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Functions of finance


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Functions of finance

  1. 1. Siddharth Kumar Sahil Sankhla Akshay Kumar Nikhil
  2. 2. 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.
  3. 3. 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
  4. 4. (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 the organization 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
  5. 5. 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
  6. 6. Short-term Investment Decisions:  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.
  7. 7. (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.
  8. 8. • 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 or increased.
  9. 9. Example: Total investment: Rs. 1,00,000 Return 15%. 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.
  10. 10. (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 payments. • 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
  11. 11.  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.
  12. 12. (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 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, severely.
  13. 13. • 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.
  14. 14. 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.
  15. 15. 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 19th century.
  16. 16.  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 thereof. ◦ Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof. • Commodity markets, which facilitate the trading of commodities. • Money markets, which provide short term debt financing and investment. • 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 various risks.
  17. 17. 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 16.6%.
  18. 18. BSE 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.
  19. 19. OTCEI 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 investors. 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
  20. 20. SEBI 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
  21. 21. Integration of Financial Markets • 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 markets. • 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 location. • 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,
  22. 22.  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 market integration.  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.
  23. 23. • 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
  24. 24. IMPORTANCE OF MARKET INTEGRATION  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 informational efficiency.  Market integration promotes the adoption of modern technology and payment systems to achieve cost effective financial intermediation services.
  26. 26. Technology, Payment and Settlement Infrastructure 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 stock exchanges. Institutional Measures 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.
  27. 27. New Instruments • 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
  28. 28. Widening Participation  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 secondary markets.  Exporters also have the ability to substitute rupee credit for foreign currency credit.
  29. 29.  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 borrowings.  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.
  30. 30. Free Pricing  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 risk.
  31. 31. Segment Wise Integration of Financial Markets
  32. 32. 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 1991.
  33. 33.  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 long run.
  34. 34. 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 requirements. • 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 debt market.
  35. 35. 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 mechanism. • 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.
  36. 36. 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 world. • 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.