Chapter 1

Chapter 1: An Overview of Financial Management
And Its Applied Fields
Learning Objectives
Students will be able to acquire the following concepts from this chapter.
 The sophisticated financial management techniques have been applied to estimate the
intrinsic value of firm those maximize the wealth of its.
 The understanding of the different internal and external sources of financing and its
features those are suitable as per the requirement of different firms.
 It has been discussed on the different types of investment including derivatives and its
features those are available and suitable for different investors.
 The different goals, principles and functions of Finance have been stated in this chapter.
It also has been stated the determinants of financial decision.
 The role and activities of financial market as well as the securitization and trading process
those have been discussed categorically in this chapter.
 The activities of stock exchanges and their environmental has been stated properly.
 About the capital flow from fund providers and to its users has been discussed properly.
 It has been discussed how is to measure the intrinsic value of various types of firm.
 Regarding securities and its papers that is associated with finance and business.
 It has been discussed about the securities and activities of International trade.
 The agency costs and its problem can be managed by taken various measures.
 About the features and role of bank advances with associated securities.
 The real rate of interest and nominal rate of interest with associated risk have been
mentioned that occurs due to the time value of money.
 Regarding the gradual evolution steps of financial management.
Key Financial Terms
Financial market, money market, capital market, primary market, secondary market, efficient
market, factoring, trade credit, over draft, collateral securities, lien, pledge, hypothecation,
mortgage, promissory notes, bill of exchange, letter of credit, revolving letter of credit, circular
letter of credit, bill of lading, bill of entry, caused bill of lading, bills for collection, mates receipt,
charter party, airway bill, manifest, ACU, peg, anticipatory credit, barter, treasury bill,
commercial paper, future contracts, options (put, call, and leaps), warrants, opened-end mutual
fund, close-end mutual fund, real rate of interest, nominal rate of interest.
1.01 Introduction
All the financial management related topics and terms have been introduced through this chapter
in which has been given the emphasis on the basic core topics and the overview of those core
topics are important even essential for the solid fundamental knowledge of students. Major topics
have been discussed sometimes in details with the analytical presentation and others are taken
like sketch to demonstrate its meaning for well understanding as the essential learning material
of students. Here we can mention the comment of renowned professor Lawrence J. Gitman on
Finance “Finance is the science and art of managing money.” It is concerned with the transaction
with its instruments among firms, institutions and market and those instruments create the benefit
for the individual, business and government.” In Finance there exist two major
Financial Management – Text and Cases Page no: 1

Part 1: Fundamental Concepts and Strategies of Corporate Finance
areas- the Public Finance or Government Finance and Private Finance. International Finance is
also a source of finance that is related and available to both Public and Private Finance. In this
text book we are concerned only with the Private Finance that generally is known as Finance.
Finance manager is to keep the main role in financial management, so all types of financial
activities are perfectly done by Finance manager to achieve the goal of wealth maximization of
firm. He is entitled with the responsibilities of three major financial decisions those are the
investment decision, financing decision and dividend decision. First of all, the investment
decision is taken by management for which the required funds are to estimate for the investment
which is adopted. Thereafter the next step of finance manager is to select the sources of financing
from the equity capital and debt capital where the total cost of financing is minimized. Another
activity of finance manager is to distribute the dividends to its owner if the rate of return from the
reinvestment is less than the market return.
Among all financial decisions Finance manager should concentrate and emphasize more on
the continuous cash generation that depends the selling activity of firm to maintain the intrinsic
value of it and along with the increasing cash growth rate so that it can achieve its goal. Finance
manager can create the cash generation by directing his usual activity along with an important
activity that is the linkage with different departments. As a result the value is added in several
ways such as customers would be satisfied with the quality product or service at reasonable price
and for the development activities of society get increased the purchasing power of their that
ultimately helps to enhance the cash stream of firm, suppliers would be encouraged with the on
time payment that tends to maintaining the supply chain of goods that leads to increasing cash
flow, the core talented employees would be retained in firm with the attractive benefited
compensation package those ultimately involve to fulfill the target of wealth maximization.
Finance manager also can increase the cash generation through the proper distribution of funds
to each department so that manager of human resource department can operate the training
program to increase productivity, the most important part is that the manager of well-established
research and development department can invent continuous improved products those would be
for the prospective customers oriented to advance from its competitors, manager of production
department can diversify through starting new more product lines, manager of supply chain and
logistic department can reduce inventory by proper timely distribution of goods, manager of
marketing department can increase the sales of goods by using all of the marketing tools with the
financial support of Finance manager.
According to the survey of the World Street Journal, the Microsoft, Google, Apple, Procter
and Gamble, Toyota, Johnson and Johnson, General Electric, Face book etc. have been
dominating for couple of years as the average annual return of those companies are almost two
times than average industry return that indicate these companies have been succeed for
contributing some intuitive merits – innovativeness, invention, diversification, quality product,
talent management, those are keeping them the world leading position. An illustration we can
mention that, Apple has revived its position through the invention of the touch screen i-phone
with unique application features more than the smart phone of Black Berry competitors from the
deteriorating condition of its. Again with the ‘Android’ application feature of the smart phones
of Samsung are still dominating over the Apple’s i phone and that will continue to next some
periods. But it is not the end scenario as the competitors companies would sustain their effort for
better product to customers than earlier through their research and development department.
These companies introduced, although during recession, the quality products to customers but
they usually followed the cost cutting rules for reducing cash generation and along with their
research and development department were continuously adding unique features to its products
till now, since around the world, the innovative products have the large market that ultimately
increased the cash flow of those companies. Thus these companies have been enabled to sustain
the increasing growth rates that tend to leading position across the world.
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Chapter 1: An Overview of Financial Management and its Applied Fields
We can enter into realize now, in the light of the above discussion, the financial decisions are
the key decisions those are related to all activities of firm that gives the expected return to firm.
Again it is universally said that Finance is the act of providing means for anything done. Some
renowned professors depicted the Finance precisely as such that are noted below.
 According to E.W. Walker finance is the “activities of a business relevant of financial
planning, coordinating, control and their application is called finance.”
 Schally and Halley have defined finance as under, “Finance is a body of fact, principles and
theories dealing with raising and using of money by individual, business and government.”
 Definition of finance developed by Ross Waterfield and Rattle say, “Finance is the study of
markets and investments that deals with cash flows over time.”
1.02 Sources of Finance
Finance of a firm means the providing or sourcing of money for investment in the form of fixed
assets and working capital for day to day requirement. Availability of finance is vital importance
to firm but securing it from the diverse sources is more important.
One of the sourcing method for the financing for firm is to seek the basic sources. These are
(1) internal source and (2) external source. Corporate firm’s the external sources of finance may
be further classified according to the ownership and debt criteria such as owned capital and debt
capital or borrowed capital.
1. Internal Sources of Finance: Internal finance sometime called self-financing “Simply refer
to what the firm earns and subsequently back in business”. Internal financing have two main
components – (1) retained earnings (2) depreciation provision.
 Retained earnings: Firm that is operated at well profit kept a portion of net profit as retained
earnings. Such retained profits represent a source of finance to firm. There is an inverse
relation between the requirements of finance from retained earnings and external sources.
Increase of retained earnings sources decrease the requirement from external source in form
of the debt equity etc. But the desirability of retaining more profit will decrease the rate of
dividend that ultimately will create the impact on the market value of shares and other factors.
Earnings which are retained with firm and shown in profit and loss account that consist of the
(a) provision of tax (b) general reserve (c) proposed dividend (d) compensation fund (e)
pension fund (f) sinking fund (g) credit balance of profit & loss account (h) provident fund
(i) accrued expenses (j) provision for bad & doubtful debt (k) fund earned from sale of excess
fixed assets etc.
 Depreciation provision: In explicit term the depreciation charged on fixed assets is not the
cash outflow of the particular financial year. The portion of sales revenue representing as the
depreciation charge that earned and realized is in fact a capital recovery in current year of the
invested capital of prior years. Recovery of capital in the form of depreciation charge included
in the cost of goods sold and realized through sales revenue is a source of finance.
2. External sources of finance: R. Westerfield and Jordan define external sources of finance in
the following word: ‘External financing refers to funds raised by either borrowing money or
selling stock’. External sources of finance are mainly obtained from following two sources. (1)
Individual or house hold fund. (2) Firms and financial institution.
 Individual or house hold fund: The individual investors should ponder on the saving decision,
investment decision, financing decision and risk management decision.
 Firms and financial institution fund: Firms have to ponder on its capital budgeting decision
for fixed assets from equity and debt capital, the capital structure or sources of capital
decision, dividend decision, working capital decision as well as risk management decision.

1.03 Institutional and Non Institutional Sources of Finance
The raising of fund from external sources are classified in addition to prior classification such as
(i) Institutional and (ii) Non institutional sources. These both types of financing sources are stated
in next that having the different terms and conditions.
Institutional Sources of Finance: Institutional sources of finance are raised as a long term loan for
capital expenditure and short term loan are raised for working capital that keep the working
process continuous (day to day operation of business).
Required loans are raised from institutional sources those are (a) commercial bank (b)
investment institution such as investment corporation (c) development financing institution such
as NIT (d) insurance company act as underwriting agent when primary shares are issued.
Moreover it also invests in shares and debentures of companies (e) capital market (f) educational
institution (g) specialized bank such as agriculture development bank, industrial development
bank, house building finance corporation (h) cottage and small industries etc.
Non Institutional Sources of Finance: Non institutional sources of finance include with the
documents those are noted below.
 Promissory note: Promissory note is an instrument issued by the borrower to the lender
promising to pay (repay) the borrowed amount and any amount accrued as per term of
contract. Promissory notes are also known as commercial paper. It is a short term unsecured
instrument with a fixed maturity that including such the usance promissory notes.
 Bill of exchange: It is an unconditional order signed by a specified person known as drawer
to pay the particular sum of money (fixed) to the drawee (payee). The order is unconditional
and is not revocable. The note requires the acceptance of the payee or endorsee.
 Debenture: Debentures are unsecured bonds issued generally by a firm for the good reputation
in market. In case of debt is promised to pay the installment of it by the issuer. All convertible
bonds are normally debentures. Investment of bank in the government approved debenture is
considered as part of the liquid asset of bank.
 Account receivable: Receivable are the asset of a firm representing the amounts of fund owed
to firm by customer from the sales of goods or services in the ordinary course of business. It
is an open account in the sense that no formal acknowledgement of debt is required. It is used
as a marketing tool. As such credit aims at (1) achieving growth in sales and profit and (2)
meeting competition.
 Outstanding expenses: Outstanding expenses are the expenses of firm are not paid to the
party. The reserved by holding such expenses become the part of the fund of firm.
 Trade credit: Trade credit is the part of spontaneous financing. Firms allow the trade credit
for increasing the sales of goods. Purchase do not require cash at the time of purchase of
goods but have to pay within net period which may be 30 days or more known as net days.
But if he pays the amount before the ‘net day’ then he will get a discount.
 Factoring: Factoring is the selling of firm’s receivable that created due to the credit sales for
goods at a discounted price to the ‘factor’ for meeting the immediate requirement of cash.
The process saves the expenses of firm on account of credit administration and the risk of
new unrecoverable debts completely diminishes.
 Mortgage: There have been existed in two ways of charging on freehold property such (1)
legal mortgage and (2) equitable mortgage. When the legal estate or property is transferred to
the mortgagee, the mortgagor retains the possession of it and has the right to have the lease
extinguished up on the full payment of debt including cost. The charge is created on signing
the mortgage deed duly registered with the registrar. Equitable mortgage is created up on
signing of memorandum that expressing the desire of creating a charge over the property and
depositing the documents related to the estate or property to cover the debt. Here mortgage
get merely an equitable interest but not like legal mortgage.

1.04 Financial Markets and Their Functions
We understand by the financial market term either an organized institutional structure or a
mechanism for creating and exchanging the financial assets. Bank, insurance companies are such
institutional structure where demander of the fund can transact directly without the knowledge of
the depositor of funds. But suppliers of the funds in financial market can know where their funds
are being invested. The two key financial markets are (1) Money Market (2)
Capital Market.
1. Money Market: We mean the money market is the market which transacts the short term
securities or debt instruments which is less than one year, marketable securities, treasury bills,
commercial papers like negotiable certificates of deposits those issued by government, business
organization and financial institutions. For example, in case of banks the cheques and letter of
credit, in case of business the promissory notes and bills of exchange and the government bonds
and treasury bills are also traded in money market. But in case the long term debts instrument of
financial institution that associated with more than one year that given for the real estate,
commercial, industrial, agriculture is literally regarded as mortgage market and for personal needs
then is known as consumer credit market. Similarly the debit and credit card of financial
institution fulfills the personal need that is called debit card market and credit card market.
2. Capital Market: Capital market is involved in trading on long term securities like the stock,
bond, debenture etc. Capital market is of two types such the (a) Primary market and (b) Secondary
market.
 Primary market: All securities are initially issued in the primary market. It is the only market
in which corporate bodies and government can directly issue and get benefit of issuance. The
firms can raise fund either directly by private placement or by public offering. By private
placement we mean sale of new stocks, securities of a firm is sold by direct approach to bank,
insurance company and pension fund owner.
This sale of securities by direct approach is known as sale in primary market. Other ways of
raising fund by the initial public offerings (IPO) where banks insurance companies are
involved in sale under an agreement of underwriting that specify them to work as agent for
the sales of stock and also to purchase the unsold stock by them. This activity of sales is
performed in the primary market. So all new stocks are traded in primary markets that sell
the stocks, bond, and debenture directly to the purchaser such as banks, insurance company
or pension fund owner or by public (individual), The sales are conducted by bank and or
insurance company under an agreement of underwriting whereby these body undertake to sell
the stocks and to purchase the unsold stocks by them.
 Secondary market: All securities are transacted first time in the primary market thereafter all
securities have been transacting in the secondary market and operated as per stock exchanges
commission’s act about the secondary market. Trading of stocks are directly transacted in the
secondary market of stock exchange. But some business organization such the mutual trust,
investment corporations and merchant banks of the banking wing are also the part of trading
and help trading indirectly in secondary market. Seasoned securities are also traded in the
secondary market. Securities exchange commission is the regulatory body that governs the
sales and listing of securities.
There are existed several kinds of secondary markets such the deal market, auction market,
spot market, future market. Dealer markets are known as over-the-counter (OTC) market
where the securities cannot fulfill the rigorous listing requirement of security exchange
commission that can be listed and traded in OTC market and dealers buy and sell for
themselves at their own risk means these are caused the major financial problem and less
liquid. In contrast, the auction market where brokers and agents act as a media for purchasing
or selling for their clients. Similarly again while the securities or assets of

capital market are transacted at specified price ‘on the spot’ or specified future date then it is
respectively known as spot market or future market.
Besides these capital markets, some more capital markets are existed on the basis of scope
and size that depends on the security registration with the market and participant clients such
while the local clients of particular city participate in the transaction of securities those are
registered with the market then it is called local market. Again if the clients of an entire
country participate in the transaction of securities those are registered with the market then it
is called national market. The clients of some regional countries are engaged in the transaction
of securities those are registered with the market then it is called regional market for example
the Hong Kong Stock Exchange. Similarly, if the clients of all over the world are involved in
the transaction of securities those are registered with the market then it is called world market
for example the New York Stock Exchange is the largest capitalism.
In different country the authority of stock exchange commission (SEC) usually categorized
the stocks in various groups such as Group A. This group of securities maintain the annual
meeting on time, paid dividend 8% over but vary in different country and the settlement cycle
of trading T+1, T=3. The securities of Group B maintain the annual meeting on time, paid
dividend less than 8% but vary in different country and the settlement cycle of trading T+1and
T+3. The securities of Group G are not in commercial operation and the settlement cycle of
trading T=1 and T=3. All newly listed securities are included in Group N and remain in this
group up to next AGM and the settlement cycle of trading T+1 and T+3. The securities of
Group Z did not pay any dividend, AGM defaulter and the settlement cycle of trading T+3
and T+7. In case of short selling of securities the above settlement cycle of trading is not
applicable due to the transaction and payments occur within the day. The authority of stock
exchange can also applied the circuit breaker to control the price of securities at limit level
i.e. the price of security remains from minimum price to maximum price otherwise the trading
would be stopped and generally higher limit for the low price securities and lower limit for
the higher price securities.
Capital Market Efficiency
The efficiency of financial market depends on the concept of efficient market hypothesis (EMH).
These hypothesis are the weak-form EMH, the semi strong -form EMH and the strong-form EMH.
The weak-form market is the financial market where all information are available that related to
only past information and private information, the semi strong-form market is the financial market
where all past and present information and private information are available to all and the strong-
form market is the financial market where all information reflect with the past, present and
futuristic information along with public published information. Some more the following issues
fulfill the efficient financial market criteria.
 The market is filled with many individual investors.
 The market is open to all with same information.
 Securities that traded in the market have good demand with the equal opportunity for all.
 The market is without taxes and transaction cost where investors are rational.
 Investors are always risk averse and expect the higher return that including lower risk.
Investor can get the information about the ability of firm to repay the credit of it’s from the report
of credit rating agency. The credit rating agency categorized the credit rating report such AAA,
AA, A, BBB, BB, and B so forth to D. Here the firm the credit rating is AAA which indicates the
ability of repay the credit is the most than other firms and the firm the credit rating is D which
indicates the ability of repay the credit is the least than other firms. The reputed credit rating
agencies of world are the Standard & Poor, Moody and Fitch.

1.05 Reasons of Securitization with Financial Market
The privilege of financial market has enormous. Firstly the different types of financial products
are created and registered with financial market for engaging more investors such the requirement
of investors who invests its funds in stocks or bond or debenture or mutual fund or other securities
for short term period and gets benefited from the price appreciation of stocks but while investor
invests the fund for long term period then gets benefited both from the capital gain and cash or
stock dividend. In case capital gain tax is less than the tax of cash dividend then investors would
be interested to get stock dividend rather than cash dividend. Besides this in case of cash dividend
investors are to incur the double taxation-firstly the corporate taxation and secondly the tax is
imposed on individual who gets cash dividend.
The target of acquiring a large amount of funds by attracting more investors, many firms issue
two types of share within which the A class share only pay cash dividend to shareholder and the
B class share only pay stock dividend which is equivalent to cash dividend to shareholder and
having option where the B class share can be converted into the A class share. So investor can
convert the additional share into cash by selling it. Again the investors who earn the large amounts
from the investment of shares fall under the higher rated tax level and prefer stock dividend rather
than cash dividend whereas the investors who earn small amounts from investing shares those fall
under the lower rated tax level and prefer cash dividend rather than stock dividend.
Secondly, the companies are listed with the capital market for using it as a plat form of buying
or selling its share at lowest transaction cost and time. Each share and bond is securitized with
financial market in small form of unit so that all types of investors can purchase share or bond as
per their requirement. Thirdly the financial market acts as a bridge among investors, so through
perfect competition the price of securities and its return are determined at an equilibrium point.
Fourthly, the reputed firms can raise the large amount of fund by issuing stock through financial
market for large production and accordingly can lend the large amount of debts by issuing bonds
or debenture or from financial institution too.
1.06 Activities and Trading Process of Financial Market
In United State the market of securities are regulated by the Federal laws, different rules of SEC
(security exchange commission) which is quasi-judicial body that is independent and different
regulations of SRO (self-regulated organization) which is well known as stock exchange such the
New York stock exchange, American stock exchange (AMEX), Nasdaq stock market. These
different stocks exchanges are entitled to formulating their own rules and regulations for directing
its members and protecting the interest of investors. The stock exchanges are under the direct
control and supervision of SEC (Security exchange commission) was created in 1934 by US
Congress and can execute the rules and regulations after getting the approval from SEC. SEC has
the authority for all types of new public issue such stock, preferred stock, bonds, debenture, right
share issue etc., so these new issues are registered with SEC.
Stock exchanges provide the physical market place through its members such the brokerage
houses, investment bankers, merchant bankers for engaging the large number of participant
investors for purchasing or selling long term securities. These brokerage firms of Stock exchanges
also facilitate the transaction of securities all over the country by two ways such the automated
trading system that is computerized electronic trading system which facilitate some cases (1) time
savings (2) cost savings (3) errorless trading (4) without paper transaction (5) the large number
of investors all over the world (individual investors, institutional investors, corporate investors
can participate at a time even without physical appearance such over telephone. Other type is the
floor trading system like auction which is almost abandoned now.
The brokerage firms offered the different types of services on the basis of which the

brokerage firms are called full service brokers, discount brokers and on line discount brokers. Full
service brokers serve investors with the transaction of securities along with all types of
information regarding securities, market, industry even economy etc. but the discount brokers
only provide the transaction facilities through the physical trading or electronic communications
networks (ECNs) at the less percentage per security than full service brokers. Another kind of
brokers is the on line discount brokers render service through internet instead of physical house
trading facilities but less charged is imposed on per security than others brokers.
All types of investors can start trading in secondary market through opening a BO account to
any brokerage house that is the identity of particular investor and all transactions are filed and
recorded in this account. Again different types of brokerage accounts are existed to facilitate
investors such the cash account where investors are to pay against purchasing securities in cash,
in margin account where the payment of securities are made by own fund along with the
borrowing money from brokerage firms with additional interest charged, in warp account brokers
finance to investors from outside and take charge for it.
Investors can place a market order among different types of orders where the buying or selling
of securities at best price available according to market during trading through brokerage house,
but in limit order where the purchasing of securities are placed at a specified price or less and the
selling of securities are placed at a specified price or more. In stop loss order the price falls to a
particular level then the selling of security is stopped. Investor can place the day order which is
sustained up to the particular date and investor can also place a good order till cancellation order
that is valid up to cancellation.
Market index is the indicator where the prices of all securities at the specified date have been
increased with the previous date or not. Some world renowned indexes are Dow Jones (NYSE),
CAC (Paris), NIKKON (Japan) etc. There may be index which based on the equity specific index
or sector specific index.
Current Index =
Yesterday′s closing index × Current market capitalization
Opening market capitalization
Stock exchange category the securities of firms that followed and maintained the regular stable
and good dividend rate is A category security and relatively the firm given less dividend than A
category security is the B category security. Investor purchases securities which are mature after
few days as per rule of stock exchange that means the securities can be sold after maturity and
the maturity days are different for different class of securities. But the short selling transactions
take place within the day.
1.07 Stock Exchanges and its Environment
The worldwide stock exchanges were usually grown and built up at the city which is the most
business oriented. The world reputed stock exchanges are the New York stock exchange,
NASDAQ, American stock exchange, Tokyo stock exchange, Hong Kong stock exchange. The
relation among the different stock exchanges is competitive for getting more business by
involving more investors, securities and also members. Besides the stock exchange can take over
other stock exchange to get benefited and keep the control over capital market. We would discuss
here regarding the New York Stock Exchange for recognizing the overall situation of stock
market. The New York stock Exchange has now become the highest capitalism which is $13
trillion that is much more than other stock exchange. The members of NYSE are over 300 and the
price of membership is about $4 millions. New York Stock Exchange was started in 1972 and
gradually has been at the center of American capitalism due to most of the American investors
and capitalist existing in New York. The New York Stock Exchange (NYSE) was merged in 2006
with Archipelago (electronics communication network) and next the Pacific Exchange was also
acquired that entitled as The NYSE Group, Inc. Again in 2007 the NYSE

Group merged with Euronext and the merged company started to operate the trading of securities
through the stock exchanges those branches are located in Brussels, Paris and Amsterdam. Later
it has been shaped as a world leading stock exchange, according to Reuters, when in 2012 the
Intercontinental Exchange Inc's (ICE) has been taken over of the NYSE at$10.9 billion and ICE
got the control about Liffe which was renowned European derivatives market. ICE kept some
parts of NYSE and divested some parts to cut the major expenses from the merged company. ICE
also planned to spin off Euronext, which includes the Paris, Amsterdam, Brussels and Lisbon
stock exchanges, in an IPO likely sometime next year. NYSE, have the problems those cannot
adjust with the rapid advances of technology, fragmentation and also its regulation. He has also
taken to keep the open floor trading of the New York Stock Exchange.
The NYSE now through the program of the Big Start Up has been undertaken by the NYSE
Euronext (NYX) in collaboration with Accion, Entrepreneurs Organization (EO) to create more
jobs that has been designed to connect the small companies and new entrepreneurs with corporate
America. Under this program the corporate community will render the lending support,
experience and resources to startups and small companies to improve procurement, networking,
business development, training, marketing and information sharing. Yelp, LinkedIn and
Microsoft are among the first corporations to participate in this endeavor. A microfinance
program with information and events that called the Accion NYSE Job Growth Fund, started with
a $1.5 million commitment by NYSE Euronext that will provide small businesses and startups
with the capital and support. The program helps to promote the increased demand for goods and
services that these growing companies need by contributing knowledge, expertise and funding.
This will occur while the established companies can direct their purchasing power to small
companies. (Source: New York Stock Exchange)
1.08 Financial Institutions
Financial institution is an intermediary that accumulates the surplus money of the individual,
business organization including government body for investing in business and industry that helps
for producing the goods and services. Among financial institutions, different types of banks,
general and life insurance companies, mutual fund operators, investment corporations are the
most significant financial institutions and play a vital role in financial market.
1. General insurance and life insurance companies: It purchases the shares or debentures of firm
that contribute to the long term needs of firm. Besides these insurance companies perform the
underwriting jobs for firm while shares are issued in the primary market.
2. Mutual fund trust: It is one of the most important financial institutions in countries of the
subcontinent is established by government initiative. At present the mutual trust fund bodies have
become a strong contributor of the funds for firms. Actually it creates a balanced portfolio of
investment in securities of diverse types and gives higher yield to its unit holders.
3. Investment Corporation: Investment Corporation is also created by the initiative of government
and act almost like the mutual trust. The corporation directly subscribes or purchase shares from
the primary and secondary market by itself through opening the BO account of its client and act
like merchant bank. But the important job that is performed by the investment corporation is its
own mutual unit issued against the securities of portfolio created by diverse shares. The
accumulated funds are the important source of finance for firm or industry.
4. Various other corporations: These types of corporations are created for financing. In India and
other countries of subcontinent, various corporations have been created for the promotion of
business and development of industry. These are the industrial development corporation,
industrial credit and Investment Corporation, industrial development bank and others. These

institutions grant the loan for the long term period or subscribe or purchase or underwrite the issue
of stocks, shares, bonds or debentures.
5. Kinds of Bank: There are mainly existed two types of bank such the (1) commercial bank and
(2) specialized banks. Commercial bank is a corporate body performs the function of accepting
the deposit from individuals, business organization etc. It advances these deposits to the business
organization. Apart from the functions described above banks also perform various functions
those include the collection of bills, clearing cheques through clearing house, issue guarantee
against security.
 Under operating international trade, banks help in export and import by issuing the letter of
credit and collecting the proceeds of the exporting bills.
 Bank is one of the most important sources of short term credit.
 Now a day the function of bank has been flourished at the every nook and corner of country
for serving the various services those are being rendered to the various social community.
 It is also an important constituent of money market.
 Commercial bank lends the short term loan to the business and industry for their working
capital in the form of loan, overdraft and cash credit.
2. Specialized Banks: (1) Industrial Development Bank is a specialized bank usually advances
the long term fund for the fixed assets of firm such as land, building, machinery and working
capital. (2) Agricultural Development Bank is also a specialized bank that advances the long term
loan for the farm development and mechanization of agriculture. It also advances for the crop
loan as well as other sectors of agriculture such as the animal husbandry, horticulture, poultry and
the manufacturing of fertilizer, foods of animal and poultry.
3. Industrial Development Bank: Its main functions are mentioned as under.
 Industrial development bank grants the long term loan for the establishment of industry and
also provides the short term working capital.
 It subscribes to purchase or underwrite the issue of stocks, share, bonds and debentures.
 It also grants the deferred payment due from industrial concerns, loan raised by them in open
market or from commercial banks.
 The banks accept, discount or rediscount the commercial bills, promissory note of industry.
 It refinance in following cases. (i) It grants the term loans to industrial enterprises that
repayable between 3 year and over by other statutory organization (ii) It also refinances the
term loan that is financed by commercial bank with repayable period up to 10 years. (iii) It
also refinances the export credit that mature within 6 months or more
1.09 Objectives of Finance
A closer look at the definition of finance reveals the following objectives of finance where some
opinion mainly the profit maximization and others support the wealth maximization.
 Identification of source of fund: Since the wealth maximization is the goal of a firm, so it is
important to identify the sources of fund that are less costly and its maximized utilization can
maximize the wealth of the firm. Such fund may be available from the internal as well as
external sources. Different types of funds such as own fund, debt and other sources may also
be mixed with the funds but the best utilization of these funds require the planning and
appropriate decision as well as the planning of capital structure.
 Fund raising: For achieving the goal of maximizing wealth of firm requires the sufficient
uninterrupted funds. Long term funds are required for the capital expenditure and the short
term funds for working capital of firm that meets day to day requirement for the continuous

production process.
 Investment of fund: Funds of firm should be employed properly on the profit generating
projects that will create the cash flows and ultimately earn the profit of firm. The general
principle in this respect is to invest fund on profitable sector considering risk factor.
 Protection of capital: It is duty of manager to protect funds of firm. So investment in sector
that is costly is to be avoided and funds should be employed on sector that is less risky.
 Profit maximization: Profit maximization is the maximization of the net income of firm. The
concept is not tenable due to the following reasons.
 It does not refer the amount of profit in dollar or others currency and in addition to there
is no proposition regarding the rate of profitability.
 It does not mention the time factor that may be involved in it, whether it is long run profit
or short run profit is not clear. Besides it is unethical to adopt the policy of short run profit
at the cost of long run profit.
 The proposition also does not clear about the risk factor for which firm may face losses
for reducing the value of it.
 Wealth maximization: The concept of wealth maximization of corporate body aims at
maximization of the wealth of owners. It measures the increased market price of stock each
year thereafter the increased cash flow is discounted for associated risk with it.
Net asset increased = [
CF1
(1+r)1
+
CF2
(1+r)2
+
CF3
(1+r)3
+
CF4
(1+r)4
+ ---- +
CFn
(1+r)n
] – initial cash outlay
Where CF = cash flow from stock, r = discount rate or risk associated with cash flow
 Financial managers themself usually involve in the activities those are directed to the
maximization of the wealth of the investors. Return in the form of cash flows and risk are
the important determinants that involve in maximizing the owner’s wealth.
 Earnings per share are considered as the indicator of the stock price of firm so for the
stable earnings and dividend get the due attention of financial managers.
Stock and
Its quantity
Current price
per Stock
Present
Wealth
Price per stock
after 1 year
Total Wealth
after 1 year
Risk adjusted total wealth
at 10% =
𝐶𝐹
(1+𝑟)1
Stock X - 100 $20 $2,000 $25 $2500 $2273
Stock Y - 200 $30 $6,000 $35 $7,000 $6364
Stock Z - 400 $25 $10,000 $30 $12,000 $10909
$18000 $19546
We can get from the above table the wealth will increase = (19546 – 18000) = $1546.
 Maintain the growth rate: Firms usually employ its fund in various investment sectors to
increase its earnings as well as maximize its wealth so as to maintain the increased growth
rate of firm. By the increased growth rate we mean the rise of price of the stock of firm.
1.10 Principles of Finance
Financial activities are regulated by certain principles which are described below.
Principles of net cash flow: Finance prefers the net cash benefit of firm rather than the net profit.
The net cash benefit is determined with adding the net profit to depreciation, reserved fund etc.
and this net cash benefit is the basis of proper firm valuation. Even in this method having the
opportunity of the total cash flow of firm to invest from which firm can be most benefited. This
net cash benefit is discounted to cover risk. For these reasons in finance the cash benefit concept
is appropriate than the net profit concept.

Principle of wealth maximization: In this principle of finance emphasize on the long term profit
rather than short term profit that are related to wealth maximization. For achieving the target of
wealth maximization the total cash flow including depreciation and reserved fund have to be
employed properly so that it can increase the profit of firm. This net cash benefit has to discount
for ensuring the risk free earnings of firm. But in profit maximization policy, the profit of firm
can be more or less as per requirement of firm by creating the reserve fund, increasing or lowering
debts or adopting such method of depreciation. So such principle of wealth maximization gets
preference in finance.
Time value of money: In finance most of the measurement is done with the discounting and
compounding method of time value of money. For example “one dollar of today is better than
two dollar of tomorrow” is the basis of time value of money due to the associated risk and inflation
of two dollars. While taking decision of better option, the two dollars is discounted with risk
factor and converted to present value. In case the converted amount of two dollars is more than
one dollar then two dollar option is better otherwise not.
Principle of suitable financing: The principle of financing is to minimize cost. So the temporary
working capital is financed from short term bank credit but the fixed working capital and fixed
assets is financed by long term debt or stock. Otherwise in one side the excess working capital
increase the cost of financing and other side the payment risk to creditors get increased due to
insufficient working capital as well as cannot meet up the demand of products.
Principle of diversification: The product or project risk can be reduced by investing more than
one product or project. By such diversification the loss of one project can be compensated by
others projects. Again sector risk can be reduced by investing more than one sector rather than
more projects in one sector such as electronic sector, pharmaceutical sector, food sector etc.
Principle of profitability and liquidity: Total current assets or working capital that consists of the
cash on hand or at bank, debtor amount, finished goods etc. and cash on hand or cash at bank is
called liquid asset. So the increase of cash amount reduces the amount of finished goods and
debtors that help the production to contribute more earnings. For this reason the more liquid
amount reduces the profitability and less liquid amount increases profitability. Whence more
liquidity reduces the payment risk to creditors and less liquidity increases the payment risk.
Principle of trade-off between risk and return: As per this principle, the project having more risk
the expected return would be more and the project having less risk the expected return would be
less. So the better project selection decision among projects would be the project that having the
higher returns with comparatively the lower risk.
Optimum capital structure: In optimum capital structure of firm, the debt equity ratio should be
well designed where the earning per share of firm would be more than other debt equity ratio.
Principle of minimum cost of capital: Generally the costs of different financing sources vary, so
we consider such the capital structure where the weighted average cost of capital is minimized
while financing from the different sources.
Principle of adjusting trade credit: The credit policy of firm is determined as per competition
existed in market. But the tight credit policy increases the profit due to more turnovers occurred.
Dividend policy: Optimum dividend policy should be relevant to the wealth maximization of firm.
So firms should follow the lower rated dividend policy in growing stage so that firm can utilize
its retained earnings to increase earnings. While the earnings of firm are in stable stage should
maintained the stable and competitive rated dividend policy otherwise the share price will be
reduced. But when firm in decline stage should follow the aggressive rated dividend policy due
to the return of retained earnings is not possible or less than any existing investment.
Principle of business cycle: The demand of products increases in some particular time during the
year such as festival time and some other times decreases the demand of products. This ups

and down of the demand of product is called business cycle. Similarly the demand of working
capital of firm gets increased or decreased with the increase and decrease of production. Besides
this in economy of a country, the other cycle which remains around some years that affects to the
financial decision of firm. The broader business cycle has been shown below.
Boom Depreciation Recession Recovery Boom
Figure no: 1.01
1.11 Importance of Financial Management
Financial experts with the help of financial management procure the long and short term finance
from comparatively less costly sources as per requirement of firms. As a result the profit of firms
would be increased.
 Financial management also helps to determine the amount of precise working capital of firm
so that it can meet up the demand of products and also reduce the cost of excess working
capital. Thus financial management increases the profit of firms through the working capital
management.
 Financial management decision is applied to select the productive fixed assets rather than
non-productive assets which only create the goodwill and capital gain that does not contribute
in operation to increase the profit of firm. This is also called the capital budgeting of firm or
performance evaluation of projects.
 Besides internal investments, the precise external investments in securities can be used by the
concept of portfolio management of financial management.
 The optimum dividend decision of financial management can be utilized to increase the share
price of firm. Whether the business expansion is profitable or not through the retained
earnings of firm or new financing, this type of decision gets from financial management.
 Financial management reduces all types of risk so that one side it ensures the protection of
investments and other side it help to increase the maximization of wealth of firm through the
concept of time value of money.
 The concept of financial management can be used to firm valuation; stock valuation and bond
valuation while purchasing stock and bond as well as joint venture, amalgamation, winding
up the business.
 Knowledge of the optimum capital structure and cost of capital of financial management help
to reduce the cost of capital and determines the amount of debt to increase the earnings
through financial leverage resulting increase the earnings per share. The benefit of debt, as
the interest amount is tax deductible and proper utilizing of reserved fund and depreciation.
 Different financial statements such as the income statement, cash flow statement, balance
sheet, statement of equity holders etc. are prepared by the concept of financial management.
Boom
DepreciationRecession
Recovery

1.12 Functions of Finance
We generally know Finance, as the act of providing means of payment. So finance is the activities
of managing money (fund), it’s planning relevant to business concerns, individuals and
government. The functions of finance regarding its coordinating, controlling, application along
with other activities have been outlined in the following paragraphs.
 Financial planning: Financial planning is the most important activities of finance that include
the finding of sources of fund-its availability, amount required, its best application for
attaining the maximization of wealth of firm considering cost effect.
 Selection of source of fund: Selection of source is another important function as every source
of finance cannot be employed anywhere, as these do not yield the same return and have
different costs. Long term funds are employed for the procurement of fixed assets whereas
the short term funds are for working capital. Long term fund without the help of short term
fund cannot produce any product. So the selection of optimal fund both of the long term and
short term is most vital to firm.
 Fund raising: Fund raising from the different sources required the prudent decision. Stocks,
retained earnings apparently have no cost or least cost funds. For raising capital, the
expenditure of these funds along with the long term debts such as bond, debenture are
preferred as these can be spread over long period including growing period of firm and can
meet any excess cost in future time. Working capital on the other hand is raised from banking
sector which is costlier and used for day to day requirement of work in process. These funds
are very useful and easily available. These funds are very important because without this fund
no firm can operate smoothly.
 Application of fund: Prudent application of fund ensures the return on fund invested,
addressing risk and finding the cost effect of the project that are favorable for good
undertaking. Therefore, the financial management decides the following.
 Fund should be prudently employed in such project that produce sufficient return to meet
the expenses incurred.
 Funds cannot be employed in projects that have higher risk.
 The project’s cost should be projected and cost effective should be acceptable so that it
run viably up to its life time.
 Finance find out nominal and effective rate of interest: Rate of interest is a major factor that
influences the decision of selecting the required fund for particular project. Nominal rate of
interest is the actual rate of interest that includes inflation and risk factor. So projects that are
evaluated with nominal rate of interest give the actual risk and return. Finance determines the
objective or goal of the individual, business and government. It provides better financial
products or services to the customer. It also provides better return to the investors at lower
risk.
1.13 Determinant Factors of Financial Decision
The management of firm is to consider prudently the following internal factors those affect the
financial decision of firm so that it can achieve the main goal of wealth maximization.
 Type of ownership factor: The owners of private firm is small number and usually fixed
ownership, so the dividend decision of the firm can be taken by finance manager within
shortage time as per owner requirement. The expansion decision of firm would be less
dividend rate. Again the owners of public firm are large number and usually changed
ownership, so the dividend decision of the firm finance manager is to take at least fixed
dividend rate or higher rate to prior period. Otherwise the stock price of the firm may fall.

 Business type factor: The financial decision of a large firm is to accept for achieving
economic scale by minimizing cost through purchasing fixed assets as the cost of buildings
rent or leasing machine is more. But small firm is not able to purchase fixed assets for fund
limitation. So the small firms rent buildings and lease machine resulting that the
manufacturing cost of small firm would be more. The large firm which having goodwill can
easily procure fund from investors by issuing stock up to authorized capital. Besides this the
large firm can also be able to procure required fund by issuing bond or debenture if firm
having stable or growing earnings. Similarly investors tend to incline its fund for investing to
old established firm not to new firm due to associated higher risk with new firm.
 Expected return and risk trade off factor: Finance manager is to consider duly the projects
with associated return, cost and risk during financial decision. So in case of project selection,
the highest returned and comparatively lower cost project should be accepted if the projects
involving equal risk. As a result, the value of firm would be increased. In case the different
risk for different projects then the highest discount rate is charged for highest risky project
and lowest discount rate for lowest risky project.
 Assets structure factor: In financial decision, the large manufacturing firms usually having
huge fixed assets in its assets structure, management can take more the long term debts by
mortgaging fixed assets as the cost of the long term debts is less than short term debts. But in
case of trading or service firm that does not have the sufficient fixed asset cannot take the
opportunity of long term debts. So the trading or service firm is to depend more on the short
term debts for the current assets.
 Stable earnings factor: Firm can issue bond or debenture if its earning is stable and having
the good credit rating. Otherwise firm should procure its required fund by issuing share. So
debt equity ratio is determined by the stable earnings of firm due to ensuring the interest
payment of debts.
 Liquidity position factor: Firm has to consider the interest payment, working capital needs
and expansion of firm while taking the dividend decision of firm. If the funds are needed for
other purposes then the dividend rate would be less due to maintaining stable liquidity.
 Management expectation factor: If management does not want to rise the shareholder’s
number then has to issue debts for procuring funds. Again if the management does not want
to take the risk of interest payment as the means of procuring fund is the issue of share.
Firm Again have to consider the following external factors those affect the financial decisions of
firm and cannot avoid these factors while taking the financial decisions.
 State’s economic condition factor: In well economic condition of country firms have the
advantage of procuring fund from different sources as per their requirement. In this case firm
can issue share for the expansion of project. Again the sound financial condition of firm along
with economic condition can also procure fund by issuing the bond for reducing the cost of
capital. Thus it can increase the earnings per share for maximizing wealth of firm. But in
recession condition firm should not take new project and can utilize the internal source of
fund such the retained earnings to meet up its fund requirement. So dividend would be less
and share price will fall. In this situation firm can produce more food products and consumer
goods due to the demand of these kind of products is not so reduced but has to reduce the
fashionable goods provided it existed in its portfolio of product lines.
 Capital market and money market factor: In case the capital and money market is developed
and operated efficiently and effectively then the procurement of fund is easy for firm. The
source of the short term financing is the money market and the long term financing is the
capital market. The best financing source can be selected from the available sources of the
two markets.

 State regulation factor: The investment decision is to take as per the industrial policy of state.
Generally in industrial policy there are some preferred sectors for the rising such an incentive
of tax relieve for a couple of years. Again government can impose the additional tax on
detrimental sector such as the tobacco sector or for competitive sector. As per policy of
government the depreciation and interest amount is tax deductible, so more depreciation and
interest amount would reduce the tax amount of firm. So such depreciation method has to
select where the depreciation amount is more than others method.
Most Financial Decisions are Trade-Off between Risk and Return: The objective of financial
decision is the wealth maximization and it is done by increasing the share price of firm. So the
three financial decisions of firm such the investment decision, financing decision and dividend
decision is taken as such that the wealth maximization target is fulfilled and the three financial
decisions those are relevant with each other. So the financing decision of firm should be less
costly along with less risky although the additional debt can rise risk but as the debts capital is
low costly so it can increase the earnings per share of firm and the investment decision of firm
should be comparatively the higher return but in this case too more risk involved with the higher
return project. The firm should follow the optimized dividend policy so that the share price of
firm gets increased.
Figure no: 1.02
Although more retained earnings may increase the earnings per share in future but for the more
retained earnings can reduce the dividend rate of firm at present that ultimately can reduce the
share price of its. So every financial decision is involved with the trade off the risk and return that
should be considered prudently while taking the financial decisions of firm.
1.14 Techniques or Tools of Financial Management
Firm have different types of techniques to achieve its financial goal. Among these techniques firm
firstly apply the planning techniques so that it operates smoothly to reach its target. Under this
technique different types of budgets are prepared and verified with the actual condition of firm to
run properly for achieving the wealth maximization. Finance manager during preparing budget,
the sales budget is estimated at first and according to the sales budgeting the production and cash
budget is to prepare for avoiding the excess or short of production and in term of cash budget.
The project of long term investment i.e. the new product line, modernization or diversification is
viable or not verify with the technique of the capital budgeting. The breakeven sales technique is
used how much the sales quantity is required to meet up the total cost of product. The capital
structure of firm is the appropriate structure of firm where the WACC is minimized and the value
of firm is maximized. The appropriate dividend policy is adopted by finance manager that sustains
both increasing growth rate and the value of firm. The product pricing is relevant to the quality
of product and market.
In analytical tools, the financial statement is used to measure the financial position, the ratio
analysis is used to determine the present performance and trend of future performance, the
Financial decision
Wealth maximization
Financing decision Dividend decisionInvestment decision
RiskReturn

standard deviation and beta is used to estimate the risk of firm, the marginal cost is based on
variable cost and used to capture outside the existing market in specific situation. Technical
analysis forecasts the changing trend of share price. The marginal cost helps firm to decide in
specific situation. The beta and standard deviation is used to estimate respectively non-
diversifiable and diversifiable risk. The operation statement of analytical technique indicates the
production schedule can be maintained on time or not and identify any deviation related to
production. Firm uses the standard costing of control technique to help in right direction so that
it can achieve its main goal. Firm can also control cost by comparing with the budget and different
types of auditing. Finally, finance manager should follow the intrinsic value method of firm to
sustain its core value along with perfect growth of firm that has been discussed on the later part
of this chapter.
Figure 1.03 Tools of Financial Management
1.15 Real Rate of Interest, Nominal Rate of Interest and Inflation
Real interest rate is the cost of money that the fund supplier gets from its demander as
compensation. This compensation arise from the fund supplier’s level of expected return i.e. is
generally called the rate of return. The amount of funds compensated to supplier for providing
the funds that may be the capital gain from selling any asset or security or profit from any
investment or rent from any building or earning from land or salary from employer.
The real interest rate depends on some factors (1) tradeoff between consumption and savings
(2) liquidity preference (3) investment opportunity (4) economic condition of state and (5) change
in tax structure. The basic principle in term of the real interest rate is that the rate is less during
the supply of fund is more than the demand of fund and the rate is more while the supply of fund
is less than the demand of fund. Thus in case of the fund consumption by provider, the real interest
rate would be high due to the supply of fund is less for consuming funds and
Control TechniqueAnalytical TechniquePlanning Technique
Standard costingFinancial statementSales budget
Standard deviation
Beta measurement
Product pricing
Dividend policy
Budget comparing
Auditing
Marginal costing
Technical analysis
Ratio analysis
Capital structure
WACC
Break-even point
Capital budgeting
Cash budget
Production budget
Operation
statement
Intrinsic Value Technique
Zero Growth
Firm valuation
Zero Growth
Stock valuation
FCFE
Ke
FCFF
WACC

similarly in term of the fund savings by provider, the real interest rate would be low due to the
supply of fund is more for saving funds. The liquidity preference which is involved the perceived
risk of converting asset into cash and thus into assets. The asset is converted quickly so that it can
increases the supply of fund which decreases the real interest rate otherwise increases the real
interest rate.
Again the real rate of interest is changed with the change of economic condition, for available
investment opportunity and for suitable tax structure in business. As the real interest rate is
increased or decreased respectively for the business activities are increased or decreased.
Therefore as in good economic condition, suitable investment opportunity and tax structure; the
real interest rate gets increased for the increase of business activities due to the demand of funds
rise at the period. Therefore as in worst economic condition, the real interest rate gets reduced for
the less of business activities due to the demand of funds reduced at the period.
There are also existed some factors those related with funds are added with the cost of fund or
real interest rate so that the compensation of fund providers is not reduced; those are inflation
factor, risk factor for which the total cost of fund gets increased that is the nominal interest rate
which is to pay the users of fund to its suppliers. The historical inflation rate which is average of
previous years is sum up to the real interest rate due to maintaining the purchasing power of
supplier. Besides these the diversifiable and non-diversifiable risk associated with assets is
aggregated as risk premium with real interest rate. But the real interest rate would be equal to
nominal interest rate while the inflation rate is zero and the risk free asset is existed.
In case any reason the preset inflation premium and risk premium vary with the current rate of
these factors then the real interest rate is affected and thus the real interest rate decrease with the
increase of these factors if nominal interest rate is kept fixed, similarly the real interest rate
increase with the decrease of these factors if nominal interest rate is kept fixed. So the real interest
rate is required to adjust for the change of these factors. According to Gitman the real rate of
interest can be estimated by subtracting the inflation premium from the nominal rate of interest.
Nominal rate of interest is the actual rate of interest. It differs from the real rate of interest k,
for two factors affecting it, the inflation premium and risk premium. If IP represent inflation
premium and Rp1 represent risk premium and nominal rate of interest is represented by K1 then,
K1 = K (real interest rate) + IP (inflation premium) + Rp1 (risk premium).
This equation of nominal rate of interest is known as Fisher equation, after the name of renowned
economist Irvine Fisher. But nominal rate of interest contain two factors- a risk free rate RF and
a risk premium RP1.
So, K1 (nominal interest rate) = RF (risk free rate) + Rp1 (risk premium).
Substituting this value of K1 in equation above and considering value of Rp1 = 0
We get K + IP + Rp1 = RF + Rp1.
So, RF = K + IP = real interest rate + average inflation.
Thus we get risk free rate of interest is equal to real interest plus inflation premium. We therefore
can define nominal rate of interest is the risk free rate plus risk premium. Inflation premium is the
average inflationary trend forecasted for future time. Treasury bills are usually risk free assets
and charge risk free rate of interest.
Effect of Federal Reserve Policy on Interest Rate: Federal Reserve performs the main control role
to stimulate the economic condition of state that affects the interest rate and inflation. Federal
Reserve took different measures to enhance the economic condition of state such open market
operation, increasing or decreasing the reserve ratio of banks, increasing or decreasing

bank rate. Federal Reserve in open market operation, for reducing inflation rate, sells the Treasury
bills to bank so that the lending funds of banks are decreased that lead to the high interest rate and
ultimately tend to less business activities gets decreased the inflation rate of state. Again Federal
Reserve in open market operation, for rising inflation rate, purchases the Treasury bills from bank
so that the lending funds of banks are increased that lead to the low interest rate and ultimately
tend to more business activities gets increased the inflation rate of state. A decade of the real
interest rate, nominal interest rate of bank lending and inflation rate of United State has been
shown in the below table and figure.
Table1.01: Source Federal Reserve Bank
Year Nominal Interest Rate Real Interest Rate Inflation
2002 4.67% 3.07% 1.6%
2003 4.12% 1.82% 2.3%
2004 4.34% 1.64% 2.7%
2005 6.19% 2.79% 3.4%
2006 7.96% 4.76% 3.2%
2007 8.05% 5.25% 2.8%
2008 5.09% 1.29% 3.8%
2009 3.25% 3.65% -0.4%
2010 3.25% 1.65% 1.6%
2011 3.25% 0.05% 3.2%
2012 3.25% 1.15% 2.1%
Figure 1.04: Source Federal Reserve Bank
Therefore it has been observed from the above table and figure that the real interest rate has been
decreased in recent year but inflation rate has been increased that indicate the business activities
gets reduced but inflation rate gets increased that lead to the growth of state is downward known
as poor economic condition.
Federal Reserve want to increase the business activities at stable inflation rate to maintain the
growth rate of state as in good economic condition the business activities get increased but the
inflation rate existed in average level. Thus Federal Reserve followed others measure in addition
to open operation to stimulate the economic condition of state.
4.67%
4.12% 4.34%
6.19%
7.96% 8.05%
5.09%
3.25% 3.25% 3.25% 3.25%3.07%
1.82% 1.64%
2.79%
4.76%
5.25%
1.29%
3.65%
1.65%
0.05%
1.15%
1.6%
2.3%
2.7%
3.4% 3.2%
2.8%
3.8%
-0.4%
1.6%
3.2%
2.1%
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Nominal interest rate, Real Interest Rate and
Inflation of US
Nominal Interest Rate Real Interest Rate Inflation

Risk factor in interest rate: It is important to note that risk factor of interest rate depend on the
term structure of the interest rate. At any point in time, the relationship between different debts is
the remaining time to maturity and its yield to maturity are represented by yield curve. It shows
that debts of equal quality and different maturity have the particular upward or downward interest
rate respectively for the long term or short term and flat slopping that is called the term structure
of interest rate and risk premium varies with specific issuer and issue characteristics even with
similar maturity, the nominal rate of interest may be different. It has been observed that higher
credited rated firms have less rate of nominal interest that gradually increases with gradual
decrease of ratings of the firms.
Effect of Deficit or Surplus Budget and Balance of Trade on Interest Rate: In deficit budget of
Federal government, the total expense of country is more than the total tax revenue. Federal
government can meet up this deficit budget with borrowing or printing money. So federal
government one side can borrow directly from the central bank, commercial bank, foreign
country, World Bank, international agency and other side different types of Treasury securities
are issued to public or banks for financing the deficit budget. Thus government take, for deficit
budget, the larger borrowing funds through selling the new Treasury securities that downward the
price of Treasury securities and lower the money supply which lead to the higher interest rate that
also pushes less inflation rate.
In good economy as the business activities are more, so the effect of deficit budget is less than
poor economy because of selling securities to public or banks reduce the amount of lending fund
of banks that pushes the interest rate upward and the inflation rate downward and again
purchasing the Treasury securities from public or banks rise the amount of lending fund of banks
that pushes the interest rate downward and the inflation rate upward. In good economy, the
business activities is more for existing the demand of consumer goods that cause both the more
funds supply in business and the surplus budget for collecting more tax revenue from business
than its total expenses that ultimate lead to stable interest rate and inflation rate which tend to the
stable growth rate of state. But if in term of surplus budget, the funds is spent in unproductive
sector rather than productive sector that would upward the inflation rate.
Similarly again in case of balance of trade if the import of a country is excess than the export
i.e. expense is more than earnings in that case the country is to borrow like deficit budget that
causing low money supply which drive up the interest rate. Inversely if the export of a country is
excess than the import i.e. earnings is more than expenses then this surplus money causing excess
money supply in economy that drive down the interest rate.
1.16 Capital Flow in Business
The group those having surplus fund known as fund providers lend their money to those known
as users of fund in form of investment who need to fulfill specific purpose. Capital flow occurred
mainly directly and indirectly between different groups as per their needs; individual needs for
consumer goods, firm needs for operating capital, financial institute needs for the depositing
money for operating lending, financial intermediary needs for the depositing money of purchasing
diversified securities in exchange of issuing own stock unit to depositors.
Again a country can gets directly loan from other country, World Bank and international
agency. In addition to capital flow also occurred by investment bankers which act as brokerage
and help all types of investors to transaction the securities of firms in exchange of commission.
So the role of investment banker is only the mediator to purchase or sell the securities of firms
for getting the percentage on per security as commission as per choice of investors. Besides these,
financial intermediaries take deposit from individual, financial institution and foreign investors
for purchasing the selected securities of firms by diversifying securities and issue its own units to
investors for their deposited funds.

So we can observe according to the following diagram, individual can directly borrow from
individual, institution, foreign investors and similarly all types of firm, government and foreign
firm can directly borrow from individual, institution, foreign investors.
Figure 1.05: Diagram of Capital flow
Users Fund Providers
1. Capital Flow
Securities transaction directly
Capital flow with return
Capital Flow for development project directly
2.
Capital Flow with return
Securities transaction indirectly
3. Capital Flow Capital Flow
Capital Flow Capital Flow
with Return with Return
Users
4. Capital Flow Capital Flow
Capital Flow Capital Flow
with Return with Return
1.17 Intrinsic Value of Firm
Finance manager sometimes is to calculate the intrinsic value of firm to verify its performance
and as per this valuation he has to decide some major decisions regarding whether has to increase
the FCFF or not and whether has to decrease the WACC of firm or not from the present context of
firm that would ultimately would increase the value of firm. So indeed the determinants of the
free cash flow to firm (FCFF), weighted average cost of capital (WACC) and number of year all
keep the role in firm valuation. Valuation of firm is required for various reasons such as all types
of investors and creditors need to know the value of firm and also need to know the value of firm
for estimating the performance of employee including finance manager and need to know the
value of firm during takeover a firm by other firm, merger one firm to another firm.
The valuation equation indicates the value of firm is more for the amount of free cash flow to
firm (FCFF) is large and similarly the value of firm is less while the amount of FCFF is small.
Inversely the value of firm is more for the less rated WACC is and similarly the value of firm is
less for the high rated WACC. As we know that the life of firm is infinitive so the equation of the
three types of firm has been shown in the following.
1. Value of firm (zero growth) =
FCFF
WACC
Individual
Partnership
Corporation
Government
Foreign firm
Individual fund providers
Institutional fund providers
Foreign investors
Investment
Bankers
Foreign investors
Foreign investors
Financial
Intermediarie
s
Individual
Partnership
Corporation
Government
Foreign firmIndividual
Partnership
Corporation
Government
Foreign Firm
Country Foreign Country
International Agency

2. Value of firm (constant growth) =
FCFF1
(1+WACC)1
+
FCFF2
(1+WACC)2 +
FCFF3
(1+WACC)3 + ------- +
FCFF∞
(1+WACC)∝
Alternatively, value of firm (constant growth) =
FCFF × (1+g)
WACC − g
3. Value of firm (multiple growth) =
FCFFn1
(1+WACC)n1
+
FCFFn2
(1+WACC)n1+n2
+
FCFF n2 + 1
WACC−g3
(1+ WACC)n1+n2
= [FCFF ×
1−
(1+g1)n1
(1+WACC) 𝑛1
WACC−g1
] + [FCFFn1
×
[1−
(1+g2) n2
(1+WACC)n1+n2
]−[ 1−
1
(1+WACC)n1
]
WACC−g2
] +
[
FCFFn2(1+g3)
WACC−g3
×
(1+ WACC)n1+n2
]
FCFFn1
= FCFF × ((1 + g1)n1 and FCFFn2
= FCFFn1
× (1 + g2)n2
We can realize that from the above equation the FCFF is one of the determinants of firm’s intrinsic
value where the cash flows are entitled to get all investors and creditors after paying all operating
expenses with taxes and required investment for maintaining growth.
FCFF = sales revenue – operating expenses – taxes – reinvestment in operating capital
Or, FCFF = operating income after tax – reinvestment in operating capital
We can calculate the reinvestment in operating capital with the following formulas.
Net operating working capital = operating current assets – operating current liabilities
Formula of the total net operating capital of current year
Total net operating capital = Net operating working capital + Operating long term assets
Reinvestment in operating capital = existing total net operating working capital – last year’s total
net operating working capital
We can also find out the calculation of FCFF has been shown in detailed at chapter 2. Some
firms have the same amount of FCFF in the entire life time are known as zero growth rate firm.
The other type of firms has the constant growth rate of FCFF in entire life time. Another type of
firms have the multiple growth rate of FCFF where initially some years might be the fixed lower
growth rate of FCFF thereafter the higher fixed growth rate or the lower fixed growth rate than
the prior growth rate and then other constant growth rate of it to infinitive. This multiple growth
rate of FCFF usually takes place for most of the firms due to the growth rate of FCFF is not fixed
for the entire life of firm.
Thus we get the FCFF of each year those are associated with different risks for which the FCFF
of each year is to discount with the WACC to get the intrinsic value of firm and the value of FCFF
is reduced for the discounting of FCFF. WACC (weight average cost of capital) is the required
rate that firm is to earn for meeting all investors and creditors. Weight average cost of capital is
the mixed of various capitals, associated the diversifiable and non-diversifiable risk of firm, those
are equity capital, preferred capital, debt capital and retained capital.
We know weighted average cost of capital, WACC = KEWE + KPWP + KDWD + KRWR
1. Cost of Equity = Risk Free Rate + {Beta × (Market Return – Risk Free Rate)}
2. Cost of Preferred Stock =
D +
F.V−(M.P−F.C
Maturity
F.V+(M.P−F.C)
2

Or, cost of Debt =
I+
F.V−(M.P−F.C)
Maturity
F.V+(M.P−F.C)
2
× (1 – tax rate)
4. Cost of Retained Earnings = Cost of Equity × (1- personal tax)
Now we can express the calculation methods of the intrinsic value of different types of firms
through the following diagram that has been shown in below.
Figure 1.06: Intrinsic value of different types of firms
1. Intrinsic value of zero growth firms:
- –
= =
Cost of Preferred Stock
= + +
Cost of Retained Earnings = Cost of Equity × (1- personal tax)
2. Intrinsic value of constant growth firms:
– =
Firm’s value (constant growth) =
FCFF × (1+g)
WACC − g
3. Intrinsic value of multiple growth firms:
– = =
Firm’s value (multiple growth) =
FCFFn1
(1+WACC)n1
+
FCFFn2
(1+WACC)n1+n2
+
FCFF n2 + 1
WACC−g3
(1+ WACC)n1+n2
Operating income after tax Reinvestment in operating
capital
FCFF
Operating income after tax Reinvestment in operating capital FCFF
Firm’s value (zero growth) =
FCFF
WACC
Operating income after tax Reinvestment in operating capital FCFF
[Beta × Risk Premium (Diversifiable and Non Diversifiable risk)] + Risk Free rate = Cost of Equity
WACC = KE WE + KP WP + KD WD + KR WR
Cost of Equity = Risk free rate + [Beta × Risk Premium (Diversifiable and Non Diversifiable risk)]
Risk Free rate Beta × Risk Premium (Diversifiable and Non Diversifiable risk)Cost of Equity
Cost of Debt = (Risk Free Rate + Spread) × (1-T)
Cost of Debt = (Risk Free Rate + Spread) × (1 – T)
Cost of Debt = (Risk Free Rate + Spread) × (1-T)
Cost of Retained =Earnings = cost of equity× (1 – personal tax)
Cost of Retained =Earnings = cost of equity× (1 – personal tax)

1.18 Different Types of Business Firms
Financial experts have defined business finance in different ways. Professor Gloss and Baker say
that “business finance is concerned with the sources of funds available to the enterprises of all
sizes and the proper use of money or credit obtained from such sources. But the definition given
by H. G. Guthman and H. E. Dougull is more relevant where they say, “Business finance can be
broadly defined as the activity concerned with the planning, raising, controlling and administering
the funds used in business”.
A firm is the business organization such large or small, privately run or publicly traded and
operated in any kind of business operation that may extend from manufacturing to retail trading
or providing services to its customer. There are existed five most common forms of legal business
firms. These are the sole proprietorship, the partnership and the corporations.
1. Sole proprietorship: A sole proprietorship business is owned by one person who operates the
business for his own benefit. This type of business is existed in the major portion among all the
businesses, such as a small business like book shop, a bakery, dress makers, grocery shop etc.
With increasing the activities and profit of firm while any proprietorship business achieve the
amount of funds that enable to produce the manufacturing product or render service to customers
may become either the partnership or corporate business. In a Sole proprietorship business, the
proprietors himself with some employees operate this type of business. So owners can take all
decisions and instant change for the benefit of business for having full controlling power over
firm. Proprietors generally finance for business from personal resources or trade credit or from
borrowing and personally responsible for the repayment of debts. The ownership is not easily
transferred in the competitive bargaining process to others owner like corporation, so in most
cases the probability i.e. the owner did not get the reasonable price of its business.
2. Partnerships Firm: A partnership business is owned by two or more partners who share to
supply the required capital to run a partnership firm and is entitled the profit or loss of firm
proportionally as per their capital. Most of the features and operating process of partnership firm
are same to the proprietorship. These firms are bigger in size and value than proprietorship and
generally engage manufacturing and service rendering. Owners direct and control the business
with the help of some appointed employees. Most partnership firms are established by a written
document known as partnership deed or article of partnership that included all the term and
conditions of business. In partnership, partners have unlimited liabilities and each partner is
legally liable all of the debts of the partnership. Partner cannot involve the partnership in any
other liability outside the partnership in the capacity of partner. In this case the ownership is not
easily transferred too like corporation as its shares are not transacted in financial market.
3. Limited Partnerships Firm: Another type of partnerships is the limited liabilities partnership
(LLP) which is operated by owners along with the employees of firm where the profit is distributed
as per percentage of their capital. Most of the features and operating process of partnership firm
are same to the general partnership firm except regarding the liabilities of firm.
In this case the liabilities portion of partners is determined by the proportion of supplying their
capital. Sometimes the general partnership firm can raise additional required funds for firm
through offering limited liabilities to prospective partners. In limited partnership at least one
partner has unlimited liabilities and the rest of the partners have limited liabilities. In term of
limited partnership firm a written document existed where all terms and conditions noted the
liabilities, privilege of partners and operating process of firm.
4. Private Limited Company: Many countries have different numbers of owners for private
company as per their existing established rules and the owner number may vary for different
company such bank, insurance company, leasing company, manufacturing company etc. The
owner number usually for private manufacturing company is from three to fifty persons but for
private banking company is from three to twenty persons. As the private equity capitals are

raised from these limited numbers of owners, so the large production is not possible for private
limited company as the limited owners cannot supply sufficient capital to produce the large
volume of products. The liability of its owner is limited as per their proportionate capital .A
private limited company is a legal entity that differentiates the management from ownership i.e.
the delegation of owner directed the private limited company. Private limited company is operated
in detailed with the help of the two documents of Memorandum of association and Article of
association. This equity capital is not as liquid as publicly traded company, so the owner may face
loss while transferring its ownership due to at first selling offer is to present to existing owners if
it is not granted then can offer outside company.
5. Public Limited Company: A public limited company is an authorized large company to raise
the large amount of fund by issuing common equity stock, preferred equity stock and bond for
the increasing demand of its products. A public limited company is an artificial person created
by law when the number of owners are from seven to unlimited and often called a legal entity
which can enter into a contract, acquire property on the name of business and can transact all
business authorized given by its article, even can sue or can be sued while any dispute is aroused.
Owners of this corporate business are the common equity holders or preferred equity holders and
as the representative of owners, the board of directors decide about the policy of firms that are
executed by the chief executive officer. The merit of public limited company like private limited
company is that the total capital is divided in a fixed small amount at affordable price so that
anyone can purchase it. As a result the ownership of firm is transferred easily as the public limited
company is publicly traded in stock exchange for having the large number of prospective stock
holders. The main demerit of public limited company is the double taxation i.e. firstly the tax is
imposed on while after paying fixed interest thereafter while the dividend is paid to its stock
holders then the tax is imposed again.
Memorandum of association and Article of association are the two documents that mention
such as the power and function of the board of directors, directors how to operate business and
also how to function the corporate body. Public limited company can offer the selling of stocks
to public through prospectus after receiving the official permission in the form of certificate of
incorporation and can start the business after receiving the certificate of commencement. The
companies usually, under the corporate rules, held its annual general meeting once in a year to
demonstrate its stake holders the pros and cons of the company affairs and for the declaration of
dividend on the basis of the performance of last year. In many countries firms usually declare
dividend annually once in a year. But in United States firms declare dividend every half yearly
and twice in a year.
1.19 Relevant Documents for the Formation of a Firm
The Memorandum of Association: The Memorandum of Association is the first document that
includes the fundamental rules regarding the constitution and activities of firm. It contains the
modus operandi of formation of firm such its operation, the purpose of its creation, description of
members, its creators and the public, the power and jurisdiction of directors, managing director
as well as all others associated with firm. It also contains the rules regarding the capital structure
and the liabilities of directors and members. Memorandum also includes the rules of altering the
provision of it.
The Article of the Association: The article of Association is another document is required for the
formation of a firm. It contains the rules, regulations bylaws as to how the internal management
of firm will function. The rules of the article must not violate any provisions of the memorandum
and are relevant with company law.
 The memorandum and Articles are public documents and could be inspected by anybody at
the office of the registrar of firm or company.

 The memorandum of Association gives the firm its contractual power and thereby firm
becomes the natural and legal possibilities for its activities.
 Firm become a legal person for this article and acts on behalf of firm.
Certificate of Incorporation: While the company or firm meets all requirements according to the
company acts for registration, the registrar (authorized person) issues a certificate of
incorporation. This certificate is essential without which the firm cannot be regarded as a
registered company or firm. This certificate recognizes the following in respect of the firm.
 All requirements as per act are complied.
 The firm is established and duly registered.
 The legal existence of the firm begins from the date of the certificate issued.
Certificate of Commencement of business: A public limited company cannot commence business
until the registrar issue the certificate of commencement of business. This certificate is issued on
the compliance of certain formalities, when a director of the company or company secretary
submits a compliance letter duly signed stating that the formalities have been properly complied.
This certificate enables the firm to enter in any contract. Prior to this certificate if any contract is
done on behalf of the firm, the contract will remain provisional and only enforceable on
completion of the certificate. A private limited company does not require this certificate as this
company do not has share capital and does not require issuance of prospectus.
1.20 Securities and Papers Related to Finance and Business
Negotiable Instrument Act defines the negotiable instrument such a promissory note, bill of
exchange or cheque. In short a promissory note is a written promise to pay a certain sum of money
unconditionally. He who promises called the maker, to whom the promise is made called payee.
A bill of exchange is a written order for the payment of certain sum of money unconditionally.
Maker of the instrument is known as drawer, to whom it is addressed is the drawee and if he
accepts the acceptor and in whose favor it is made is the payee. A cheque is a species of bill of
exchange drawn on a specified banker and always payable on demand. It is intended for the
immediate payment and needs no acceptance. We have discussed these in details in the following
lines.
Promissory Note: A promissory note is an written instrument is signed by maker and undertaken
by its receiver that contains an unconditional for paying pay on demand a specified amount of
money only to or to the order of a specified person or to the bearer of the instrument at specified
period of time. The promissory note is considered as a magna carta in the realm of debtors and
creditors. Any writing between a debtor and creditor may not be promissory note. Simple
acknowledgement of debt or a simple promise to repay debt may not be a promissory note.
Promissory note is used when bank advances to its customer in the form of loan, cash credit
or overdraft. The debtor issues a promissory note undertaking to pay the amount for value
received along with any amount susceptible in the form of interest and other charges accrued
during the payment period of debt. This note of undertaking is not revocable.
A promissory note requires the following essential elements.
 It is not a bank note or currency note.
 It must be written and signed by the maker.
 It must contain a promise to pay on demand or on a fixed or specified future time.
 Promise must be unqualified.
 Maker of the promise must be certain i.e. easily recognizable.
 Promise to pay money and money only.

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