Business Finance Functions CBMFM3T03

Syllabus topics (RTMNU)

• Definition, Nature, and Scope of Business Finance
• Objectives of Business Finance (Profit Maximization vs. Wealth Maximization)
• Functions of Business Finance
• Role of Finance in Business Decision-Making
• Sources of Finance: Long Term and Short Term sources

Business Finance: Definition, Nature and Scope

Meaning: Every business needs money to start, run and grow. Getting this money and using it well is called business finance.

Definition: Business finance is the activity of planning, raising, using and controlling the funds of a business so that its goals are met at the lowest cost and risk.

Nature of business finance:

1. Lifeblood of business – no firm can buy machines, raw material or pay wages without funds.
2. Continuous function – funds are needed every day, not only at the start.
3. Related to all departments – production, marketing and HR all need money, so finance links them.
4. Involves risk and return – every finance decision balances the profit expected and the risk taken.
5. Centralised in nature – major finance decisions are usually taken by top management (CFO, Board).
6. Measures performance – profit, return on capital and cash flow show how well a firm is doing.

Scope of business finance (areas it covers):

• Estimating fund needs – how much fixed and working capital is needed.
• Financing decision – choosing sources like shares, debentures, loans.
• Investment decision – where to invest: new plant, new product (capital budgeting).
• Dividend decision – how much profit to pay to shareholders and how much to retain.
• Working capital management – managing cash, stock, debtors and creditors.
• Financial control – budgets, ratio analysis and audits.

Objectives of Business Finance: Profit Maximization vs. Wealth Maximization

Profit maximization means the firm should take decisions that give the highest profit (₹ earnings) in a period.

Wealth maximization means the firm should take decisions that raise the market value of its shares, i.e. the net present value of all future benefits to shareholders. It is the modern, accepted objective.

Functions of Business Finance

A. Executive (main) functions:

1. Estimating capital requirement – forecast how much money is needed for fixed assets and day-to-day work.
2. Deciding capital structure – the mix of equity, preference shares and debt.
3. Choosing sources of funds – shares, debentures, banks, public deposits, etc.
4. Investment of funds – selecting profitable long-term projects and short-term uses.
5. Dividend policy – distribution vs. retention of profit.
6. Working capital management – enough cash and stock, not too much.
7. Financial control – comparing actual results with budgets.

B. Routine (incidental) functions: keeping cash records, handling bank accounts, safe custody of securities, preparing financial reports, and filing tax returns.

Role of Finance in Business Decision-Making

• Production decisions – buy or lease a machine? Finance compares cost and benefit.
• Marketing decisions – ad budget and credit allowed to customers depend on fund availability.
• Expansion decisions – a new branch or plant is accepted only if NPV is positive.
• Pricing decisions – cost data from finance helps fix selling price.
• Risk management – insurance, hedging and keeping reserves.
• Make or buy, merger, takeover – all are judged on cost of capital and expected returns.

Example: When a car maker like Tata Motors plans a new EV plant, the finance team estimates the cost, chooses the funding (equity, bonds, loans) and checks whether the expected cash flows justify the investment.

Sources of Finance: Long Term and Short Term Sources

Long-term sources (more than 5 years; used for fixed assets and permanent working capital):

1. Equity shares – owners' capital; no fixed dividend, no repayment; shareholders have voting rights.
2. Preference shares – fixed dividend, paid before equity; no normal voting right.
3. Debentures/bonds – borrowed money; fixed interest; interest is tax-deductible.
4. Retained earnings – profits kept back (ploughing back of profits); no flotation cost.
5. Term loans from banks and financial institutions (e.g. SBI, SIDBI).
6. Public deposits (medium term), lease finance, and venture capital for start-ups.

Short-term sources (up to 1 year; used for working capital):

1. Trade credit – suppliers allow time to pay.
2. Bank credit – cash credit, overdraft, loans, bill discounting.
3. Commercial paper – unsecured promissory note issued by big companies.
4. Factoring – selling debtors to a factor for immediate cash.
5. Customer advances and outstanding expenses (wages, rent payable).

Likely exam questions

1. (Long, 8/16 marks) What is business finance? Explain its nature, scope and functions.
2. (Long, 8/16 marks) Distinguish between profit maximization and wealth maximization. Why is wealth maximization considered a better objective?
3. (Short, 4 marks) Define business finance.
4. (Short, 4 marks) Explain any four long-term sources of finance.
5. (Short, 4 marks) State the role of finance in business decision-making.

Syllabus topics (RTMNU)

• Concept and Importance of Financial Planning
• Short-term vs. Long-term Financial Planning
• Factors Influencing Financial Planning
• Capital Structure: Meaning and Components
• Theories of Capital Structure (Modigliani & Miller, Trade-Off Theory)
• Cost of Capital and Leverage Analysis

Financial Planning: Concept and Importance

Definition: Financial planning is the process of estimating how much money a business needs, deciding where it will come from and how it will be used, in advance.

It answers three questions: How much capital? From where? How to use it?

Importance:

1. Right amount of funds – avoids both shortage and idle surplus of money.
2. Smooth operations – cash is ready for wages, raw material and bills.
3. Lower cost of capital – the cheapest suitable sources are chosen in time.
4. Helps growth – funds for expansion are arranged before they are needed.
5. Control – actual spending can be compared with the plan.
6. Faces uncertainty – keeps reserves for bad times.
7. Builds confidence of banks and investors.

Short-term vs. Long-term Financial Planning

Factors Influencing Financial Planning

• Nature of business – a steel plant needs more fixed capital than a trading firm.
• Size and stage – a start-up plans differently from a mature company.
• Future growth plans and diversification.
• Government policy – taxes, RBI credit policy, SEBI rules.
• Capital market conditions – boom makes share issue easier.
• Risk and uncertainty, flexibility needed, and attitude of management.

Capital Structure: Meaning and Components

Definition: Capital structure is the mix of long-term sources of funds used by a firm – equity share capital, preference share capital, retained earnings and long-term debt.

Components: (1) Equity shares, (2) Preference shares, (3) Retained earnings/reserves, (4) Debentures, bonds and long-term loans.

Optimum capital structure is the mix at which the cost of capital is lowest and the value of the firm is highest. Using debt is called trading on equity: cheap debt raises the return to equity shareholders, but too much debt raises risk.

Theories of Capital Structure (Modigliani & Miller, Trade-Off Theory)

1. Modigliani–Miller (MM) Approach:

• Without taxes (1958): In a perfect market the value of a firm does not depend on its capital structure. Two firms with the same earnings and risk have the same value, whether they use debt or not. If values differ, investors will buy the cheaper one and sell the costlier one (arbitrage) until values become equal.
• With taxes (1963): Interest is tax-deductible, so debt gives a tax shield. Value of levered firm = Value of unlevered firm + (Tax rate × Debt). So more debt raises value.
• Assumptions: perfect capital market, no transaction cost, investors can borrow at the same rate as firms, no bankruptcy cost, same risk class.
• Criticism: markets are not perfect; personal and corporate borrowing rates differ; bankruptcy costs exist.

2. Trade-Off Theory: A firm balances (trades off) the benefit of debt (tax saving on interest) against its costs (financial distress, risk of bankruptcy, agency costs). At low debt, tax benefit is larger; at high debt, distress cost becomes larger. The best (optimum) debt level is where the extra tax benefit equals the extra distress cost.

Cost of Capital

Definition: Cost of capital is the minimum rate of return a firm must earn on its investments to satisfy its investors (shareholders and lenders). It is used as the cut-off rate in capital budgeting.

• Cost of debt (after tax): K_d = Interest rate × (1 – Tax rate)
• Cost of preference shares: K_p = Preference dividend ÷ Net proceeds × 100
• Cost of equity (dividend growth model): K_e = (D₁ ÷ P₀) × 100 + g
• Weighted Average Cost of Capital (WACC): K_o = Σ (Weight × Cost of each source)

Illustration 1 (WACC): A company has Equity capital ₹5,00,000, 9% Preference capital ₹1,00,000 (issued at par) and 10% Debentures ₹4,00,000. Tax rate is 25%. The next expected equity dividend is ₹4 per share, market price ₹50, growth rate 5%. Find WACC.

Working: K_d = 10 × (1 – 0.25) = 7.5%; K_p = 9%; K_e = 4/50 × 100 + 5 = 8 + 5 = 13%.

WACC = 1,04,000 ÷ 10,00,000 × 100 = 10.4%

Leverage Analysis

Leverage means using fixed costs (operating or financial) to magnify the effect of a change in sales on profits.

• Operating leverage (OL) = Contribution ÷ EBIT – shows the effect of fixed operating cost.
• Financial leverage (FL) = EBIT ÷ EBT – shows the effect of fixed interest.
• Combined leverage (CL) = OL × FL = Contribution ÷ EBT – total risk.

Illustration 2: A firm sells 10,000 units at ₹50 each. Variable cost is ₹30 per unit, fixed cost ₹1,00,000 and interest ₹40,000. Calculate OL, FL and CL.

OL = 2,00,000 ÷ 1,00,000 = 2; FL = 1,00,000 ÷ 60,000 = 1.67; CL = 2,00,000 ÷ 60,000 = 3.33 (check: 2 × 1.67 ≈ 3.33).

Meaning: OL of 2 means a 10% rise in sales raises EBIT by 20%. CL of 3.33 means a 10% rise in sales raises EBT by about 33%.

Likely exam questions

1. (Long, 8/16 marks) What is capital structure? Explain the Modigliani–Miller approach and the Trade-Off theory of capital structure.
2. (Long, 8/16 marks) From the following, calculate operating, financial and combined leverage: Sales 20,000 units at ₹40 each; variable cost ₹25 per unit; fixed cost ₹1,50,000; interest ₹50,000.
3. (Short, 4 marks) Define financial planning and state its importance.
4. (Short, 4 marks) Distinguish between short-term and long-term financial planning.
5. (Short, 4 marks) A company issues 12% debentures; tax rate is 30%. Calculate the after-tax cost of debt.

Syllabus topics (RTMNU)

• Introduction to Investment Decision-Making
• Time Value of Money and Discounted Cash Flow (DCF) Techniques
• Capital Budgeting Techniques: Payback Period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)

Introduction to Investment Decision-Making

Investment decision means deciding where to put the firm's long-term funds – buying machinery, building a new plant, launching a product, replacing old assets. Such decisions are called capital budgeting decisions.

Definition: Capital budgeting is the process of planning and evaluating long-term investment proposals whose benefits are spread over several years.

Features / why important:

1. Large amount of money is involved.
2. Long-term effect on profitability and growth.
3. Irreversible – a plant once built cannot be sold easily without loss.
4. Risky – future cash flows are uncertain.
5. Decides the future of the firm – capacity, cost and competitiveness.

Steps: identify proposals → estimate cash flows → evaluate with techniques → select → implement → review (post-audit).

Time Value of Money and Discounted Cash Flow (DCF) Techniques

Time value of money (TVM): ₹1 received today is worth more than ₹1 received in future, because today's money can be invested to earn interest, there is inflation, and the future is uncertain.

• Future value (compounding): FV = PV × (1 + r)ⁿ. Example: ₹10,000 at 10% for 3 years = 10,000 × 1.331 = ₹13,310.
• Present value (discounting): PV = FV ÷ (1 + r)ⁿ. Example: ₹13,310 receivable after 3 years at 10% is worth ₹10,000 today.
• PV factor = 1 ÷ (1 + r)ⁿ (taken from tables; at 10%: 0.909, 0.826, 0.751, 0.683, 0.621 for years 1–5).

DCF techniques are methods that discount future cash flows to present value before comparing them with cost: NPV, IRR and PI. Non-discounted (traditional) methods ignore TVM: Payback period and Accounting Rate of Return.

Capital Budgeting Techniques: Payback Period

Meaning: The number of years needed to recover the original cost of a project from its cash inflows (profit after tax + depreciation).

• Even cash flows: Payback = Initial investment ÷ Annual cash inflow.
• Uneven cash flows: add cumulative inflows until cost is recovered.
• Decision: accept if payback is less than the target period; shorter is better.
• Merits: simple, shows liquidity, good for risky industries. Demerits: ignores TVM and cash flows after payback.

Net Present Value (NPV) and Profitability Index (PI)

NPV = Present value of cash inflows – Present value of cash outflows. Decision: accept if NPV is positive; among projects choose the highest NPV.

PI (Benefit–Cost ratio) = PV of cash inflows ÷ PV of cash outflows. Decision: accept if PI > 1.

Merits of NPV: considers TVM and all cash flows; supports wealth maximization. Demerits: needs a discount rate; harder to understand.

Illustration 1: A project costs ₹5,00,000. Expected cash inflows: Year 1 ₹1,50,000; Year 2 ₹1,60,000; Year 3 ₹1,80,000; Year 4 ₹1,70,000; Year 5 ₹1,40,000. Cost of capital is 10%. Find Payback period, NPV and PI.

(a) Payback period: After 3 years, ₹4,90,000 is recovered. Balance ₹10,000 is recovered from Year 4 inflow of ₹1,70,000.
Payback = 3 + 10,000/1,70,000 = 3 + 0.06 = 3.06 years (about 3 years 1 month).

(b) NPV = 6,06,740 – 5,00,000 = ₹1,06,740 (positive → accept).

(c) PI = 6,06,740 ÷ 5,00,000 = 1.21 (more than 1 → accept).

Internal Rate of Return (IRR)

Meaning: IRR is the discount rate at which NPV becomes zero, i.e. PV of inflows = cost. It is the project's own rate of return.

Decision: accept if IRR > cost of capital.

Interpolation formula: IRR = Lower rate + [NPV at lower rate ÷ (NPV at lower rate – NPV at higher rate)] × Difference in rates.

Illustration 2: A machine costs ₹3,00,000 and gives ₹1,00,000 every year for 4 years. Find IRR. (PV annuity factor for 4 years: 12% = 3.037; 13% = 2.974.)

Step 1: Fake payback factor = 3,00,000 ÷ 1,00,000 = 3.000. It lies between 3.037 (12%) and 2.974 (13%).

Step 2: IRR = 12 + [3,700 ÷ (3,700 + 2,600)] × 1 = 12 + 0.59 = 12.59%.

If the cost of capital is 10%, the machine should be accepted.

Likely exam questions

1. (Long, 8/16 marks) What is capital budgeting? Explain its importance and the Payback, NPV, IRR and PI techniques with their merits and demerits.
2. (Long, 8/16 marks) A project costs ₹2,00,000 and gives cash inflows of ₹60,000, ₹70,000, ₹80,000 and ₹50,000 in years 1 to 4. Cost of capital is 10% (PV factors 0.909, 0.826, 0.751, 0.683). Calculate Payback period, NPV and Profitability Index.
3. (Short, 4 marks) Explain the concept of time value of money.
4. (Short, 4 marks) A machine costs ₹1,20,000 and gives an annual cash inflow of ₹30,000. Find the payback period.
5. (Short, 4 marks) What is Internal Rate of Return? State its decision rule.

Syllabus topics (RTMNU)

• Meaning, Concept, Importance of Working Capital
• Factors determining Working Capital requirement
• Components of Working Capital
• Computation of Working capital requirement

Working Capital: Meaning and Concept

Definition: Working capital is the fund needed to run the day-to-day operations of a business – buying raw material, paying wages and expenses, holding stock and giving credit to customers.

Two concepts:

• Gross working capital = Total current assets (stock, debtors, bills receivable, cash, prepaid expenses).
• Net working capital = Current assets – Current liabilities (creditors, bills payable, outstanding expenses, short-term bank borrowings).

Kinds by time: (1) Permanent (fixed) working capital – the minimum amount always needed; (2) Temporary (variable) working capital – extra amount needed in peak season, e.g. a sweet shop before Diwali.

Operating cycle: Cash → Raw material → Work-in-progress → Finished goods → Debtors → Cash. The longer this cycle, the more working capital is needed.

Importance of Working Capital

1. Smooth production – raw material and wages are always available.
2. Solvency and goodwill – bills are paid on time.
3. Cash discounts – prompt payment to suppliers saves money.
4. Easy bank loans – banks lend readily to firms with a good current ratio.
5. Use of fixed assets – machines stay busy only if material and labour are there.
6. Facing crises – helps in slumps, strikes or delayed payments.
7. Higher morale – regular salary payment keeps employees satisfied.

Factors Determining Working Capital Requirement

1. Nature of business – trading firms and public utilities (electricity) need less; manufacturing firms need more.
2. Size of business – larger scale, larger need.
3. Length of production cycle – longer process (e.g. heavy machinery) needs more.
4. Seasonal nature – sugar mills, woollen goods need more in season.
5. Credit policy – liberal credit to customers raises need; credit from suppliers reduces it.
6. Business cycle – more in boom, less in depression.
7. Growth and expansion plans.
8. Price level changes – inflation increases the money needed.
9. Operating efficiency – faster stock and debtor turnover reduces need.
10. Dividend policy and availability of bank credit.

Components of Working Capital

Current assets: cash and bank balance, marketable securities, debtors (receivables), bills receivable, inventory (raw material, WIP, finished goods), prepaid expenses, accrued income.

Current liabilities: creditors (payables), bills payable, outstanding expenses, bank overdraft/cash credit, short-term loans, provision for tax, proposed dividend (where applicable).

Working capital management therefore covers four areas: cash management, receivables management, inventory management and payables management.

Illustration 1: From the following, find gross and net working capital: Stock ₹1,20,000; Debtors ₹90,000; Bills receivable ₹20,000; Cash ₹30,000; Creditors ₹70,000; Outstanding expenses ₹15,000; Bank overdraft ₹25,000.

Gross working capital = ₹2,60,000; Net working capital = 2,60,000 – 1,10,000 = ₹1,50,000. Current ratio = 2,60,000 ÷ 1,10,000 = 2.36 : 1.

Computation of Working Capital Requirement

Steps: (1) find the cost per unit; (2) find the monthly (or weekly) production; (3) value each current asset for the period it is held; (4) value each current liability for the credit period; (5) Net working capital = CA – CL; (6) add a margin for contingency if asked.

Illustration 2: A company plans to produce 12,000 units a year (1,000 units per month). Cost per unit: Raw material ₹40, Labour ₹20, Overheads ₹20 (total ₹80); selling price ₹100. Raw material is held 1 month; production takes 1 month (WIP is complete for material, 50% for labour and overheads); finished goods are held 1 month; customers get 2 months' credit; suppliers give 1 month's credit; wages are paid ½ month late. Cash balance needed ₹50,000. Add 10% for contingencies. Estimate working capital (debtors at cost).

Likely exam questions

1. (Long, 8/16 marks) What is working capital? Explain its concepts, importance and the factors determining working capital requirement.
2. (Long, 8/16 marks) Estimate the working capital required: annual production 24,000 units (2,000 per month); cost per unit – raw material ₹50, labour ₹25, overheads ₹25; raw material held 1 month; WIP 1 month (material 100%, labour and overheads 50%); finished goods 1 month; debtors 2 months at cost; creditors 1 month; cash balance ₹1,00,000.
3. (Short, 4 marks) Distinguish between gross and net working capital.
4. (Short, 4 marks) What are permanent and temporary working capital?
5. (Short, 4 marks) State the components of working capital.