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
Understanding the universality and importance of
finance, finance manager is associated, in modern
business, in all activities as no activity can exist
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
(A) Investment Decision or Long-term Asset
(B) Finance Decision or Capital mix decision
(C) Liquidity Decision or Short-term asset mix
(D) Dividend Decision or Profit allocation
(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
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 the
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
(i) Long-term investment decisions – Long-term assets
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
The short-term investment decisions are,
generally, referred to, 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 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.
• 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
Total investment: Rs. 1,00,000
Composition of investment:
Equity Rs. 60,000
Debt @ 7% interest Rs. 40,000
Return on investment
@ 15% Rs. 15,000
Interest on Debt Rs. 2,800
7% on Rs.40,000
Earnings available to
Equity shareholders Rs. 12,200
Return on equity (ignoring tax) is 20%, which is at the expense of debt
as they get 7% interest only.
In the normal course, equity would get a return of 15%. But they are
enjoying 20% due to financing by a combination of debt and equity.
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. 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
• However, funds have economic cost. Idle current
assets do not earn anything. Higher liquidity is at the cost
of profitability. Profitability would suffer with more idle
funds. Investment in current assets affects the
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
• 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 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 o
dividend affects the market price of equity shares,
• 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
A financial market is a market in which
people and entities can trade financial
securities, commodities, and other
fungible items of value at low
transaction costs and at prices that
reflect supply and demand. Securities
include stocks and bonds, and
commodities include precious metals
or agricultural goods.
Indian Financial Market
What does the India Financial market comprise of? It talks about
the primary market, FDIs, alternative investment options,
banking and insurance and the pension sectors, asset
management segment as well. With all these elements in the
India Financial market, it happens to be one of the oldest across
the globe and is definitely the fastest growing and best among all
the financial markets of the emerging economies. The history of
Indian capital markets spans back 200 years, around the end of
the 18th century. It was at this time that India was under the rule
of the East India Company. The capital market of India initially
developed around Mumbai; with around 200 to 250 securities
brokers participating in active trade during the second half of the
Within the financial sector, the term "financial markets" is
often used to refer just to the markets that are used to raise
finance: for long term finance, the Capital markets; for short
term finance, the Money markets. Another common use of
the term is as a catchall for all the markets in the financial
sector, as per examples in the breakdown below.
• Capital markets which consist of:
◦ Stock markets, which provide financing through the issuance of
shares or common stock, and enable the subsequent trading
◦ Bond markets, which provide financing through the issuance
of bonds, and enable the subsequent trading thereof.
• Commodity markets, which facilitate the trading of
• Money markets, which provide short term debt financing and
• Derivatives markets, which provide instruments for the
management of financial risk.
• Futures markets, which provide standardized forward
contracts for trading products at some future date; see
also forward market.
Insurance markets, which facilitate the redistribution of
NSEThe National Stock Exchange (NSE) is a stock exchange located at
Mumbai, Maharashtra, India. It is the 16th largest stock exchange in the
world by market capitalization and largest in India by daily turnover and
number of trades, for both equities and derivative trading. NSE has a market
capitalization of around US$985 billion and over 1,640 listings as of
December 2011.Though a number of other exchanges exist, NSE and
the Bombay Stock Exchange are the two most significant stock
exchanges in India, and between them are responsible for the vast
majority of share transactions. The NSE's key index is the S&P CNX
Nifty, known as the NSE NIFTY (National Stock Exchange Fifty), an
index of fifty major stocks weighted by market capitalisation.
NSE is mutually-owned by a set of leading financial institutions, banks,
insurance companies and other financial intermediaries in India but its
ownership and management operate as separate entities. There are at least
2 foreign investors NYSE Euronext and Goldman Sachs who have taken a
stake in the NSE. As of 2006, the NSE VSAT terminals, 2799 in total, cover
more than 1500 cities across India. NSE is the third largest Stock Exchange
in the world in terms of the number of trades in equities. It is the second
fastest growing stock exchange in the world with a recorded growth of
The Bombay Stock Exchange (BSE) is a stock exchange located on
Dalal Street, Mumbai and is the oldest stock exchange in Asia. The
equity market capitalization of the companies listed on the BSE was
US$1 trillion as of December 2011, making it the 6th largest stock
exchange in Asia and the 14th largest in the world. The BSE has the
largest number of listed companies in the world.
As of December 2011, there are over 5,112 listed Indian companies and
over 8,196 scrips on the stock exchange, the Bombay Stock Exchange
has a significant trading volume. The BSE SENSEX, also called "BSE
30", is a widely used market index in India and Asia. Though many other
exchanges exist, BSE and the National Stock Exchange of India account
for the majority of the equity trading in India. While both have similar total
market capitalization (about USD 1.6 trillion), share volume in NSE is
typically two times that of BSE.
Over-the-Counter Exchange of India is based in
Mumbai, Maharashtra. It is the first exchange for
small companies. It is the first screen based
nationwide stock exchange in India. It was set up to
access high-technology enterprising promoters
in raising finance for new product development
in a cost effective manner and to provide
transparent and efficient trading system to the
OTCEI is promoted by the Unit Trust of India, the
Industrial Credit and Investment Corporation of
India, the Industrial Development Bank of India, the
Industrial Finance Corporation of India and others
and is a recognized stock exchange under the SCR
The Securities and Exchange Board of India
(frequently abbreviated SEBI) is the regulator for the
securities market in India. It was formed officially by
the Government of India in 1992 with SEBI Act 1992
being passed by the Indian Parliament. SEBI is
headquartered in the business district of Bandra Kurla
Complex in Mumbai, and has Northern, Eastern, Southern
and Western regional offices in New Delhi, Kolkata,
Chennai and Ahmedabad.
Initially SEBI was a non-statutory body without any
statutory power. However in 1995, the SEBI was given
additional statutory power by the Government of India
through an amendment to the securities and Exchange
Board of India Act 1992. In April, 1998 the SEBI was
constituted as the regulator of capital market in India under
Integration of Financial
• Integration of financial markets is a process of unifying
markets and enabling convergence of risk adjusted
returns on the assets of similar maturity across the
• In integrated financial markets, domestic investors can buy
foreign assets and foreign investors can buy domestic
assets. Among countries that are fully integrated into world
financial markets, assets with identical risk should
command the same expected return, regardless of
• With more integration you can transmit price signals more
efficiently, reduce arbitrage opportunities, achieve higher
level of efficiency in market operation of intermediaries and
increase efficacy of monetary policy in the economy.
• Financial markets all over the world have witnessed
growing integration within as well as across boundaries,
Central banks in various parts of the world have
made concerted efforts to develop financial
markets, especially after the experience of
several financial crises in the 1990s.
At the same time, deregulation in emerging
market economies (EMEs) has led to removal of
restrictions on pricing of various financial
assets, which is one of the pre-requisites for
Capital has become more mobile across
national boundaries as nations are increasingly
relying on savings of other nations to supplement
the domestic savings .
Technological developments in electronic
payment and communication systems have
substantially reduced the arbitrage opportunities
across financial centres, thereby aiding the cross
border mobility of funds.
• India, too, has taken a large number of measures in the
process of financial liberalization during the 1990s. The
overall package of structural reform in India has been
designed to enhance the productivity and efficiency of
the economy as a whole and thereby make the
economy internationally competitive.
• These reforms include, inter alia, partial deregulation of
interest rates; reduction of pre-emption of resources from
banks through cash reserve ratio (CRR) and statutory
liquidity ratio (SLR); issue of government securities at
market related rates; increasing reliance on the indirect
method of monetary control; participation of the same set
of players in the alternative markets; move towards
universal banking; development of secondary markets for
several investments; repeal of foreign exchange regulation
act (FERA); full convertibility of rupee on the current
account; cross-border movement of capital and adoption of
liberal exchange rate policies that assure flexible exchange
rates; and investors’ protection and curbing of speculative
activities through wide ranging reforms in the capital market
IMPORTANCE OF MARKET
Efficient and integrated financial markets constitute an
important vehicle for promoting domestic savings,
investment and consequently economic growth.
Financial market integration fosters the necessary
condition for a country’s financial sector to emerge as an
international or a regional financial centre.
Financial market integration, by enhancing competition
and efficiency of intermediaries in their operations and
allocation of resources, contributes to financial stability.
Integrated markets lead to innovations and cost
effective intermediation thereby improving access to
financial services for members of the public,
institutions and companies.
Integrated financial markets induce market discipline and
Market integration promotes the adoption of modern
technology and payment systems to achieve cost effective
financial intermediation services.
Technology, Payment and
The Delivery-versus-Payment system (DvP), the Negotiated Dealing System
(NDS) and subsequently, the advanced Negotiated Dealing System –
Order Matching (NDS-OM)trading module and the real time gross settlement
system(RTGS) have brought about immense benefits in facilitating
transactions and improving the settlement process, which have helped in the
integration of markets. In the equity market, the floor-based open outcry
trading system was replaced by electronic trading system in all the
Institutions such as Discount and Finance House of India (DFHI), Securities
Trading Corporation of India (STCI) and PDs were allowed to participate in
more than one market, thus strengthening the market inter-linkages. The
Clearing Corporation of India Ltd. (CCIL) was set up to act as a central
counter-party to all trades involving foreign exchange, government
securities and other debt instruments routed through it and to
guarantee their settlement.
• Repurchase agreement (repo) was introduced as a tool of short term
liquidity adjustment. The liquidity adjustment facility (LAF) is open to banks
and primary dealers. The LAF has emerged as a tool for both liquidity
management and also signaling device for interest rates in the overnight
market. Several new financial instruments such as inter-bank participation
certificates (1988), certificates of deposit (June 1989), commercial paper
(January1990) and repos (December 1992) were introduced. Collateralized
borrowing and lending obligation (CBLO) and market repos have also
emerged as money market instruments.
• New auction-based instruments were introduced for 364-day, 182-day, 91-
day and 14-day Treasury Bills, the zero coupon bond and government of
India dated securities. In the long-term segment, Floating Rate Bonds
(FRBs) benchmarked to the 364-day Treasury Bills yields and a 10-year
loan with embedded call and put options exercisable on or after 5 years
from the date of issue were introduced.
• Derivative products such as forward rate agreements and interest rate
swaps were introduced in July 1999 to enable banks, FIs and PDs to hedge
interest rate risks. A rupee-foreign currency swap market was developed.
ADs in the foreign exchange market were permitted to use cross-currency
options, interest rate and currency swaps, caps/collars and forward rate
agreements (FRAs) in the international foreign exchange market, thereby
facilitating the deepening of the market and enabling participants to diversify
Enhanced presence of foreign banks, in line
with India’s commitment to the World Trade
Organization under GATS, strengthened
domestic and international markets inter-
linkages, apart from increasing competition.
Foreign Institutional Investors (FIIs) were
allowed to participate in the Indian equity
market and set up 100 per cent debt funds to
invest in government (Central and State)
dated securities in both the primary and
Exporters also have the ability to substitute
rupee credit for foreign currency credit.
Indian companies were permitted to raise
resources from abroad, through American/Global
Depository Receipts (ADRs/ GDRs), foreign
currency convertible bonds (FCCBs) and external
commercial borrowings (ECBs), thus, facilitating
integration of domestic capital market with
international capital market.
Corporate are allowed to undertake active hedging
operations by resorting to cancellation and
rebooking of forward contracts , using foreign
currency options and forwards, and accessing
foreign currency-rupee swap to manage longer-
term exposures arising out of external commercial
Integration of the credit market and the equity
market was strengthened by application of capital
adequacy norms and allowing public sector banks
to raise capital from the equity market up to 49 per
cent of their paid-up capital.
Free pricing in financial markets was
facilitated by various measures. These
include, inter alia, freedom to banks to decide
interest rate on deposits and credit;
withdrawal of a ceiling of 10per cent on call
money rate imposed by the Indian Banks’.
Association in 1989; replacement of
administered interest rates on government
securities by an auction system; shift in the
exchange rate regime from a single currency
fixed-exchange rate system to a market-
determined floating exchange rate regime
and to use derivative products for hedging
Stock Market Integration
The Indian stock market is considered to be one of the
earliest in Asia, which is in operation since 1875. However,
it remained largely outside the global integration process
until 1991. A number of developing countries in association
with the International Finance Corporation and the World
Bank took steps to establish and revitalize their stock
markets as an effective way of mobilizing and allocation of
funds. In line with the global trend, reform of the Indian
stock market also started with the establishment of
Securities and Exchange Board of India (SEBI), although it
became more effective after the stock market scam in
With the establishment of SEBI and technological
advancement Indian stock market has now reached
the global standard. The major indicators of stock
market development show that significant
development has taken in the Indian stock market
during the post-reform period. The introduction of
NEW ECONOMIC POLICY in 1991 i.e. liberalisation
and globalisation policies have led to the integration
of Indian stock markets with the developed stock
markets i.e. USA, UK and Hong Kong stock markets
and Indian stock markets are sensitive to the
dynamics in these markets in a long run.
The nature and extent of equity market integration is
of importance for corporate managers as it
influences the cost of capital, and for investors as it
influences international asset allocation and
diversification benefits. The studies finds that the
Indian stock market (BSE Sensex) is not co-
integrated with the developed markets and hence
not sensitive to the dynamics in these markets in the
Government Securities Market
• The Government Securities Market is at the core of financial
markets in most countries. It deals with tradable debt
instruments issued by the government for meeting its financing
• A Government security is a tradable security issued by the Central
Government or the State Governments, acknowledging the
Government’s debt obligation. Government securities carry practically
no risk of default and, hence, are called risk-free instruments.
Importance of Government Securities Market:
• The development of the primary segment of this market enables the
managers of public debt to raise resources from the market in a cost
effective manner with due recognition to associated risks.
• A vibrant secondary segment of the government securities market
helps in the effective operation of monetary policy through
application of indirect instruments such as open market
operations, for which government securities act as collateral.
• The existence of an efficient government securities market is seen as
an essential precursor, in particular, for development of the corporate
Integration of credit markets
• Credit markets have, historically, played a crucial role in sustaining
growth in almost all countries, including advanced countries, which now
have fully developed capital markets.
• Credit markets perform the critical function of intermediation of
funds between savers and investors and improve the allocative
efficiency of resources. Banks, which are major players in the
credit market, play an important role in providing various financial
services and products, including hedging of risks.
• Credit markets also play a key role in the monetary transmission
• Credit institutions range from well-developed and large sized
commercial banks to development finance institutions (DFIs) to
localised tiny co-operatives. Also, the integration have been similar to
that of government securities.
Foreign Exchange Market
• The foreign exchange market (forex, FX, or currency market)
is a form of exchange for the global decentralized trading of
international currencies. The foreign exchange market
determines the relative values of different currencies.
• Globally, operations in the foreign exchange market started in a
major way after the breakdown of the Bretton Woods system in
1971, which also marked the beginning of floating exchange rate
regimes in several countries. Over the years, the foreign
exchange market has emerged as the largest market in the
• The origin of the foreign exchange market in India could be
traced to the year 1978 when banks in India were permitted to
undertake intra-day trade in foreign exchange. However, it was
in the 1990s that the Indian foreign exchange market witnessed
major changes in the currency regime. The exchange rate of
rupee was floated fully in the year 1993.