies exist for which no unanimous solutions have
been reached as yet. Practising managers are interested inthis subject because among the most
crucial decisions of the firm are those which relate to finance, and an understanding of the theory
of the financial function provides them with conceptual and analytical insights to make those
decisions skilfully.
ONCEPT OF FINANCIAL MANAGEMENT
The general meaning of finance refers to providing funds, as and when needed. However,
as management function, the term ‘Financial Management’ has a distinct meaning.
Financial management deals with the study of procuring funds and its effective and
judicious utilisation, in terms of the overall objectives of the firm, and expectations
of the providers of funds. The basic objective is to maximise the value of the firm. The
purpose is to achieve maximisation of share value to the owners i.e. equity
shareholders.
The term financial management has been defined, differently, by various authors. Some
of the authoritative definitions are given below:
1. “Financial Management is concerned with the efficient use of an important
economic resource, namely, Capital Funds” -Solomon
2. “Financial Management is concerned with the managerial decisions that result in
the acquisition and financing of short-term and long-term credits for the firm”
-Phillioppatus
3. “Business finance is that business activity which is concerned with the conservation
and acquisition of capital funds in meeting financial needs and overall objectives
of a business enterprise”. -Wheeler
4. “Financial Management deals with procurement of funds and their effective
utilisation in the business.” -S.C. Kuchhal

The definition provided by Kuchhal is most acceptable as it focuses, clearly, the Basic
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 requirements of financial management. From his definition, two basic aspects emerge:
(A) Procurement of funds.
(B) Effective and judicious utilisation of funds.
Financial management has become so important that it has given birth to Financial
Management as a separate subject.

NATURE OF FINANCIAL MANAGEMENT

Financial management refers to that part of management activity, which is concerned with
the planning and controlling of firm’s financial resources. Financial management is a part
of overall management. All business decisions involve finance. Where finance is needed,
role of finance manager is inevitable. Financial management deals with raising of funds
from various sources, dependant on availability and existing capital structure of
the organisation. The sources must be suitable and economical to the organisation.
Emphasis of financial management is more on its efficient utilisation, rather than raising
of funds, alone.
The scope and complexity of financial management has been widening, with the growth
of business in different diverse directions. As business competition has been increasing,
with a greater pace, support of financial management is more needed, in a more
innovative way, to make the business grow, ahead of others.

SCOPE OF FINANCIAL MANAGEMENT

Financial management is concerned with optimum utilisation of resources. Resources
are limited, particularly in developing countries like India. So, the focus, everywhere, is to
take maximum benefit, in the form of output, from the limited inputs.
Financial management is needed in every type of organisation, be it public or private
sector. Equally, its importance exists in both profit oriented and non-profit organisations.
In fact, need of financial management is more in loss-making organisations to turn them to
profitable enterprises. Study reveals many organisations have sustained losses, due to
absence of professional financial management.
Financial management has undergone significant changes, over the years in its scope
and coverage. Approaches: Broadly, it has two approaches:
Traditional Approach- Procurement of Funds
Modern Approach- Effective Utilisation of Funds
1. Traditional Approach
The scope of finance function was treated, in the narrow sense of procurement or
arrangement of funds. The finance manager was treated as just provider of funds, when
organisation was in need of them. The utilisation or administering resources was
considered outside the purview of the finance function. It was felt that the finance
manager had no role to play in decision- making for its utilisation. Others used to
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 take decisions regarding its application in the organisation, without the involvement of
finance personnel. Finance manager had been treated, in fact, as an outsider with a
very specific and limited function, supplier of funds, to perform when the need offunds
was felt by the organisation.
As per this approach, the following aspects only were included in the scope of
financial management:
(i) Estimation of requirements of finance,
(ii) Arrangement of funds from financial institutions,
(iii) Arrangement of funds through financial instruments such as shares, debentures,
bonds and loans, and
(iv) Looking after the accounting and legal work connected with the raising of
funds.
Limitations
The traditional approach was evolved during the 1920s and 1930s period and continued
till 1950. The approach had been discarded due to the following limitations:
(i) No Involvement in Application of Funds: The finance manager had not been
involved in decision-making in allocation of funds. He had been treated as an
outsider. He had been ignored in internal decision- m a k i n g process and
considered as an outsider.
(ii) No Involvement in day-to-day Management: The focus was on providing long-
term funds from a combination of sources. This process was more of one time
happening. The finance manager was not involved in day to day administration of
working capital management. Smooth functioning depends on working capital
management, where the finance manager was not involved and allowed to play
any role.
(iii) Not Associated in Decision-Making Allocation of Funds: The issue of
allocation of funds was kept outside his functioning. He had not been involved
in decision- making for its judicious utilisation.
Raising finance was an infrequent event. Its natural implication was that the issues
involved in working capital management were not in the purview of the finance function.
In a nutshell, during the traditional phase, the finance manager was called upon, in particular,
when his speciality was required to locate new sources of funds and as and when the
requirement of funds was felt.
The following issues, as pointed by Solomon, were ignored in the scope of financial
management, under this approach:
(A) Should an enterprise commit capital funds to a certain purpose?
(B) Do the expected returns meet financial standards of performance?
(C) How does the cost vary with the mixture of financing methods used?
The traditional approach has outlived its utility in the changed business situation. The
scope of finance function has undergone a sea change with the emergence of different
capital instruments.
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 2. Modern Approach
Since 1950s, the approach and utility of financial management has started changing in a
revolutionary manner. Financial management is considered as vital and an integral part
of overall management. The emphasis of Financial Management has been shifted
from raising of funds to the effective and judicious utilisation of funds. The modern
approach is analytical way of looking into the financial problems of the firm.
Advice of finance manager is required at every moment, whenever any decision with
involvement of funds is taken. Hardly, there is an activity that does not involve funds.
In the words of Solomon “The central issue of financial policy is the use of
funds. It is helpful in achieving the broad financial goals which an enterprise sets
for itself”.
Nowadays, the finance manger is required to look into the financial implications of
every decision to be taken by the firm. His Involvement of finance manager has
been before taking the decision, during its review and, finally, when the final
outcome is judged. In other words, his association has been continuous in every
decision-making process from the inception till its end.

AIMS OF FINANCE FUNCTION

The following are the aims of finance function:
1. Acquiring Sufficient and Suitable Funds: The primary aim of finance function is
to assess the needs of the enterprise, properly, and procure funds, in time. Time is
also an important element in meeting the needs of the organisation. If the funds
are not available as and when required, the firm may become sick or, at least, the
profitability of the firm would be, definitely, affected.
It is necessary that the funds should be, reasonably, adequate to the demands of
the firm. The funds should be raised from different sources, commensurate to the
nature of business and risk profile of the organisation. When the nature of business
is such that the production does not commence, immediately, and requires long
gestation period, it is necessary to have the long-term sources like share capital,
debentures and long term loan etc. A concern with longer gestation period does
not have profits for some years. So, the firm should rely more on the permanent
capital like share capital to avoid interest burden on the borrowing component.
2. Proper Utilisation of Funds: Raising funds is important, more than that is its proper
utilisation. If proper utilisation of funds were not made, there would be no revenue
generation. Benefits should always exceed cost of funds so that the organisation can
be profitable. Beneficial projects only are to be undertaken. So, it is all the more
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 necessary that careful planning and cost-benefit analysis should be made before the
actual commencement of projects.
3. Increasing Profitability: Profitability is necessary for every organisation. The
planning and control functions of finance aim at increasing profitability of the firm.
To achieve profitability, the cost of funds should be low. Idle funds do not yield
any return, but incur cost. So, the organisation should avoid idle funds. Finance
function also requires matching of cost and returns of funds. If funds are used
efficiently, profitability gets a boost.
4. Maximising Firm’s Value: The ultimate aim of finance function is maximising
the value of the firm, which is reflected in wealth maximisation of shareholders.
The market value of the equity shares is an indicator of the wealth maximisation.

FUNCTIONS OF FINANCE
Finance function is the most important function of a business. Finance is, closely, connected
with production, marketing and other activities. In the absence of finance, all these
activities come to a halt. In fact, only with finance, a business activity can be commenced,
continued and expanded. Finance exists everywhere, be it production, marketing, human
resource development or undertaking research activity. Understanding the universality
and importance of finance, finance manager is associated, in modern business, in all
activities as no activity can exist without funds.
Financial Decisions or Finance Functions are closely inter-connected. All decisions
mostly involve finance. When a decision involves finance, it is a financial decision in a
business firm. In all the following financial areas of decision-making, the role of finance
manager is vital. We can classify the finance functions or financial decisions into four
major groups:

(A) Investment Decision or Long-term Asset mix decision

(B) Finance Decision or Capital mix decision
(C) Liquidity Decision or Short-term asset mix decision
(D) Dividend Decision or Profit allocation decision

(A) Investment Decision

Investment decisions relate to selection of assets in which funds are to be invested by the
firm. Investment alternatives are numerous. Resources are scarce and limited. They have
to be rationed and discretely used. Investment decisions allocate and ration the resources
among the competing investment alternatives or opportunities. The effort is to find out
the projects, which are acceptable.
Investment decisions relate to the total amount of assets to be held and their
composition in the form of fixed and current assets. Both the factors influence the risk
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the organisation is exposed to. The more important aspect is how the investors perceive
the risk.
The investment decisions result in purchase of assets. Assets can be classified, under
two broad categories:
(i) Long-term investment decisions – Long-term assets
(ii) Short-term investment decisions – Short-term assets
Long-term Investment Decisions: The long-term capital decisions are referred to as
capital budgeting decisions, which relate to fixed assets. The fixed assets are long term,
in nature. Basically, fixed assets create earnings to the firm. They give benefit in
future. It is difficult to measure the benefits as future is uncertain.
The investment decision is important not only for setting up new units but also for
expansion of existing units. Decisions related to them are, generally, irreversible. Often,
reversal of decisions results in substantial loss. When a brand new car is sold, even
after a day of its purchase, still, buyer treats the vehicle as a second-hand car. The
transaction, invariably, results in heavy loss for a short period of owning. So, the finance
manager has to evaluate profitability of every investment proposal, carefully, before funds
are committed to them.
Short-term Investment Decisions: The short-term investment decisions are,
generally, referred as working capital management. The finance manger has to allocate
among cash and cash equivalents, receivables and inventories. Though these current assets
do not, directly, contribute to the earnings, their existence is necessary for proper,
efficient and optimum utilisation of fixed assets.

(B) Finance Decision

Once investment decision is made, the next step is how to raise finance for the concerned
investment. Finance decision is concerned with the mix or composition of the sources
of raising the funds required by the firm. In other words, it is related to the pattern
of financing. In finance decision, the finance manager is required to determine the
proportion of equity and debt, which is known as capital structure. There are two main
sources of funds, shareholders’ funds (variable in the form of dividend) and borrowed
funds (fixed interest- bearing). These sources have their own peculiar characteristics. The
key distinction lies in the fixed commitment. Borrowed funds are to be paid interest,
irrespective of the profitability of the firm. Interest has to be paid, even if the firm incurs
loss and this permanent obligation is not there with the funds raised from the
shareholders. The borrowed funds are relatively cheaper compared to shareholders’
funds, however they carry risk. This risk is known as financial risk i.e. Risk of
insolvency due to non-payment of interest or non-repayment of borrowed capital.
On the other hand, the shareholders’ funds are permanent source to the firm. The
shareholders’ funds could be from equity shareholders or preference shareholders. Equity
share capital is not repayable and does not have fixed commitment in the form of
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 dividend. However, preference share capital has a fixed commitment, in the form of
dividend and is redeemable, if they are redeemable preference shares.
Barring a few exceptions, every firm tries to employ both borrowed funds and
shareholders’ funds to finance its activities. The employment of these funds, in
combination, is known as financial leverage. Financial leverage provides profitability,
but carries risk. Without risk, there is no return. This is the case in every walk of life!
When the return on capital employed (equity and borrowed funds) is greater than the
rate of interest paid on the debt, shareholders’ return get magnified or increased. In period
of inflation, this would be advantageous while it is a disadvantage or curse in times of
recession.
The finance manager follows that combination of raising funds which is optimal mix of
debt and equity. The optimal mix minimises the risk and maximises the wealth of
shareholders.

(C) Liquidity Decision

Liquidity decision is concerned with the management of current assets. Basically, this is
Working Capital Management. Working Capital Management is concerned with the
management of current assets. It is concerned with short-term survival. Short term-survival
is a prerequisite for long-term survival.
When more funds are tied up in current assets, the firm would enjoy greater liquidity.
In consequence, the firm would not experience any difficulty in making payment of
debts, as and when they fall due. With excess liquidity, there would be no default in
payments. So, there would be no threat of insolvency for failure of payments. However,
funds have economic cost. Idle current assets do not earn anything. Higher liquidity is at
the cost of profitability. Profitabilitywould suffer with more idle funds. Investment in
current assets affects the profitability, liquidity and risk. A proper balance must be
maintained between liquidity and profitability of the firm. This is the key area
where finance manager has to play significant role. The strategy is in ensuring a
trade-off between liquidity and profitability. This is, indeed, a balancing act and
continuous process. It is a continuous process as the conditions and requirements of
business change, time to time. In accordance with the requirements of the firm, the
liquidity has to vary and in consequence, the profitability changes. This is the major
dimension of liquidity decision- working capital management. Working capital
management is day to day problem to the finance manager. His skills of financial
management are put to test, daily.

(D) Dividend Decision

Dividend decision is concerned with the amount of profits to be distributed and
retained in the firm. Dividend: The term ‘dividend’ relates to the portion of profit, which
is distributed to shareholders of the company. It is a reward or compensation to them
for their investment made in the firm. The dividend can be declared from the current
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 profits or accumulated profits.
Which course should be followed – dividend or retention? Normally, companies distribute
certain amount in the form of dividend, in a stable manner, to meet the expectations of
shareholders and balance is retained within the organisation for expansion. If dividend is
not distributed, there would be great dissatisfaction to the shareholders. Non-declaration of
dividend affects the market price of equity shares, severely. One significant element in
the dividend decision is, therefore, the dividend payout ratio i.e. what proportion of
dividend is to be paid to the shareholders. The dividend decision depends on the
preference of the equity shareholders and investment opportunities, available within the
firm. A higher rate of dividend, beyond the market expectations, increases the market
price of shares. However, it leaves a small amount in the form of retained earnings
for expansion. The business that reinvests less will tend to grow slower. The other
alternative is to raise funds in the market for expansion. It is not a desirable decision
to retain all the profits for expansion, without distributing any amount in the form of
dividend.
There is no ready-made answer, how much is to be distributed and what portion is to
be retained. Retention of profit is related to-
• Reinvestment opportunities available to the firm.
• Alternative rate of return available to equity shareholders, if they invest
themselves.

ROLE OF FINANCE MANAGER

The finance manager handles finance. The role of finance manager is pivotal. He can
change the fortunes of the organisation with proper planning, monitoring and timely
guidance. Equally, if the manager is not competent, even a profitable organisation may
dwindle or even sink. The finance manger is, now, responsible in shaping the fortunes of
the enterprise. The role of finance manager, in a modern business, is pervasive in all the
activities of business firm, including production and marketing.
It has been rightly said, money begets money. Business needs money to make more
money. However, business can make money, when it is properly managed. The financial
history is replete with stories how even the profitable organisations were wound up, when
the management of finance had turned bad due to mismanagement of financial affairs.
It is misunderstood, in some corners, that the role of finance manager is important
only in private organisations. It is not so. His role is important, both in private and public
sector. He has a positive role to play in every type of organisation. Even in non-profit
making organisations, his role exists as long as there is involvement of funds.
Influences Fortunes of Firm: The history of failures of organisations is
interesting. Manyfirms have failed, not because of inefficiency of production, inability
in marketing or non- availability of funds but due to the absence of competent
finance manager. In many public sector undertakings, in particular, state government

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 undertakings, importance is given to the appointment of peons, more than adequately, but
not to the appointment of competent professional manager in finance, even after lapse
of several years. That is the real secret of numerous loss- making organisations, in
public sector! Over the years, the picture has been changing, but only after the real
damage has already occurred in those public sector undertakings, due to the non-
appointment of professional finance managers, at the time of formation of those
undertakings.

In several public sector undertakings, the presence of competent finance manager is often
found inconvenient. A finance manager cannot play any significant role in the public sector,
unless he is allowed to play.
Exists Everywhere: The role of finance manager, in modern times, can be well
said, universal and pervasive. Hardly, we find any activity, which does not involve finance.
Even entertainment in a firm requires financial management due to financial implications.
In modern business, no decision is taken without the consultation of finance. Even in
recruitment, the presence of finance representative has been a normal feature manager.
Only the level of finance representative changes, dependant upon the status of position for
which recruitment is held. At times, people working in other departments feel that the
finance manager has been interfering in all matters, unconnected to him. It is due to
inadequate understanding of the role and expectations expected of him in modern business.
The finance manager can, definitely, contribute to the overall development of the
organisation provided he is competent and allowed to perform his functions,
independently.
In his new role, the finance manager must find answers for the following three
questions, again in the words of Solomon:
• How large should an enterprise be, and how fast should it grow?
• How should the funds be raised?
• In what form, should the firm hold its assets?
To sum up, finance functions or decisions include the following important areas,
where the finance manager has to contribute:
• Investment decision or long term asset-mix decision
• Finance decision or capital-mix decision
• Liquidity decision or short-term asset mix decision
• Dividend decision or profit allocation decision
The main objective of all the above decisions is to increase the value of the shares,
held by the equity shareholders. The finance manager has to strive for shareholders’
wealth maximisation.
While discharging the functions, the finance manager has to focus his attention on the
following aspects to maximise the shareholders’ wealth:

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 1. Procuring the funds as and when necessary, at the lowest cost,
2. Investing the funds in those assets, which are more profitable, and
3. Distributing the dividends to the shareholders to meet their expectations and
facilitate expansion to achieve the long-term goals of organisation.

FINANCIAL GOAL: PROFIT MAXIMIZATIONVERSUS WEALTH

MAXIMIZATION
The firm’s investment and financing decisions are unavoidable and continuous. In orderto make
them rationally, the firm must have a goal. It is generally agreed in theory that the financial goal
of the firm should be shareholders’ wealth maximization (SWM), as reflected in the market
value of the firm’s shares. In this section, we show that the shareholders’ wealth maximization
is theoretically logical and operationally feasible normative goal for guiding the financial
decision-making.
Profit Maximization
Firms, producing goods and services, may function in a market economy, or in a government-
controlled economy. In a market economy, prices of goods and services are determined in
competitive markets. Firms in the market economy are expected to produce goods and services
desired by society as efficiently as possible.
Price system is the most important organ of a market economy indicating what goods and services
society wants. Goods and services in great demand command higherprices. This results in higher
profit for firms; more of such goods and services are produced. Higher profit opportunities
attract other firms to produce such goods and services. Ultimately, with intensifying
competition, an equilibrium price is reached atwhich demand and supply match. In the case of
goods and services, which are not required by society, their prices and profits fall. Producers drop
such goods and services in favour of more profitable opportunities. Price system directs
managerial efforts towards more profitable goods or services. Prices are determined by the
demand and supply conditions as well as the competitive forces, and they guide the allocation
ofresources for various productive activities.
A legitimate question may be raised: Would the price system in a free market economy
serve the interests of the society? Adam Smith has given the answer many years ago. According
to him: ‘(The businessman), by directing...industry in such a manner as its produce may be of
greater value...intends only his own gain, and he is in this, as in many other cases, led by an
invisible hand to promote an end which was not part of his intention...pursuing his own interest he
frequently promotes that of society more effectually than he reallyintends to promote it.’
Following Smith’s logic, it is generally held by economists that under the conditionsof free
competition, businessmen pursuing their own self-interests also serve the interestof society. It is
also assumed that when individual firms pursue the interest of maximizing profits, society’s
resources are efficiently utilised.
In the economic theory, the behaviour of a firm is analysed in terms of profit
maximization. Profit maximization implies that a firm either produces maximum output for a
given amount of input, or uses minimum input for producing a given output. Theunderlying
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 logic of profit maximization is efficiency. It is assumed that profit maximizationcauses the efficient
allocation of resources under the competitive market conditions, andprofit is considered as the
most appropriate measure of a firm’s performance.
Objections to Profit Maximization
The profit maximization objective has been criticised. It is argued that profit maximizationassumes
perfect competition, and in the face of imperfect modern markets, it cannot be a legitimate
objective of the firm. It is also argued that profit maximization, as a business objective,
developed in the early 19th century when the characteristic features of thebusiness structure
were self-financing, private property and single entrepreneurship. The only aim of the single
owner then was to enhance his or her individual wealth andpersonal power, which could easily
be satisfied by the profit maximization objective.12 The modern business environment is
characterised by limited liability and a divorce between management and ownership.
Shareholders and lenders today finance the business firm but it is controlled and directed by
professional management. The other important stakeholders of the firm are customers,
employees, government and society. In practice, the objectives of these stakeholders or
constituents of a firm differ and may conflict witheach other. The manager of the firm has the
difficult task of reconciling and balancing these conflicting objectives. In the new business
environment, profit maximization is regarded as unrealistic, difficult, inappropriate and
immoral.
It is also feared that profit maximization behaviour in a market economy may tend to
produce goods and services that are wasteful and unnecessary from the society’s point of
view. Also, it might lead to inequality of income and wealth. It is for this reason that
governments tend to intervene in business. The price system and therefore, the profit
maximization principle may not work due to imperfections in practice. Oligopolies and
monopolies are quite common phenomena of modern economies. Firms producingsame goods
and services differ substantially in terms of technology, costs and capital. In view of such
conditions, it is difficult to have a truly competitive price system, and thus, it is doubtful if the
profit-maximizing behaviour will lead to the optimum social welfare. However, it is not clear
that abandoning profit maximization, as a decision criterion, would solve the problem.
Rather, government intervention may be sought to correct market imperfections and to
promote competition among business firms. A market economy, characterised by a high
degree of competition, would certainly ensure efficientproduction of goods and services desired
by society.
Is profit maximization an operationally feasible criterion?Apart from the aforesaid
objections, profit maximization fails to serve as an operational criterion for maximizing the
owner’s economic welfare. It fails to provide an operationally feasible measure for ranking
alternative courses of action in terms of their economic efficiency. It suffers from the
following limitations:
 It is vague
 It ignores the timing of returns

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  It ignores risk
Definition of profit: The precise meaning of the profit maximization objective is unclear. The
definition of the term profit is ambiguous. Does it mean short- or long-term profit?Does it refer to
profit before or after tax? Total profits or profit per share? Does it meantotal operating profit or
profit accruing to shareholders?
Time value of money: The profit maximization objective does not make an explicit distinction
between returns received in different time periods. It gives no considerationto the time value of
money, and it values benefits received in different periods of time asthe same.
Uncertainty of returns: The streams of benefits may possess different degree of certainty.
Two firms may have same total expected earnings, but if the earnings of one firm fluctuate
considerably as compared to the other, it will be riskier. Possibly, owners of the firm would
prefer smaller but surer profits to a potentially larger but less certain stream of benefits.

Maximizing Profit After Taxes

Let us put aside the first problem mentioned above, and assume that maximizing profit means
maximizing profits after taxes, in the sense of net profit as reported in the profit and loss account
(income statement) of the firm. It can easily be realised that maximizingthis figure will not maximize
the economic welfare of the owners. It is possible for a firmto increase profit after taxes by selling
additional equity shares and investing the proceeds in low-yielding assets, such as the government
bonds. Profit after taxes would increase but earnings per share (EPS) would decrease. To
illustrate, let us assume that a company has 10,000 shares outstanding, profit after taxes of `
50,000 and earnings pershare of ` 5. If the company sells 10,000 additional shares at ` 50 per share
and investsthe proceeds (` 500,000) at 5 per cent after taxes, then the total profits after taxes will
increase to ` 75,000. However, the earnings per share will fall to ` 3.75 (i.e., ` 75,000/20,000).
This example clearly indicates that maximizing profits after taxes does not necessarily serve
the best interests of owners.

Maximizing EPS
If we adopt maximizing EPS as the financial objective of the firm, this will also not ensure the
maximization of owners’ economic welfare. It also suffers from the flaws already mentioned,
i.e. it ignores timing and risk of the expected benefits. Apart fromthese problems, maximization
of EPS has certain deficiencies as a financial objective. For example, note the following
observation:

... For one thing, it implies that the market value of the company’s shares is a function ofearnings
per share, which may not be true in many instances. If the market value is not a function of
earnings per share, then maximization of the latter will not necessarily result in the highest
possible price for the company’s shares. Maximization of earningsper share further implies that
the firm should make no dividend payments so long as funds can be invested internally at any
positive rate of return, however small. Such a dividend policy may not always be to the
shareholders’ advantage.
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 It is, thus, clear that maximizing profits after taxes or EPS as the financial objective fails to
maximize the economic welfare of owners. Both methods do not take account of thetiming and
uncertainty of the benefits. An alternative to profit maximization, which solvesthese problems, is the
objective of wealth maximization. This objective is also considered consistent with the survival
goal and with the personal objectives of managers such as recognition, power, status and personal
wealth.

Shareholders’ Wealth Maximization (SWM)

What is meant by shareholders’ wealth maximization (SWM)? SWM means maximizingthe net
present value of a course of action to shareholders. Net present value (NPV)or wealth of a
course of action is the difference between the present value of its benefits and the present value
of its costs.17 A financial action that has a positive NPV createswealth for shareholders and,
therefore, is desirable. Afinancial action resulting in negative NPV should be rejected since it
would destroy shareholders’ wealth. Between mutually exclusive projects the one with the
highest NPV should be adopted. NPVs of a firm’s projects are addititive in nature. That is
NPV(A) + NPV(B) = NPV(A + B)
This is referred to as the principle of value-additivity. Therefore, the wealthwill be
maximized if NPV criterion is followed in making financial decisions.18
The objective of SWM takes care of the questions of the timing and risk of theexpected
benefits. These problems are handled by selecting an appropriate rate (the shareholders’
opportunity cost of capital) for discounting the expected flow of future benefits. It is
important to emphasise that benefits are measured in terms of cash flows. In investment
and financing decisions, it is the flow of cash that is important, notthe accounting profits.
The objective of SWM is an appropriate and operationally feasible criterion to choose
among the alternative financial actions. It provides an unambiguous measure ofwhat financial
management should seek to maximize in making investment and financingdecisions on behalf of
shareholders.19
Maximizing the shareholders’ economic welfare is equivalent to maximizing theutility of
their consumption over time. With their wealth maximized, shareholders canadjust their cash
flows in such a way as to optimise their consumption. From the shareholders’ point of view,
the wealth created by a company through its actions is reflected in the market value of the
company’s shares. Therefore, the wealth maximizationprinciple implies that the fundamental
objective of a firm is to maximize the market value of its shares. The value of the company’s
shares is represented by their market price that, in turn, is a reflection of shareholders’
perception about quality of the firm’s financial decisions. The market price serves as the firm’s
performance indicator. How isthe market price of a firm’s share determined?

Need for a Valuation Approach

SWM requires a valuation model. The financial manager must know or at least assume the
factors that influence the market price of shares, otherwise he or she would find himself or
herself unable to maximize the market value of the company’s shares. What is the appropriate
13
 share valuation model? In practice, innumerable factors influence theprice of a share, and also,
these factors change very frequently. Moreover, these factors vary across shares of different
companies. For the purpose of the financial management problem, we can phrase the crucial
questions normatively: How much should a particular share be worth? Upon what factor or
factors should its value depend? Although thereis no simple answer to these questions, it is
generally agreed that the value of an asset depends on its risk and return.

Risk-return Trade-off
Financial decisions incur different degree of risk. Your decision to invest your money in
government bonds has less risk as interest rate is known and the risk of default is veryless. On the
other hand, you would incur more risk if you decide to invest your money inshares, as return is not
certain. However, you can expect a lower return from government bond and higher from shares. Risk
and expected return move in tandem; the greater therisk, the greater the expected return. Figure
1.1 shows this risk-return relationship.

Financial decisions of the firm are guided by the risk-return trade-off. Thesedecisions
are interrelated and jointly affect the market value of its shares by influencingreturn and risk of
the firm. The relationship between return and risk can be simply expressed as follows:
Return = Risk-free rate + Risk premium (1)
Risk-free rate is a rate obtainable from a default-risk free government security. Aninvestor
assuming risk from her investment requires a risk premium above the risk- free rate. Risk-free
rate is a compensation for time and risk premium for risk. Higherthe risk of an action, higher will
be the risk premium leading to higher required return onthat action. Aproper balance between return
and risk should be maintained to maximizethe market value of a firm’s shares. Such balance is
called risk-return trade-off, and every financial decision involves this trade-off. The interrelation
between market value,financial decisions and risk-return trade-off is depicted in Figure 1.2. It
also gives anoverview of the functions of financial management.
The financial manager, in a bid to maximize shareholders’ wealth, should strive tomaximize
returns in relation to the given risk; he or she should seek courses of actionsthat avoid unnecessary
risks. To ensure maximum return, funds flowing in and out of the firm should be constantly
monitored to assure that they are safeguarded and properlyutilised. The financial reporting system
14
 must be designed to provide timely and accuratepicture of the firm’s activities.

OBJECTIVES OF FINANCIAL MANAGEMENT

Profit Maximisation
Profit earning is the main aim of every economic activity. Business is also an economic
activity. So, every business seeks profit. Profit earning is the real barometer to measure the
efficiency of business firm.
The term ‘profit’ refers to the amount of income, which is due to the owners of
business, whether distributed in the form of dividend or not. Profitability is an operational
concept. In other words, profitability refers to a situation where output exceeds input
i.e. the value created by the use of resources is more than the total of input resources.
Profitability refers to Earnings Before Interest and Taxes (E.B.I.T).
Arguments in Support
1. Aim of Business: According to this approach, actions that increase profit should
be undertaken and those that decrease profit are to be avoided. The approach is,
indeed, simple. It implies that all the financial management decisions, the
investment, finance and dividend decisions – should be oriented towards
maximisation of profits.
2. Barometer for Measuring Efficiency: Real test for measuring comparative
performance of firms is profit. So, this is the ground of rationality.
3. Economic Conditions Change: Business may undergo recession, depression and
severe competition, as economic conditions do not remain the same, always. When
conditions are favourable, firm has to make more profits to withstand the
unfavourable situations, later. Firm can rely on the past earnings, if it sustains
loss. So, every firm has to concentrate to make more money, when the going is
15
 good.
4. Growth: Firm can accumulate profits, which could be a supporting or main source
offinance for expansion and growth, in future years.
5. Social Goals: Personal objectives are primary to every-one. If profits are high,
a business firm can meet its personal objectives and also can help the society for
socio-economic welfare. If profits are small, who allocates funds for social benefits?
So, profitability is essential for fulfilling social goals.
In view of the above, it is argued that every firm should be guided by the aim of profit
maximisation.
Criticism:
The arguments against profit maximisation and main technical flaws of this criterion
are as follows:
(A) Ambiguity-Vague: The term ‘profit’ is vague and has different interpretations. It
means different things to different people. It can be pre-tax or post-tax profit. It is
not clear whether it is short-term profit or long-term profit. Does it mean operating
profit or profit available for shareholders? The other equivalent term, often used,
is ‘Return’. Return can be on total capital employed or total assets or
shareholders equity and so on.
Further, it is also possible that the net profits may increase, but earning per
share may decline. To illustrate, a firm has issued 1,000 equity shares and has
made a net profit of Rs. 10,000. So, the earnings per share (EPS) are Rs.10 per
share. Later, the firm has increased the number of equity shares, further by
2,000. After increase of share capital, the net profit of the firm has been Rs.
15,000. The net profit has increased by 50% from Rs. 10,000 to Rs. 15,000 but
EPS has declined from Rs. 10 to Rs. 5. In such a situation, the market value of
the share does not increase, despite more profits. In fact, there would be a fall
in market price of equity share, due to reduction in EPS.
The above explains maximising profits does not maximise economic welfare of the
owners.
Profit maximisation concept is neither precise nor exact. A loose expression like profit can
not be the basis for operational financial management.
(B) Timing and Value of Money - Ignored: The concept of profit maximisation
does not help in making a choice between projects, giving different benefits,
spread over a period of time. It ignores the difference in time in respect of
benefits arising from the similar amount of investment. The fact that a rupee
received today is more valuable than the rupee received later is ignored in this
concept.
The following illustration explains how time value of money is ignored.
Time pattern of Benefits (Profits)
16
 Alternative A Alternative B
(Rs.) (Rs.)
First Year 5,00 Nil
0
Second year 10,000 10,000
Third year 5,00 10,000
0
Total 20,000 20,000
If profit maximisation were the decision criterion, both the alternatives would be
ranked, equally, as the amount of profit is same in both the alternatives.
‘A’ provides higher returns in earlier years. In case of ‘B’, the returns are in later years.
The returns, arising in the earlier years, can always be reinvested to earn extra returns.
The basic dictum in financial planning is “The Earlier-The Better”. This is referred to
as time value of money.
Profit maximisation criterion does not differentiate the returns received at different
periods.
Costs and benefits, received over a period, are treated alike, irrespective of their timings.
The second and third characteristics of a good operational decision criterion –
Recognition of time value of money and ‘Bigger the Better’ principle are not complied by
profit maximisation concept.
(C) Quality (Certainty) of Benefits: The term ‘Quality’ refers to certainty, with which
benefit can be expected to materialise. Profit maximisation gives weight to the
size of returns, but not to the certainty of the returns. Basically, investors are
risk averse i.e. they want to avoid or at least minimise risk. So, the investors
give preference to those returns, which are certain even with small variations,
over the years.
This concept can be understood well with the following example:
Uncertainty about Expected Benefits
(Profits)
State of Economy Alternative A (Rs.) Alternative B
(Rs.)
RECESSION (Period I) 900 NIL
NORMAL (Period II) 1,000 1,000
BOOM (Period III) 1,100 2,000
Total 3,000 3,000

Returns are identical in the normal situation, in both the cases. However, the returns
vary, widely, during recession and boom, in both the alternatives, and fluctuate depending on
17
the state of economy.
To put it differently, earnings associated with alternative ‘B’ are more uncertain and
risky, with no returns during the recession period and highest returns in the boom period.
In recession period, it is difficult to make money and every firm can make profits
during boom.
Obviously, alternative ‘A’ is better from the point of risk and certainty.
Profit maximisation criterion is inappropriate and unsustainable as operational
objective in the financial management decisions of different kinds – investment, finance
and dividend decisions of a firm. It ignores two important dimensions, namely, (i) risk
and (ii) time value of money.
So, the last characteristic of a good operational decision criterion, ‘quantity and quality’
is also ignored by profit maximisation theory.
(D) Change in Organisation Structure: Principle of profit maximisation was, earlier,
accepted when the structure of the business was sole proprietorship. In this type of
structure, sole proprietor managed the business, individually, and was the
recipient of total profits. As total profit belonged to him, his wealth maximised.
This was the picture in 19th century, when the business was, totally, self-
managed.
Over a period, the sole proprietorship concept has changed to Joint stock company.
In this changed structure, there is divorcee between ownership and management.
Shareholders own the company while professional managers manage the business. There
are several stakeholders in the joint stock company-shareholders, customers, employees,
Government and society. Due to varied stakeholders, their interests are diverse and so
finance manager has to reconcile their divergent and conflicting interests.
In the changed scenario, the concept of ‘Profit Maximisation’ is unrealistic and
inappropriate.
(E) Social Welfare may be Ignored: Due to profit maximisation objective, business
may produce goods and services, which may not be necessary and beneficial
to the society. So, it is, indeed, doubtful how far the profit maximisation
objective serves or promotes social welfare, let alone optimises social welfare.
(F) Ignores Financing and Dividend Aspects: The profit maximisation concept
concentrates on profitability aspect alone and impact of financing and dividend
decisions on the market value of shares are, totally, ignored.
Let us explain the point further. A firm may borrow, beyond its capacity, to finance
the projects on hand. The firm’s main concern is to maximise the profit alone, ignoring
the financial risk- risk of insolvency due to non-payment of interest and repayment of
principal. Totally ignoring risks associated with the huge borrowing is not in the interests
of organisation. So, it can not be said that such type of borrowing is to promote
economic welfare of shareholders as risk aspect has been ignored. More so, this heavy
risk is likely to dampen the market price of shares.
18
 Normally, dividend decision influences market price of equity shares. Even if the
firm declares a higher rate of dividend than the preceding year, still, market price of the
equity share may decline if the market expectations are not fulfilled. In such a situation,
even if the firm makes more profit and ignores the expectations of shareholders in
respect of dividend, it is unlikely the market value of share would improve. The logic is
simple. The real owners, equity shareholders may not appreciate this type of working.
So, profit maximisation is not a proper objective of financial management.
Let us examine whether wealth maximisation is a better objective of Financial
Management, compared to Profit Maximisation.

WEALTH MAXIMISATION
Wealth maximisation of the firm is the most appropriate objective of the enterprise.
The wealth maximisation principle implies to maximise the value of its equity shares. The
wealth created by a company is reflected in the market value of the company’s equity
shares. This situation indicates efficiency of management.
When this objective is achieved, the net worth of the firm would be high. When
net worth is high, earnings per share (EPS) would be at its peak. When EPS is high, market
price of the share would also be high. The shareholders’ wealth would be maximum as
the wealth of the shareholder is a product of number of shares held and its market
price.

Shareholders' current wealth in a firm = Number of equity shares

owned × Current market price

Presence of All Characteristics of a Good Operational Decision Criterion

The wealth maximisation criterion is based on the concept of cash flows. Cash
flows refer to the firm’s future cash flows. In case of profit maximisation criterion, the
accounting profit is the basis of the measurement of benefits.

Cash Flow is a Better Concept: The concept of cash flows is better than the accounting
profit, for the following reasons:
1. Precision Concept: Cash flow is a precise concept, with a definite connotation.
2. Quality Concept: The more certain the cash flows are, the better the quality
of benefits and higher the value. Conversely, the less certain the flows are, the lower
the quality and, therefore, value of benefits is also lower. So, quality dimension
is complied with.
3. Time Concept: Cash flows are discounted (taking the opportunity cost of

19
 capital) to arrive at the present value, which reflects the recognition of time
value of money.
4. Quantity Concept: Bigger cash flows, after discounting, would result in bigger
value. So, quantity aspect is also complied with. All financial decisions should be
based on cost-benefit analysis. Financial action has to be undertaken, only when
benefit exceeds cost. Conversely, if cost is more than benefit, the decision will
not serve the purpose of maximising the wealth. So, those actions should be
rejected. ‘The bigger, The better’ principle is recognised.

CRITICISM OF WEALTH MAXIMISATION

Wealth maximisation is criticised by certain financial theorists on the following grounds:
1. The objective of wealth maximisation is not, necessarily, socially desirable.
2. There is some controversy whether the objective of maximisation of wealth is
of the firm or stockholders. If wealth of firm were maximised, it would be
benefiting the interests of debenture holders and preference shareholders too.

SUPERIORITY OF WEALTH MAXIMISATION COMPARED TO PROFIT

MAXIMISATION
3. In corporate sector, ownership and management are separate unlike in a sole
proprietorship. Management acts as the agents of real owners i.e. shareholders.
However, there is always a possibility of conflict of interest between the
shareholders’ interests and managerial interests. The managers may act to maximise
their managerial utility but not the wealth of stockholders of the firm. A particular
decision may be taken to exhibit their managerial utility and that decision may not
be in the exclusive interests of the firm. Many a time, individuals place their
personal preferences and selfish interests, ahead of the institutional interests.
Wealth maximisation is superior to profit maximisation for the following reasons:
1. Profit maximisation objective measures the performance of firm, in terms of
total profits only. This objective does not consider the risk the firm may undertake
in maximising the profits. This objective ignores the effect of earnings per share,
dividends paid or any other return to the shareholders.
The wealth maximisation objective considers all future cash flows, dividend,
earning per share and impact of risk decisions. The objective of wealth
maximisation is operational and objective in its approach.
2. A firm that wishes profit maximisation may opt not to declare any dividend,
at all, and invest the amount of retained earnings for expansion. The objective of
wealth maximisation allows the firm to pay regular dividend. Shareholders,
certainly, prefer dividend declaration. The profit maximisation can be considered
as a part of wealth maximisation strategy.
20
 It can be said wealth maximisation is considered to be the main objective of financial
management, in comparison to profit maximisation.

OTHER OBJECTIVES OF FINANCIAL MANAGEMENT

Besides the above basic objectives, the following are the other objectives of financial
management:
1. Ensuring a fair return to shareholders.
2. Ensuring maximum operational efficiency by efficient and effective utilisation of
finances.
3. Building up reserves for expansion and growth, and
4. Ensuring financial discipline in the organisation.

CONFLICT OF GOALS
Conflict between departmental goal and firm goal: There are several departments in
a firm such as sales department, purchase department, production department and
marketing department etc. There may be conflicts among the goals of these departments.
Moreover, the internal operative goal of the department may conflict with the goal of the
firm. At times, the departmental head may fail to visualise the ultimate corporate goal,
which is more important to achieve. It is necessary to resolve these conflicts to achieve
the goal of the firm.
Diverse Interests of Stakeholders: Company is a complex organisation. There are
various stakeholders in a company, other than the shareholders. They are creditors,
debenture holders, employees, customers and society who have their own interest in the
organisation.
The interests of stakeholders are different. Every group wants to evaluate the
performance of management from its own objective viewpoint. Each group recognises the
efficiency of management only when their interests are satisfied. So, management has to
satisfy all the groups. By achieving wealth maximisation, management can satisfy all
stakeholders. Shareholders are benefited with the maximisation of their equity share
prices in the market. Market is defined as the place where the shares are quoted e.g.
Bombay stock exchange or National stock exchange. Creditors are more secured about
refund of their principal as well as interest amount. Employees get better salaries and
can have better career, with improved working conditions.
The real focus of wealth maximisation is on the satisfaction of customers through
production of goods and services, with better quality. Unless the customers are satisfied,
there would be no survival for the organisation. Even the Government can secure higher
revenue through higher tax collection, due to increase in profits. Society, in general, gets
the gain in the long run.
Concentration on easily attainable goals: In case of corporate firms, the ownership is
held by the shareholders while the management is in the hands of Board of Directors and
21
 senior management who work as functional directors or heads. The owners set the goals for
management to achieve. Certain goals are easy while others may be difficult to achieve. In a
company, the decision-making authority lies in the hands of management. The management
may concentrate on easily attainable goals like achievement of production and ignore the
effect of the other variables on the market price of the share.
Differing Viewpoints: Usually, the shareholders are scattered and ill organised to
control the Board of Directors. Board of Directors may tend to develop their own goals on
account of their functional autonomy. More so, now, the professionals hold the senior
management positions. This may result in differing viewpoints between the shareholders
and management. The professional management may alienate from the viewpoint of the
shareholders. This situation has not been there, earlier, when sole proprietorship firms
conduct the business.
Survival of Management: The survival of management will be threatened if any
objective ofthe stakeholders remains unfulfilled. It is certain that the management wants
to survive, satisfying the interests of all stakeholders, over a long run. So, the management
can not pursue its own personal goals because of the continuous supervision by the
company’s owners, employees, creditors, customers and Government. The responsibility
of the management is to maintain a balance between the goals of various groups.
The objective of wealth maximisation may be in general harmony with the interests
of the various groups such as owners, employees, creditors and society.

ORGANISATION OF FINANCE FUNCTION IN A MUTI-DIVISIONAL INDIAN

COMPANY
Structure not standardised: The finance function is very vital for every business
firm. A firmshould give proper attention to the structure and organisation of its finance
department. However, the structure of the finance department is not standardised. The
structure depends upon the nature, size of the business and requirements and, in particular,
expectations of the top management. When sole proprietor conducts the business, he
performs even the finance function. With the increase in size of business, joint stock
companies have been formed. As there is a divorce in ownership and management,
professionals handle this important function.
Freedom with accountability: Due to development of corporate functioning, the
finance function is centralised due to its importance. Organisation of the finance function
differs from company to company, dependent upon their respective needs and financial
philosophy. More so, the role of finance has been increasing as the realisation has
been gaining ground, gradually, that the survival and growth of business are more
dependent on the finance function. The finance function is delegated to a top
management executive who is designated as General Manager (Finance), Executive
Director (Finance), Chief Financial Officer (CFO) or even Vice- President (Finance). The
finance chief is a member of top management and closely associated with the
formulation of policy and decision- making. Below the top head, various functions are
22
described and responsibilities assigned to avoid overlapping and at the same time given
freedom of functioning, with the necessary accountability.
Structure Chart: Basically, there are two most important functions – the accounting
and finance functions. The accounting functions are performed by Controller while the
Treasurer performs the finance functions. Both these functionaries work under the close
supervision of vice-president (Finance).
An illustrative organisation chart of finance function of management in a large, multi-
divisional Indian company is shown, diagrammatically, below:

1. Controller or Comptroller (Accounts Manager)

2. Treasurer (Finance Manager)
Controller’s Functions: Controller’s functions, basically, include accounting
function, inventory management, planning and budgeting, payroll, all types of tax
23
administration, statutory and internal audit, preparation of annual and financial reports,
economic appraisal and reporting and internal control. In some organisations, he is
designated as Accounts Manager.
Treasurer’s Functions: The major duties of Treasurer include forecasting of financial
needs, present and future, both long-term and short-term and arranging required funds,
at economic cost, in time. The main function of treasurer is to plan, provide the needed
capital and working capital funds and their management. Additionally, he assumes
responsibility for cash management and administering the flow of cash, management of
receivables, retirement benefits, cost control and protecting funds and securities. He is to
coordinate with banks and financial institutions. The treasurer is also designated as
Finance Manager.
It may be stated that controller’s functions are concerned with the assets side of
the balance sheet, while treasurer’s functions relate to the liability side in a firm.
Capital Expenditure Decisions: Looking to the importance of capital expenditure,
the function is in direct control of Vice-President (Finance). Decisions relating to capital
expenditure are taken through Finance Committee, presided by the President, where all the
functional heads are the members.
It is interesting to note that the controller does not control the finances. He utilises the
information relating to finance for planning and management control. The routine
functions are always delegated to the officers, working under their supervision.
Additional functions may be assigned to the finance division. But, the culture, of late,
has been to allow the finance chief to concentrate on the finance functions, alone, as finance
has been considered a very important function, demanding full time attention to maintain
the efficiency of the organisation. Earlier, Government reporting and insurance functions
used to be handled by the finance. Now, they are handled by the Company Secretary to
enable the Vice-President (Finance) to concentrate on the management of the financial
resources. His duties are not compounded with the other duties, generally, in large
companies.
Treasurer Controller
1. Provision of capital (Both long- 1. Accounting
function term and short-term funds)
2. Maintaining relationship with 2. Preparation of Annual
Report banks and financial institutions and financial reports
3. Credit Management 3. Planning and Budgetary control
4. Cash Management 4. Statutory Audit and Internal Audit
5. Receivables Management 5. Tax Administration
6. Protection of funds and securities 6. Internal Control
7. Cost Control 7. Economic Appraisal

24
 Controller Vs. Treasurer: Both the terms ‘Controller’ and ‘Treasurer’ are used in the
United States of America, where the total finance functions are divided between them.
Many a time, their functions overlap with each other. Both these designations have not
become popular in India and these functions are performed by the Manager (Accounts)
and Manager (Finance). However, in private sector, with modern management, there is
always a trend to give the designations, in a phasionable manner.
The functions of finance depend, largely, on the size of the organisation and the
competence and professional background of the person who handles the functions.

Check your Understanding

A. State whether the following statements are True or False:
1. The objective of every company is to maximise value of the equity shares held by
its shareholders.
2. A company has drastically reduced the expenditure on R & D to increase
current earnings, significantly, which is termed as a good long-term decision as
it, maximises profits, immediately.
3. The market price of a share depends on the current and prospective earnings per
share.
4. The proper goal of financial management is wealth maximisation, not profit
maximisation.
5. When the organisation carries excessive liquidity, profitability does not suffer.
6. It is function of finance manager to bring trade off between liquidity and
profitability.
7. Decisions that increase profits are to be undertaken and those that decrease
profits are to be avoided.
8. Profit maximisation criterion does not differentiate the returns received at
different periods and treats them, alike, irrespective of their timing.
9. Profit maximisation criterion does not recognise time value of money.
10. Wealth maximisation concept is based on the concept of cash flows generated by
the organisation.
11. Wealth maximisation is the primary goal of financial decision-making.
12. The traditional objective of financial management is maximisation of
profitability of the organisation.
13. Financial management is nothing but cash management.
14. Controller performs the accounting functions while the Treasurer performs the
finance functions.
15. The basic dictum in financial planning is “The Earlier-The Better”, also referred
as time value of money.

25
 Answers
1. True 2. False 3. True 4. True 5. False
6. True 7. True 8. True 9. True 10. True
11. True 12 True 13. False 14. True 15. True
B. Select the most appropriate answer
1. The appropriate objective of an enterprise is
(A) Maximisation of owner’s wealth
(B) Maximisation of net profits
(C) Maximisation of sales
2. Basic objective of financial management is
(A) Maximisation of profits
(B) Maximisation of shareholders’ wealth
(C) Ensuring financial discipline in the firm
Answers 1. A 2. B
C. Fill in the blanks with the most appropriate word
1. The side of the balance sheet is managed by the Comptroller.
2. Amongst the functions of , rising of finance is a primary function.
Answers 1. assets 2. treasurer

Check Your Understanding

(A) State whether the following statements are TRUE or FALSE.
1. Finance function is limited to supply of funds to the requirements of the
organisation.
2. Finance function involves procurement of funds, at economic cost, and their
effective utilisation in business.
3. Financial Management involves receipt and disbursement of cash.
4. Finance function is concerned with all aspects of business operations, where
money is involved.
5. The financial management decisions can be classified into four basic kinds¾
Investment Decisions, Financing Decisions, Liquidity Decisions and Dividend
Decisions.
6. Investment decision is concerned with allocating limited resources among the
competing investment alternatives.
7. Cash flows, at different times, carry different values.
8. The finance manager is required to look into the financial implications of every
decision in the firm.
9. It is not the function of finance manager to look to the optimal mix of debt and
equity to finance the investment needs.
10. It is not the job of finance manager to get involved with the change in
distribution channel decision.
11. Finance manager creates problems in decision-making process where money is
involved.
26
 12. Market prices of shares in the stock market fall when expectations of
shareholders in respect ofdividend declaration are not fulfilled.
13. Board of Directors is the owners of Joint Stock Company.
14. Dividend can be declared by the company in the form of cash or bonus shares.
15. Board of Directors is the final authority to decide the quantum of dividend.
16. Dividend can be declared from the current as well as cumulative profits of an
organisation.
17. It is not wise to borrow when interest rate is lower than the return on capital
employed.
18. Bonus shares are issued by the company, capitalising profits.
19. Working Capital Management is concerned with management of fixed assets.
Answers
1. False 2. True 3. False 4. True 5. True
6. True 7. True 8. True 9. False
10. False (decision involves financial implication)
11. False 12. True 13. False 14. True 15. False
16. True 17. False 18. True 19. False
(B) Select the most appropriate answer from the following statements:
1. Financial management is mainly concerned with
(A) Efficient management of every activity of business
(B) Arrangement of funds required to the firm
(C) Obtaining required funds in the appropriate mix and utilising them,
efficiently
2. Financial decisions involve
(A) Investment, sales and dividend decisions
(B) Finance, investment and dividend decisions
(C) Finance, investment and cash decisions
3. Financial management helps in
(A) Short-term planning of company’s activities
(B) Estimating the total funds’ requirement and their proper utilisation in
fixed assets and working capital
(C) Profit planning of the firm
Answers
1. C 2. B 3. B
(C) Fill in the Blanks
1. One who takes financial risks is called the .
2. The finance function provides the required by the Business enterprises.
3. Ownership is divorced from the in a limited company
Answers
1. Entrepreneur 2. Funds 3. Management

27
 INTRODUCTION TO TIME VALUE OF MONEY

Financial management is concerned with the procurement and judicious use of funds. Its
main aim is to maximise the earnings and value of the equity share, in the best interests
of the firm.
Every firm should have a goal or objective to achieve. In the context of that objective, the
finance manager evaluates the decisions to be taken. A goal of the firm may be defined as ‘a
target against which its performance can be measured’. Several goals of financial
management have been cited. The goals are maximisation of sales revenue, net profit, return
on investment, size of the firm, percentage of market share etc. The problem is to identify one
of these several goals. It is, generally, agreed that the financial goal of the firm should
be the maximisation of owners’ economic welfare. Owners’ economic welfare can be
maximised with the Shareholders’ Wealth Maximisation (SWM) as reflected in the
market value of the equity shares.
The above objective of financial management can be achieved, by the following widely
accepted approaches:
(A) Profit maximisation
(B) Wealth maximisation

CHARACTERISTICS OF A GOOD OPERATIONAL DECISION CRITERION

An appropriate operational (financial) decision criterion should
(a) Precision Concept – Be precise and exact.
(b) Time Concept – Recognise the Time value of Money
(c) Quantity Concept – Be based on ‘Bigger the Better’ principle.
(d) Quality Concept – Consider both Quantity and Quality dimensions.
Now, let us examine which approach, profit maximisation or wealth maximisation, would
complywith all the characteristics of a good operational decision criterion.
CONCEPT OF TIME VALUE OF MONEY
The concept ‘Time Value of Money’ is based on the fact that the money has a time
value i.e. a rupee today is much more valuable than a rupee that is received tomorrow.
Even a child prefers today’s enjoyment in preference for tomorrow’s fulfilment.
MONEY HAS TIME VALUE
These are the following reasons that money has a time value.
1. Uncertainty and Risk: Future is always uncertain and risky. Outflows are in
our control as payments to others are to be made by us. There is no certainty for
future cash inflows. Inflows are dependent on others’ convenience. People prefer
to receive, immediately, than waiting for the uncertain tomorrow.

28
 2. Present needs are more important: Individuals generally prefer current
consumption. Even a child wants an ice cream today rather than tomorrow.
3. Opportunity to invest: An individual or firm can invest money for returns.
An investor can profitably employ a rupee received today to give him a higher value
to be received tomorrow or after a certain period.
4. More Purchasing Power in Inflationary Economy: In an inflationary economy,
today’s rupee has more purchasing power to buy, rather than the same amount
of money can buyat a later date.
From the above, it is evident that money received, today, is more valuable than the
money that may be received tomorrow. One can spend today, invest the amount for a return
or can buy more goods, if the economy is passing through the period of inflation. Often,
individuals or firms encounter difficulty in comparing inflows and outflows as they
occur at different periods of time. The logical solution is to recognise the principle of
time value of money and make appropriate adjustments for time. Otherwise, faulty
financial decisions are likely to occur. Time value of money is of vital importance to
reach a proper financial decision.
Example 1: A loan of Rs. 5,000 is given carrying an interest rate of 10% per
annum. At the end of one year, the individual receives back Rs. 5,500. So, Rs. 5,000 at
the beginning of the year is equivalent to Rs.5,500 received at the end of the year.
Example 2: A project needs an initial investment of Rs. 1,00,000. The return is spread
over a period of eight years, with a return of Rs. 15,000 to be received annually. The
question is whether the project is to be accepted or rejected. The outflow is at the
‘Zero year’, initially. The inflows are at different future periods. The firm has to
ascertain the current value of the future annual returns or inflows, at the desired rate
of interest or return. If the discounted value of the future inflows exceeds the initial
investment or at least equals the initial investment, then only the project is accepted or
otherwise rejected.
Example 3: A firm has an option to receive two types of returns for the initial
investment ofRs. 20 lakhs. The first option is to receive annual return of Rs. 5 lakhs
for a period of seven years, commencing from the end of the first year. The second one
is to receive a return of Rs. 10 lakhs for five years, commencing from the end of the
third year of investment. The firm can make the correct choice only when the present
value of the inflows of both options is calculated.

IMPORTANCE OF TIME VALUE OF MONEY IN FINANCIAL MANAGEMENT

The objective of financial management is wealth maximisation rather than the profit
maximisation as the later ignores the principle of ‘Time value of money’. All financial
decisions recognise the importance of this concept ‘Time value of money’. When assets
are purchased, funds outgo occurs, immediately, while returns in the form of ‘inflow’
occur in future period. Similarly, when funds are borrowed, ‘inflow’ is immediate while
‘outflow’ by repayment happens later. If these inflows and outflows are just identical,
29
no financial decision take place as no one likes to part current sacrifice for future
uncertain receipt. It is necessary that there should be some compensation for present
sacrifice. When assets are purchased, the inflow has to be more than the outflow. In
the same way, outflow has to be more than the inflow, if funds are to be raised. How
the inflow and outflow can be matched? The logical answer is to make necessary
adjustment for the flows that happen in the future date to compare them with the
current flows so that financial decisions do not go wrong. This is recognition of time
value of money, which is the basis for financial decisions. In this process, the owner’s
equity is maximised when the net present worth is created from such financial decisions.
Time Value of Money or Time Preference for Money means the same. This is
one of the central ideas of finance for decision-making.
Important terms-
Present Value = It is the value of a sum of money today.
Future Value = It is the value of a sum of money in the future.
Compounding = Finding the future value from present value.
Discounting = Finding the present value from future value.

TECHNIQUES OF TIME VALUE OF MONEY

There are two techniques for adjusting time value of money. They are:
(A) Compounding Technique
(B) Discounted or Present Value of Technique
A. COMPOUNDING TECHNIQUE
Every one wants to have money, immediately, rather than at a later date. However, he
may like to wait if he is duly compensated for the waiting time. If an individual is offered
Rs. 100 immediatelyor Rs. 110 after one year, he may opt the later choice provided
his preference is for an interest rate of 10%. In other words, to him the later preference
is more attractive or Rs. 100 today and Rs.110 at the end of one year are at least the
same. It means one has to receive, in future, more for a rupee than received today.
FV= PV(1+r) n
Where;
FV = future value of the investment
n = number of periods
PV = present value of the investment
r = rate of interest
In case of this concept, the interest earned on the initial principal becomes a part of
principal, at the end of the compounding period. For example, if Rs.100 is invested
for a period of two years at an interest rate of 10% per annum, at the end of first year,
the return is Rs.10. This interest Rs.10 becomes part of the principal amount at the
30
beginning of the next year and interest is calculated on Rs. 110. Along with interest
Rs.11 (10 % interest on Rs.110), the total amount at the end of the second year becomes
Rs.121. This is the yearly compounding of interest. This compounding procedure
continues for an indefinite period.
The general equation used to calculate the compounded value at the end of ‘n’
years is as under:
Computation of this formula is cumbersome, manually, if the number of years is very
large. The other alternative is to use compound value tables. These tables are available
for a wide range of combinations of ‘i’ and ‘n’.
Multiple Compounding Periods
Interest may be compounded monthly, quarterly and half yearly. The above formula used
for annual compounding requires suitable adjustment. If compounding is quarterly,
annual interest rate is to be divided by 4 and number of years is to be multiplied by 4.
Similarly, if monthly compounding is to be made, annual interest rate is to be divided
by 12 and number of years is to be multiplied with 12.
The formula to calculate the compounded value is:
m×n
A = F (1+ i/m )
Where m = umber of ıimes for hich compou di g is ıo be do e.

With annuity table, compound value can be calculated even if the compounding is on
half yearly, quarterly or monthly interest basis. If 12% interest per annum for 5 years
on quarterly basis is to be calculated, then annuity table – 3% interest (dividing 12% by
four) and for 20 years period (multiplying 5 by four) – provides the compounding interest
on quarterly basis. Similar procedure can be adopted for half yearly and monthly interest.
The term Compounded value is also referred as terminal value i.e. value at the end
of the period.
Example 1.
Calculate the compound value when Rs.10,000 is invested for 3 years and interest 10%
per annum is compounded on quarterly basis.
Solution:
The formula to calculate the compounded value is:
A = P (1+ i/m)m x n
A = 10,000(1+ 0.10/4)3x 4
= 10,000(1 + 0.025)12
= Rs. 13, 448.89

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FUTURE VALUE OF SERIES OF CASH FLOWS
Earlier, we have considered the future value of a single payment made at the time zero. At
times, different cash flows may occur at different periods of time. We may like to know
the future value of series of payments made, at the end of the period.

Example 2.
Calculate the future value at the end of five years of the following series of payments at
10% interest rate:
At the end of Cash
Year Flow
(Rs.) (Rs.)
1 1,000
2 2,000
3 3,000
4 2,000
5 1,500

Solution:

= 1000(1 +.10)4 + 2000(1+.10)3 + 3000(1+.10)2

+
2000(1+.10) + 1500
= 1464 + 2662 + 3630 + 2200 + 1500 = Rs.11,456
ANNUITY
The term ‘Annuity’ means a fixed amount, either receipt or payment, at regular
intervals for a specified period. Annuity is an equal instalment, evenly spread over
a specified period. The relevant point is annuity could be a payment or receipt.
Importance is series of equal cash flows occurring over equally spaced periods, in time.
The classical example for annuity is the instalment amount in a recurring deposit with a
bank. Here, the instalment is fixed and the same amount is paid over a period, at regular
intervals. Other examples are equated monthly instalments when a housing loan is taken.
Insurance premium paid on the insurance policy, be it monthly, half- yearly or yearly, is
also an annuity. Even if the house is taken for rent for a period of one year, even the
fixed rent paid per month is also an annuity. If the instalment differs from month
to month or period to period, this is not called annuity.
Compound Value of Annuity
The value of annuity at the end of the specified period is called compound value
of annuity. So, compound value of annuity includes the total instalments paid and interest
accrued on the instalments. Interest compounding may be annual, half-yearly or monthly,
32
 depending on the terms of the contract agreed.
Formula for Compound value of Annuity is as below:

COMPOUND VALUE OF AN ANNUITY DUE

The concepts of compound value and present value of annuity are based on the
assumption that series of payments are made at the end of the year. A series of fixed
payments starting at the beginning of the year for a specified number of years is called
Annuity Due. When a fridge is purchased, first instalment is to be paid, immediately,
and subsequent instalments in the beginning of each period. Its calculation is as under:

DIFFERENCE BETWEEN ANNUITY AND ANNUITY DUE

When the cash flow or instalment occurs at the end of each period, it is called regular
annuity or deferred annuity. When the cash flow or instalment occurs at the beginning
of each period, it is called Annuity Due.
A depositor has deposited equal instalment of Rs. 1,000 every year for a period of five
years, carrying an interest rate of 10% per annum. For calculating the compounding
value of annuity, annuity table gives compound value of annuity of one rupee for 10%
for five years –6.105 – that is to be multiplied with the constant amount Rs. 10,000 to
arrive at the compound value of annuity.

33
 DOUBLING PERIOD
Example 3.
If you deposit an amount of Rs.5,000 at 8 per cent rate of interest, in how many years
will this amount double? Work out the problem by using Rule of 72.
Solution:
For calculating the double period, the formula is
72
Doubling period
=
Rate of Interest

= 72

8
= 9 years

B. DISCOUNTING OR PRESENT VALUE TECHNIQUE

Present value is the exact opposite of compound or future value. In case of

compounding, we calculate the value of money at the end of the period, while in case
of present value concept, we estimate the present worth of a future payment / instalment.
Future value shows the amount receivable of present money on a future date. Principal
amount always appreciates with interest. So, the future value is always higher than the
present money. In case of present value, we calculate the value of future money
receivable as on date, so it would be always lower than the future amount.
The present value approach is based on the concept that money has opportunity cost
for money lying idle.
The formula for calculating discounting value is
PV= FV/ (1+r)n
Where, PV = Present Value
n = Future Value at the end of ‘n’ period
Example 4.
X has an option to receive the value today for a debenture, face value Rs. 1,000 carrying
interest rate of 10% per annum. The debenture falls due for payment after three years.
34
 Calculate the present value today?
Solution:
1,000
Present value =
(1+ 0.10)3

=1000/1.331
= Rs. 751.31

PRESENT VALUE OF SERIES OF CASH FLOWS

In a business situation, investment is made today and returns are spread over a future
period. One would like to know whether the investment is desirable or not. Cash
flows may be uniform or changing at periodical intervals. In other words, the following
formula is useful to calculate the present value of annuity where the cash flow is constant
or cash flows vary from period to period. For this, series of future cash flows are to
be adjusted for the present value.
The present value of series of cash flows can be calculated by the following formula.
Where PV =Sum of individual present values of cash flows
A1, A2, A3 =Cash flows after period 1,2,3 etc
i =Discount rate
t =time period

35
Example: Quentin buys a financial asset. In accordance to the terms, the asset pays $5000 at the end
ofeach year for the next 7 years. Assume a required rate of return of 6.4%. What is the payment for this
asset today?
Solution:
A = 5000; r = 6.4%; N = 7. Using Equation 8: PV = 5000 ( (1+0.064)7 ) = $27,519

Check Your Understanding

(A) State whether the following statements are True or False
1. Value of money received today is more than the value of the same amount of
money received tomorrow.
2. Discounting technique is also known as compounding technique.
3. An annuity is a series of receipts or payments of unequal amounts.
4. There are no differences between simple interest and compound interest value of
money.
5. Time value of money and time preference for money conveys the same meaning.
6. Cash flows of different years in absolute terms are comparable.
7. The term ‘annuity’ does not necessarily apply to equal annual cash flows; it can
even apply to monthly or quarterly cash flows occurring at equal intervals.
8. If cash flows occur at the end of the each period, the annuity is called regular
annuity or deferred annuity.
9. Annuity and perpetuity are different concepts.
10. Even if the instalment differs from month to month or period to period, this is
called annuity.
11. Effective interest rate brings all the different bases of compounding such as yearly, half-
yearly, quarterly and monthly on a single platform for comparison to select the
beneficial base.
12. Rule of 72 is useful to calculate period required for doubling principal amount, in the
absence of interest rate.

Answers
1. True 2. False 3 . False 4. False 5. True
6. False 7. True 8. True 9. False 10. False
11. True 12. False
(B) Select the most appropriate one
1. Formula for sinking fund is
(A) same as compounding annuity formula

(B) reciprocal of compounding annuity

(C) reverse of effective interest rate formula
2. Discounting technique is

36
 (A) slightly different from compounding technique
(B) exactly opposite to compounding technique
(C) same as compounding technique
3.Formula for Compound value of a sum is
(A) P (1 + i)n
(B) P (1 - i)n
(C) C (1 +i) n
Where P = Principal
i = interest rate
n = number of years
A = amount at the end of ‘n’ number of years
4. Effective Interest Rate means
(A) simple interest rate
(B) compound interest rate
(C) a single common interest rate for comparison between half-yearly, quarterly and
monthly interest rates.
5. Cash flows of two years in absolute terms are
(A) comparable
(B) different
(C) same
6. When interest is compounded on half-yearly basis, interest amount works out ….
than the interest calculated on yearly basis.
(A) less
(B) more
(C) same
7. The worth of money in hand today is … than money receivable in future.
(A) same
(B) more
(C) less

Answers
1. (B) 2. (B) 3. (A) 4. (C) 5. (B)
6. (B) 7. (B)

37
 UNIT II
LECTURE NOTES ON
BBA 305 FINANCIAL MANAGEMENT
By: DR.SWASTIKA TRIPATHI

INTRODUCTION TO CAPITAL BUDGETING

Definition
Capital budgeting may be defined as the decision-making process by which firms evaluate the purchase of
major fixed assets such as machinery, equipment, buildings, acquisition of other firms either through the
purchase of equity shares or group of assets to conduct an on-going business. Capital budgeting describes
the firm’s formal planning process for the acquisition and investment of capital and results in a capital
budget i.e., the firm’s formal plan outlay for purchase of fixed assets.
Importance
Preparation of the firm’s formal capital budget is necessary for a number of reasons:
It affects profitability: Capital budgeting decisions affect the profitability of the firm. They also have a
bearing on the competitive position of the firm. They determine the future destiny of the company. An
opportune investment decision can yield spectacular returns. On the other hand, an ill-advised and incorrect
investment decision can endanger the very survival even of the large sized firms.
Effects are felt over long time periods: The effects of capital spending decisions will be felt by the firm over
extended periods of time, e.g., construction of a factory affects the company’s future cost structure.
It involves substantial expenditures: Capital expenditure may range from a single piece equipment costing
thousands of rupees to complete. Profit and other physical facilities costing crores of rupees.
Not easily reversible: Capital investment decisions once made, are not easily reversible without much
financial loss to the firm, since there may be no market for second hand plant and equipment, or conversion
to other uses may not be financially feasible.
Based on long-term policy decisions: Capital budgeting decisions should be based on long- term policy
decisions and should rest firmly on organisation policies on growth, marketing, industry share, social
responsibility and other matters and not taken on ad hoc basis.
Scarce capital resources: Capital investment involves cost and the majority of the firm’s resources are
limited. This underlines the need for thoughtful and correct investment decisions.
Difficulties in evaluation: Evaluation of capital investment proposals is difficult since the benefits from
investment are received in some future period. Hence there is a substantial risk involved in estimation of
the future benefits. Added to this, the possibility of shifts in consumer preferences, the actions of
competitors, technological developments and changes in the economic and political environment. Even to
quantify the future benefits in rupees is not an easy task.

9.2 Capital Budgeting Process

A capital budgeting decision is a two-sided process:
1. Calculation of likely or expected return from the proposal. Here the focus is cash outflow at the
beginning of the project and a stream of cash flow flowing into the firm over the life of the project. The
calculation of expected return from cash outflow and cash inflows may be done by different methods
discussed later.
2. To select a required return that a project must achieve before it is acceptable. The focus is the
38
relationship between risk and return. Two methods may be used weighted average cost of capital (if project
risk is identical to firms current risk) or capital asset pricing model (if project risk differs from firm’s current
risk).

Techniques of Capital Budgeting

Traditional/Non-Discounted
Techniques of Capital
Budgeting
Modern/Discounted Techniques
of Capital Budgeting

Techniques of Capital Budgeting

Traditional/Non-Discounted Techniques Modern/Discounted Techniques

a. Pay Back Period a. NET PRESENT VALUE (NPV)

i. Even/ Constant Cashflow b. INTERNAL RATE OF RETURN (IRR)
ii. Uneven Cashflow c. PROFITABILITY INDEX (PI)
iii. Discounted Pay Back Period
b. Average Rate of Return

1. Traditional/Non-Discounted Techniques
a. Pay Back Period- Payback (PB) is one of the most popular and widely recognized traditional methods of
evaluating investment proposals. Payback is the number of years required to recoverthe original cash outlay
invested in a project. If the project generates constant annual cash inflows, the payback period can be
computed by dividing cash outlay by the annualcash inflow.
i. Constant Cash Flows:
Payback = Initial Investment = C0
Annual Cash Inflow C
Illustration 1: Assume that a project requires an outlay of ` 50,000 and yields annual cash inflow of

39
 Rs.12,500 for 7 years. The payback period for the project is:

PB= Rs 50,000 =4 years

Rs12,000
Unequal cash flows: In case of unequal cash inflows, the payback period can be foundout by adding up the cash
inflows until the total is equal to the initial cash outlay. Considerthe following example.

ii. Uneven Cash Flows

Illustration 2: Suppose that a project requires a cash outlay of ` 20,000, and generates cash inflows of ` 8,000; `
7,000; ` 4,000; and ` 3,000 during the next 4 years. What is the project’s payback? When we add up the cash
inflows, we find that in the first three years ` 19,000 of the original outlay is recovered. In the fourth-year cash
inflow generated is ` 3,000 and only ` 1,000 of the original outlay remains to be recovered.
Years Cashflow (Rs.) Cumulative Cashflow
1 8000 8000
2 7000 15000
3 4000 19000
4 3000

E+B/C = 3 Years + 1000/3000

= 3 + 0.33 X 12 months
= 3 + 3.96 months = 3 years 4months
iii. Discounted payback period = E + B / C
where,
A refers to the period in which maximum discounted cash flow has been recovered
B refers to the value of discounted cumulative cash flow yet to be recovered
C refers to the next year`s discounted cash flow
Illustration 3: Initial investment = Rs. 70000; Years (n) = 5; Rate (i) = 12%; Cash Flow = Rs. 20000
Calculate what is Discounted Payback Period.
Year Cash Flow Present Value Discounted Cash Cumulative Discounted Cash
(n) (CF) Factor Flow Flow (CCF)

PV = 1 / (1+i) n (CF x PV)

1 20000 0.89 17800 17800

2 20000 0.79 15800 33600

3 20000 0.71 14200 47800

40
 Year Cash Flow Present Value Discounted Cash Cumulative Discounted Cash
(n) (CF) Factor Flow Flow (CCF)

4 20000 0.64 12800 60600

5 20000 0.57 11400

E= 4; B=9400; C=11400
Discounted Payback Period = E + B / C
Discounted Payback Period = 4 + 9400 / 11400 = 4.82 years

Acceptance Rule
Many firms use the payback period as an investment evaluation criterion and a methodof ranking projects. They
compare the project’s payback with a predetermined, standard payback. The project would be accepted if its
payback period is less than the maximumor standard payback period set by management. As a ranking method,
it gives highest ranking to the project, which has the shortest payback period and lowest ranking to theproject with
highest payback period. Thus, if the firm has to choose between two mutuallyexclusive projects, the project with
shorter payback period will be selected.
Merits of PBP-
1.This method is quite simple and easy to understand; it has the advantage of making it clear that there is no
profit of any project unless the payback is over. When funds are limited it is always better to select projects
having shorter payback periods. This method is suitable to industries where the risks of obsolescence are
very high.
2.The payback period can be compared to a break-even point, the point at which costs are fully recovered,
but profits are yet to commence.
3.The risk associated with a project arises due to uncertainty associated with the cash inflows. A shorter
payback period means less uncertainty towards risk.
Demerits of PBP-
1.The method does not give any considerations to time value of money. Cash flows occurring at all points of
time are simply added.
2.This method becomes a very inadequate measure of evaluating two projects where cash inflows are
uneven.
3.It stresses capital recovery rather than profitability. It does not take into account the returns from a project
after its payback period. Therefore, this method may not be a good measure to evaluate where the
comparison is between two projects one involving a long gestation period and other yielding quick results
only for a short period.
b. The Accounting rate of return (ARR), also known as the return on investment (ROI), uses accounting
information, as revealed by financial statements, to measure the profitability of an investment. The accounting rate
of return is the ratio of the average after taxprofit divided by the average investment. The average investment
would be equal to halfof the original investment if it were depreciated constantly. Alternatively, it can be foundout
by dividing the total of the investment’s book values after depreciation by the life ofthe project. The accounting
rate of return, thus, is an average rate and can be determined by the following equation:
41
 ARR = Average Annual Profit or income or Earnings / Average Investment
Where:
Average Annual Profit = Total profit over Investment Period / Number of Years
Average Investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2
Illustration 4: If the annual profit for a project over the life of the investment averages to Rs. 20,000, and
the average investment value in a given year is Rs. 100,000, then ARR would be calculated as below:
20000 / 100000 = 20% is the ARR

Illustration 5: There are two different projects a company is considering for investment and a decision
has to be made based on which project yields better ARR. Following are the details:
Description Proposal I Proposal II
Estimated average annual profit from the projects (A) RS. 40,000 Rs. 30,000
Average Investment Value (B) Rs. 140,000 Rs. 100,000
Estimated ARR (A/B) 29% 30%
When a decision has to be made only based on the accounting rate of return: The proposal II has 30%
ARR and yields a better result to the company. Hence Proposal II should be selected.

Illustration 6: A Company wants to invest in new set of vehicles for the business. The vehicles cost
Rs. 350,000 and would increase the company’s annual revenue by Rs.100,000, as well as the company’s
annual expenses by Rs.10,000. The vehicles are estimated to have a useful shelf life of 20 years, with no
salvage value. So, the ARR calculation is as follows:
Average annual profit = Rs.100,000 - Rs.10,000 = Rs.90,000
Depreciation expense = Rs.350,000 / 20 = Rs.17,500
True average annual profit = Rs.90,000 - Rs.17,500 = Rs.72,500
ARR = Rs.72,500 / 350,000 *100 = 0.2071 = 20.71%
So, in this example, for every pound that your company invests, it will receive a return of 20.71%. That’s
relatively good, and if it’s better than the company’s other options, it may convince them to go ahead with
the investment.
Merits of ARR: This method is quite simple and popular because it is easy to understand and includes
income from the project throughout its life.
Limitations of ARR:
1. This method ignores the timing of cash flows, the duration of cash flows and the time value of
money.
2. It is based upon a crude average of profits of the future years. It ignores the effect of fluctuations
in profits from year to year.

2. Modern/Discounted Techniques
a. Net Present Value- We invest our hard-earned money in companies or other projects with the aim of
generating returns. Before investing, every investor would want to know the potential returns their
investment can generate. The Net Present Value or NPV is one of the most common ways to examine
returns from potential or current investments. Thus, Net present value (NPV) is a calculation used by
businesses and investors that estimate the current value of future cash flows.

42
Illustration 7: A company has to choose between 2 machines – Machine A and Machine B. Both machine
costs Rs. 1,00,000. The useful life is 5 years for both the machines. Salvage value at the end of their useful
lives is Nil. The profits before depreciation and tax from Machine A are Rs. 28,000; Rs. 29,500, Rs. 30,000;
Rs. 31,200 and Rs. 32,000 while that from Machine B are Rs. 26,000, Rs. 27,800, Rs. 30,000, Rs. 32,400
and Rs. 34,000. Comment as to which machine should be bought by calculating their NPV. The cost of
capital is 10% and tax rate is 30%.

Since the NPV of Machine A is higher than that of Machine B, Machine A should be chosen.
43
Positive NPV: A positive result from an NPV calculation means the project or investment may be
profitable and worth pursuing.
Negative NPV: A negative result from an NPV calculation means the project or investment is unlikely to
be profitable and should probably not be pursued.
Zero NPV: An NPV of zero means the project or investment is neither profitable nor costly. A company
may still consider projects and investments with an NPV of zero if the project has significant intangible
benefits, such as strategic positioning, brand equity, or increased consumer satisfaction.
•Accept the project when NPV is positive NPV > 0
•Reject the project when NPV is negative NPV < 0
•May accept the project when NPV is zero NPV = 0
Merits of NPV:
1.It recognises the time value of money.
2.The whole stream of cash flows throughout the project life is considered.
3.A changing discount rate can be built into the NPV calculations by altering the denominator.
4.NPV can be seen as the addition to the wealth of shareholders. The criterion of NPV is, thus, in
conformity with basic financial objectives.
5.This method is useful for selection of mutually exclusive projects.
6.An NPV uses the discounted cash flows i.e., expresses cash flows in terms of current rupees. The
NPV’s of different projects therefore, can be added/compared. This is called the value additive principle,
implying that NPV’s of separate projects can be added. It implies that each project can be evaluated
independent of others on its own merit.
Limitations of NPV:
1.It is difficult to calculate as well as understand and use in comparison with the payback method or even
the ARR method.
2.The calculation of discount rate presents serious problems. In fact, there is difference of opinion even
regarding the exact method of calculating it.
3.PV method is an absolute measure. Prima facie between the two projects, this method will favour the
project, which has Higher Present Value (or NPV). But it is likely that this project may also involve a
larger initial outlay. Thus, in case of projects involving different outlays, the present value method may
not give dependable results.
4.This method may not give satisfactory results in case of projects having different effective lives.

b. Internal Rate of Return (IRR)- The internal rate of return (IRR) method is another discounted
cash flow technique, which takes account of the magnitude and timing of cash flows. Other terms
used to describe the IRR method are yield on an investment, marginal efficiency of capital, rate of
return over cost, time-adjusted rate of internal return and so on.
IRR= r1 + V1-V/ V1-V2 * (r2 – r1)
Illustration 8: The annual inflow will be ₹5,600 for five years. You can calculate the internal rate of
return as
F= I/C
Where;
F= factor to be located; 1 = Initial investment; C= Average cash inflow;
= ₹18,000/ ₹5600
= 3.214

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After calculating the factor as above, you can locate it in the different annuity tables on the line representing
the number of years corresponding to the project's economic life.
In the above example, according to the annuity table, the factor closest to 3.21 for five years are 16% and
17%.
Rate of Discount 16% 17%
Total Present Value 5,600 x 3.274 =< 18,334.40 5,600 x 3.199 = < 17,914.40
Less: initial outlay 18,000.00 18,000.00
NPV 334.4 -85.6

Net Present Value is greater than zero ₹334.40 at a 16% discount rate, and we need a higher discount rate
to equalise Net Present Value with total outlay. ₹ -85.60 at a 17% discount rate; we need a lower rate. So,
the above exercise shows that the Internal Rate of Return lies between 16% and 17%. for the exact figure,
you can use interpolation i.e.
PVCFAT = 18334.40
PVc = 18000
ΔPV = 420
Δr = 1
IRR = 16 + 334/420 x 1 = 16 + .8 = 16.8%

Advantages of IRR:
1.It possesses the advantages, which are offered by the NPV criterion such as it considers time value of
money and takes into account the total cash inflows and outflows.
2.IRR is easier to understand. Business executives and non-technical people understand the concept of
IRR much more readily that they understand the concepts of NPV.
3.It does not use the concept of the required cost of return (or the cost of capital). It itself provides a rate
of return which is indicative of the profitability of the proposal. The cost of capital enters the calculation,
later on.
4.It is consistent with the overall objective of maximizing shareholders wealth since the acceptance or
otherwise of a project is based on comparison of the IRR with the required rate of return.
Limitations of IRR:
1.It involves tedious calculations.
2.It produces multiple rates, which can be confusing.
3.In evaluating mutually exclusive proposals, the project with the highest IRR would be picked up to the
exclusion of all others. However, in practice, it may not turn out to be one that is the most profitable and
consistent with the objectives of the firm i.e., maximization of the wealth of the shareholders.
4.Under IRR method, it is assumed that, all intermediate cash flows are reinvested at the IRR rate. It is
not logical to think that the same firm has the ability to re-invest, the cash flows at different rates. In
order to have correct and reliable results it is obvious, therefore, that they should be based on realistic
estimates of the interest rate at which the income will be re-invested.
5.The IRR rule requires comparing the projects IRR with the opportunity cost of capital. But, sometimes,
there is an opportunity cost of capital for 1 year cash flows, a different cost of capital for 2-year cash
flows and so on. In these cases, there is no simple yardstick for evaluating the IRR of a project.

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 c. Profitability Index (P.I.)- The profitability index rule is a decision-making exercise that helps
evaluate whether to proceed with a project. The index itself is a calculation of the potential profit
of the proposed project. The rule is that a profitability index or ratio greater than 1 indicates that the
project should proceed. A profitability index or ratio below 1 indicates that the project should be
abandoned.
The profitability index is calculated as the ratio between the present value of future expected cash
flows and the initial amount invested in the project. A higher PI means that a project will be
considered more attractive.
Profitability Index = (Net Present Value + Initial Investment) / Initial Investment
PI =1: Neutral/Acceptable
PI >1: Approve Project
PI <1: Reject Project
Illustration 9: Let’s assume the cash flows of a project as mentioned year-wise in the second column of
the below table. The negative cash flows are the costs, and the positive ones are the benefits. In the third
column, they are discounted at a 10% rate. All the discounted benefits are added to make Rs. 16,832 and
discounted costs to make Rs.15,450.

Year Cash Flows Discounted Benefits Costs

(CF) CF @ 10%

0 -10000 -10000 10000

1 5000 4545 4545

2 5000 4132 4132

3 -5000 -3757 3757

4 4000 2732 2732

5 4000 2484 2484

6 -3000 -1693 1693

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 7 3000 1539 1539

8 3000 1400 1400

Total 6000 1382 16832 15450

NPV 16832 – 15450 = 1382

Profitability Index 16832/15450= 1.09

The benefit to cost ratio or the PI can be found by dividing benefits by costs (16832/15450 = 1.09)

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