FINANCE FUNCTION
By: R. P. Sharma
ACTIVITIES OF BUSINESS FIRM
Production Marketing and Finance
Finance Functions
Investment Decision Financing Decision Dividend Decision Liquidity Decision Other routine finance functions viz. cash management, custody of securities, bookkeeping and financial reporting etc.
Investment Decisions
Evaluation of the prospective profitability of the new investments
Measurement of a cut-off rate against which the return on new investment is to be assessed / compared.
Financing Decision
When to acquire funds From where to source the funds
How to raise the funds
Other factors viz. control, flexibility, loan covenants, legal aspects etc in deciding its capital structure.
Dividend Decision
How much of the profit earned by the firm should be distributed as dividend to the shareholders How much should be retained with the firm Will the dividend policy will maximise the market value of the firms' shares. Other factors to be kept in mind : dividend stability, cash dividend payout, bonus shares and legal provisions .
Liquidity Decision
It pertains to current assets management Investment in current assets affects : liquidity of the firm on one hand and profitability on the other
If a firm does not invest sufficiently in current assets it may become illiquid and therefore risky. However, it would loose profitability, as idle current assets would not earn anything. Thus a proper trade-off must be achieved between liquidity and profitability .
Other routine finance functions
Supervision of cash receipts and payments and safeguards of cash balances. Custody and safeguarding of securities, insurance policies and other important papers. Taking care of the mechanical details of new outside financing. Record keeping and reporting.
Functions of Finance Manager
Role of finance manager is to ensure that funds of the enterprise are utilized in the most efficient manner. Main functions are: Fund Raising Fund Allocation Profit Planning and Understanding Capital Markets
Financial Goal
Profit Maximisation , or Wealth Maximisation
Profit Maximisation
In the economic theory, Profit maximization implies that a firm either produces maximum output for a given amount of inputs or uses minimum inputs for producing a given output. The underlying logic of profit maximisation is efficiency. Profit maximisation causes the efficient allocation of resources under the competitive market conditions, and the profit is considered as the most appropriate means of a firm's performance
Profit Maximisation
In line with Adam Smith's logic it is generally held by the economists that under the conditions of free competition, businessmen pursuing their own self interests also serves the interest of the society. It is also assumed that when individual firms pursue the interest of maximising profits, society's resources are efficiently utilized
Objections to Profit Maximisation
Profit maximisation assumes perfect competition, and in the face of imperfect modern markets it can not be the legitimate objective Profit maximisation concept was developed in 19th century when the businesses were self-financing, private property and single entrepreneurship
Objections to Profit Maximisation
The modern business environment is characterized by limited liability and a divorce between management and ownership In practice the objective of different stakeholders differ and may conflict with each other
Objections to Profit Maximisation
In the new business environment, profit maximisation is regarded as unrealistic, difficult, inappropriate and immoral It is feared that profit maximisation behavior in a market economy may tend to produce goods and services that are wasteful and unnecessary from 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
Objections to Profit Maximisation
Monopolies and oligopolies are quite common phenomena of the modern economies. Firms producing same goods and services differ substantially in terms of technology, costs and capital In view of aforementioned conditions it is doubtful that the profit maximisation criteria would lead to the optimum social welfare
Limitations of Profit Maximisation
Definition of profit is vague Time value of money is ignored Uncertainty of returns
Illustration
Let us assume that maximising profit means maximising profit after tax i.e. the net profit as reported in the Profit & Loss Statement of the firm. It can easily be realized that maximising this fig. will not serve economic welfare of the owners. It is possible for a firm to increase profit after tax by selling additional equity shares and investing the proceeds in low yielding assets, such as Govt. securities./ bonds. Thus profit after tax would increase but earning per share (EPS) will reduce.
Illustration
Let us assume that a company has 10,000 shares outstanding, profit after taxes of Rs.50,000/- and thus EPS as Rs.5/ Now, if the company sells additional 10,000 shares at Rs 50 per share and invests the proceeds (Rs.500,000/-) at 5% after taxes, then the total profits after taxes will increase to Rs.75,000/-(50,000+500,000@5%). Now the earnings per share will fall to Rs.3.75 (75,000/ 20,000)
Illustration
This example clearly indicates that maximising profits after taxes does not necessarily serve best interests of owners. If we adopt maximising EPS as the financial objective of the firm, this will also not ensure maximisation of owner's economic welfare It also ignores timing and risk of the expected benefits
Shareholder's Wealth maximisation (SWM)
SWM means maximising the 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 A financial action that has a positive NPV creates wealth for the shareholders and therefore is desirable.
Expression for NPV
NPV = W = [C1/(1+k) + C2/(1+k)^2 + ---Cn/(1+k)^n] - Co Co is the cash outflow (cost) of that action C1,[Link] the stream of cash flows (benefits) expected to occur k is the appropriate discount rate Adopt a course of action only when W is positive i.e. when there is net increase in the wealth of the firm
Shareholder's Wealth maximisation (SWM)
A proposal with negative NPV should be rejected since it would destroy shareholder's wealth Between mutually exclusive projects the one with higher NPV should be adopted NPVs of a firm's projects are additive in nature i.e. NPV(A) + NPV(B) = NPV(A+B)
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