Critically examine the classical Theory of Interest OR Fisher’s Time Preference Theory of Interest

The Classical Theory of Interest or Real Theory of Interest seeks to explain the determination of rate of interest by real factors like productivity and thrift i.e. productivity of capital goods and saving of goods. According to this theory the rate of interest is payment for savings. The rate of interest in this theory is determined by demand for savings to invest in capital goods and the supply of savings. Let us explain there demand and supply side.

Demand for Savings:

The demand for capital goods comes from firms which desire to invest, that are to purchase or to make new capital goods. Capital goods are demanded because they have a revenue productivity like all other factors. For any given type of capital assets e.g. a machine, it is possible to draw marginal revenue productivity curve showing the addition made to the total revenue by additional unit of machine at various levels of stock of that machine. We have said that capital like other factors of production has marginal revenue productivity. But marginal revenue productivity of capital is more complex concept than that of other factors, because capital has a lie of many years. 

A capital asset continues to yield returns for many years. Therefore the entrepreneurs have to take into consideration the uncertainties of the future and estimate the percentage yield or returns from capital after making allowance for maintaining and operating costs. In other words they have to find out the net expected return of the marginal unit of capital expressed as percentage of the cost of the capital assets. The more capital assets of given kind of entrepreneur has the less revenue or income he will expect to earn by purchasing one more machine of the same kind. Therefore the marginal revenue productivity curve of capital slopes down ward towards the right. Now under perfect competition, it is profitable for a firm to purchase any factor up to the point at which the price of that factor equals to its marginal revenue productivity. The price of the savings required to purchase the capital goods is obviously the rate of interest. Hence the entrepreneur will demand capital goods or will demand savings to purchase capital goods up to the point at which the expected net rate of return on the capital goods equals the rate of interest. Since the marginal revenue productivity curve of capital goods slopes down words, it follows that as the rate of interest falls, more capital goods will be demanded and also more money will be required to purchase these capital goods.

Here MRP is the marginal revenue. On the Y-axis net rate of return on capital and rate of interest are shown, while X-axis represents the amount of capital. At or rate of interest, OM amount of capital is demanded. This is so because only at OM amount of capital the falling net rate of return on capital becomes equal to prevailing rate of interest Or. Now if the rate of interest fall, from Or to Or', then the amount of capital demanded will increase from OM to OM', the falling net rate of return equal to the new interest rate Or'.

Thus it is clear that marginal revenue productivity curve of capital shows the demand for capital and further that the demand for capital or demand for savings to buy the capital, the capital slopes downwards to the right. This is true for individual industries and for the community as a whole.

Thus we conclude that demand for individual capital goods and for capital goods in general will increase at the rate of interest falls.

Supply of Savings

According to this theory, the money which is to be used for purchasing capital goods is made available by those who save from their current income. By postponing consumption of a part of their current incomes, they release resources for productive purpose. Saving involve the element of waiting for the future enjoyment of saving. But people prefer the present enjoyment of goods and services to the future enjoyment of then. Therefore if people are to be persuaded to save money and to lend it to entrepreneurs they must be offered some interest as reward. More savings the people will do, the more consumption they will have to postpone, the higher must be rate of interest they will to make such postponement worth while. Thus to induce people to save higher rates of interest must be offered. Moreover higher rates of interest have also to be paid if savings have to come from those persons whose rate of time preference are relatively more strongly in favour of present satisfaction. The supply curve of capital will therefore slope upward to the right.

Equilibrium between Demand and Supply

The rate of interest is determined by the interaction of the forces of demand for capital or investment and the supply of savings. The rate of interest at which the demand for capital or demand for savings to invest capital goods and the supply of savings are in equilibrium will be determined in the market.

Here SS is the supply curve of savings and II is the demand curve of savings to invest in capital goods (II is also called curve for investment). The demand for investment and supply of savings are in equilibrium at Or rate of interest, where the curve intersect each other. Hence Or is the equilibrium rate of interest, which will come to stay in the market. In this equilibrium position OM amount of capital is lent, borrowed and invested. If any change in the demand for investment tend to supply of savings come about, the curve will shift accordingly, and therefore the equilibrium rate of interest will also change.

Criticism

The Classical Theory of Interest came in for serious criticism at the hands of Keynes.

i) It is pointed out that Classical Theory of Interest is based upon assumption of full employment of resources. In other words it assumes that an increase in production of one thing must mean the withdrawal of some resources from the production of other things. With in the framework of the system of the theory built on the assumption of full employment, the notion of interest as a reward for waiting or abstinence is highly plausible. It is the premise that resources are typically fully employed that lacks plausibility in the contemporary world. If at any time in the country, unemployed resources are found on large scale to wait in order that more resources should be devoid to the production of capital goods.

ii) According to Classical theory of Interest, more investment can take place only by curtailing consumption. Greater the reduction of consumption more is the saving and therefore more investment. But a decrease in the demand of consumer goods is likely to lessen the incentive to produce capital goods and therefore will affect investment adversely.

iii) By assuming full employment, the Classical Theory has neglected changes in the income level. By neglecting the change sin the income level, the Classical theory is led into error of viewing the rate of interest as the factor which brings quality between savings and investment is brought about not by changes in the rate of interest but by changes in the level of income.

iv) According to Classical Theory the investment demand schedule can change or shift without causing a change or shift in saving curve schedule. For example according to Classical Theory, if investment demand schedule or curve shifts downwards, then the new equilibrium rate of interest will be determined. Where this new investment demand curve cuts the old saving curve which has remained unchanged. But this is wrong. As we know from Keynesian Economics, fall in investment leads to decrease in income and out of the reduced income, less is saved and therefore savings curve also changes. Thus we see that Classical Theory ignores the effect of changes in investment on savings.

v) Classical Theory as pointed out by Keynes is indeterminate. Position of the savings schedule or curve depends upon the income level, which is the position of savings curve or schedule will very with the level of incomes. There will be different savings schedules for different levels of incomes. As income rises for example the savings scheduled or curve will shift to the right. Thus we can not know what the rate of interest will be unless we already know the income level without already knowing the rate of interest, since a lower rate of interest will mean a large volume of investment and so via the multiple, a higher level of real income. 

The Classical Theory therefore offers no solution and is determinate.

Factors Affecting Business Risk Of A Firm

The business risk of a firm is measured by the variability in operating income of the firm. Larger variability in operating income denotes larger business risk. The firm's business risk changes over time and it varies from firm to firm. Some factors affecting business risk of a firm are as follows: 

1. Variability In Demand

The operating income of the firm fluctuates widely if variability in demand for firm's product is larger. Thus, a firm with larger variability in demand is more exposed to business risk.

2. Variability In Selling Price

A firm's product does not sell at constant price. The selling price of the firm's product may be volatile because of alternative demand and supply conditions, nature of competitions and so on. Thus, larger the variability in selling price wider will be the fluctuations in operating income leading to higher business risk.

3. Uncertainty Of Input Costs

Cost of input keeps on changing over time, affecting the total cost of output. The total operating cost of the firm widely fluctuates if the uncertainty associated to input cost is larger. This exposes the firm to high business risk.

4. Ability To Price Adjustment

When there is an increase in input costs, the selling price must also increase to maintain the stability in firm's operating income. However, the speed with which selling price is adjusted in response to the change in input costs, depends on price adjustment capacity of the firm.Thus, higher the firm's ability to price adjustment, lower will be the business risk.

5. Speed Of Technological Changes

The firm should adapt to changing technology over the years. If the speed of technological changes is greater and the firm is not able to adapt to changing technology, demand for firm's product will be adversely affected. The level of business risk associated to such firm is larger.

6. Extent Of Fixed Operating Costs

If larger portion of the firm's costs are fixed, the firm has to make larger sales to meet the fixed costs. At lower sales level such firm is not able to meet the fixed cost. There larger fixed cost exposes the firm to larger degree of business risk.

Concept And Meaning Of Business Risk

Business risk is defined as the riskiness on the firm's stock provided that the firm has used no debt capital. It is the risk inherent in operation of the business. A firm's business risk arises because of uncertainty associated  to projection of return in invested capital (ROIC). ROIC is calculates as below.

ROIC = NOPAT/Capital

In this equation, NOPAT is the net operating profit after tax, which is calculated as net income available to common stockholders plus after-tax interest payment. Capital includes both debt and equity. We assume for simplicity that the firm has used no preferred stock capital. If a company uses no debt capital, its interest expenses will be zero and the capital consists only common equity. Therefore, return on invested capital with zero debt os calculated as below.

ROIC = Net income/Common equity

This equation gives same result as to that of return on equity (ROE), if company has used debt capital, In such a case, the business risk is simply indicated by standard deviation, which measures the variability associated to firm's ROE assuming no debt financing used.

Concept Of Financial Forecasting

Financial forecasting is a process of projecting future financial requirements of a firm. Financial manager is concerned with the futurity of financial performance. Financial forecasting, an integral part of finance manager's job, is an act of deciding in advance the quantum of funds requirements of the firm and the time pattern of such requirements. In the process of financial forecasting, financial manager is supposed to develop projected financial statements. Efficient financial forecasting enables a financial manager to plan for future financing requirements and to identify the appropriate sources of funds to satisfy the financing needs. An efficient financial forecasting should consists of the following activities:

1. Setting up projected income statement and balance sheet so that the effect of operating plan on firm's future profit and other indicator of financial performance can be analyzed.

2. Determining need of financing to support firm's growth in sales and other investment opportunities.

3. Forecasting appropriate sources of financing that can be generated internally as well as externally.

4. Setting up proper mechanism of control relating to allocation and utilization of funds.

Sales Forecasting Methods

There are several methods of sales forecasts. Some of them are as follows:

1. Sales persons

A firm can employ its sales persons to provide a close forecast of sales. These sales person are employed at many places where firm's products are offered. They collect market information personally from customers, collect customer's response to the firm's product and thus provide an estimate if likely sales that the firm can achieve in the future.

2. Customer Survey

It is a formal process of sales forecasts applied by the firm on the basis of survey of customers in many places. Firm employs some survey people to visit many customers of many places and takes the response of existing as well as prospective customers on the basis of direct interview and questionnaire.Existing and prospective customers are asked to give their opinion verbally or in written format about the product offered by the firm. On the basis of opinion survey of customers, these survey people provide an estimate of future sales.

3. Time Series Model

Time series model is a mathematical model of sales forecasts. This model assumes that level of sales varies according to change in time period. A time series model states that the relationship between two variables, one of them being the time period and another being sales. A series of time period is regarded as independent variable and the level of sales over several time periods is used as dependent variable. Under this method, past sales data are arranged chronologically and statistical analysis of these chronological sales data is made to forecast the level of sales in some future date. Here the sales level is regarded as a function of time period. The time series model is stated as below:

Yt = f(t)

Where, 'Yt' represents the value of sales in time 't'.

4. Econometric Model

Econometric model is an important model used in sales forecasting. This method assumes that sales of firm are influenced by many factors such as level of inventory, advertisement expenses, cost of production, cost of quality control, research and development expenditure and so on. Sales are regarded as dependent variable and all other factors under considerations are regarded as independent variables. Once these variables are identified, they are into the following model to provide a forecast of sales.

Y = a+b1X1+b2X2+b3X3+...........+bnXn+e

Where,

Y = Estimated sales

X1,X2,X3 = value of independent variables influencing sales

b1,b2,b3 = the coefficient of respective independent variables

a = the intercept constants

e = standard random error term.

Concept Of Sales Forecast And Factors To Be Considered For Sales Forecasting

Concept Of Sales Forecast

Financial forecasting is a significant part of financial planning process. The financial forecasting begins with sales forecast. Sales forecast is a forecast of firm's future sales both in terms of volume and value. The sales forecast always begins with analyzing the historical trends in sales over the past periods. It also takes to consideration the future economic prosperity if given line of business. To determine the forecasted sales growth, the firm must rely on competitive market conditions, customers' tastes and preferences, change in technology and future possibilities of market expansion. Nowadays, several statistical methods like regression analysis, time series analysis, econometric models are used to consider all these factors in providing sales forecasts.

Factors To Be Considered For Sales Forecasting

Some factors that should be considered while developing sales  forecast are as follows:

1. Provide a projection of divisional sales based on historical growth and combine the divisional sales forecasts to provide a approximate corporate sales forecast.

2. Forecast the level of economic activity in each market area of the firm along with the change in population and their economic growth.

3. Estimate the market share of the firm that is expected in each market area depending on the firm's production and distribution capacity, capacity of competitors, possibility of new product and so on.

4. Forecast the effect of future rate of inflation in the consumer's purchasing power and price of products.

5.Consider the effect of advertisement campaigns, price discounts, credit terms and so on.

6. Provide the ultimate forecasts of sales for each division in aggregate and on an individual product basis.

The accurate sales forecast must be as accurate as possible. If it is overly optimistic, the firm may have idle plant capacity and unnecessary investment in inventories. If the sales forecast is overly pessimistic, it may result into loosing the customers because of failure to meet demand. Both of these conditions result into low profit margin, low return on assets, low return on equity and decline in market price of share. Therefore, accurate sales forecast is significant to improve profitability of the firm. 

Financial Planning Process

A firm's financial plan largely involves the forecast and use of various types of budgets. These budgets are prepared for every key area of firm's activities such as production, marketing, research and development, purchase and so on. The major steps involved in financial planning are as follows:

1. Project financial statements and use these projections to analyze the effects of the operating plan on projected profits and various financial ratios. The projections can also be used to monitor operations after the plan has been finalized and put into effect.

2. Determine the funds needed to support periodic plan which includes funds for plant and equipments, inventories, receivables,new product development, research and developments and for other major activities.

3. Forecast availability of funds over the planning horizon. This involves estimating the funds to generate internally as well as those to be obtained from external sources.

4. Establish and maintain a system of control to govern the allocation and use of funds within the firm.

5. Develop procedures for adjusting the basic plan, if the economic forecast upon which the plan was based do not materialize.

6. Establish a performance based management compensation system.

Concept And Objectives Of Financial Plan

Concept Of The Financial Plan

The financial plan refers to the projection of future financial course of action to be carried for efficient execution of operating plans and effective accomplishment of corporate objective. Financial plan begins with the preparation of strategic plans that in turn guides the formulation of operating plans and budgets. Financial plan provides road map for guiding, coordinating and controlling firm's financial action in order to achieve the objectives. 

Therefore, a plan that spells out future course of action, budgets and capital expenditures required for execution of operating plans is known as financial plan.

Objectives Of The Financial Plan

Most corporate organizations spend significant time and labor in preparing the financial plan as it enables a firm:

* To identify significant actions to be taken in various aspects of firm's finance functions.

* To develop various options in the field of finance functions, which can be exercised as condition change.

* To state clearly the relationship between present and future financial decision.

* To systematize the interaction required between investment and financing decision.

* To ensure that the strategic plan of the firm is financially viable.

* To provide standard against which future financial performance is compared.

Can’t spend a vacation in peace, can you?

It’s time for New Year! Parties and celebration everywhere! 

You turn on the TV, there are holiday based shows. Your mailbox is full with New Year greetings from family, friends and colleagues. Everyone is home for good – but if you are a business owner and you manage your accounts yourself, you just cannot spend a vacation in peace, can you? There are always some “vacation spoilers” and one of them is business accounts. 

Your books need to be updated regularly so that they are complete by the tax season. In cases where the owner is managing their accounts themselves, they are hard pressed for time. They often have more important appointments that they hardly find the time to make the bookkeeping entries. So it’s during the weekends and other holidays that they update accounts. They also spend sleepless nights if there is a large volume of work. 

But how long can one person keep doing this? A human being needs to eat and sleep too. You get a sense of foreboding when you think about working on your account books. It is then that you start thinking of alternatives to DIY bookkeeping. Obviously, hiring an in-house accountant is out of question as they are hardly affordable. The overheads would cost a fortune. It is also not a wise decision to let a family member or a friend to manage accounts because you do not really know if they are capable of managing accounts. 

In such a case, the best thing to do is outsource it to firms in other countries such as India and China where you get quality work done at affordable rates. It is like having your own bookkeeper but on who works from a remote location. There are no overheads so you need not spend a fortune. So research the possibilities of hiring a remote bookkeeper – you have nothing to lose. And you will finally be able to spend a vacation in peace!

Concept Of The Cost Of Money And Factors Affecting It

Concept Of The Cost Of Money

The cost of money refers to the price paid for using the money, whether borrowed or owned. Every sum of money used by corporations bears cost. The interest paid on debt capital and the dividends paid on ownership capital are examples of the cost of money. The supply of and demand for capital is the factor that affects the cost of money. In addition, the cost of money is affected by the following factors as below:

Factors Affecting The Cost Of Money

1. Production Opportunities

Production opportunities refer to the profitable opportunities for investment in productive assets. Increase in production opportunities in an economy increases the cost of money. Higher the production opportunities more will be the demand for money which leads to higher cost of money.

2. Time Preference For Consumption

Time preference for consumption refers to the preference of consumers for current consumption as opposed to future consumption. The cost of money also depends on whether the consumers prefer  to consume in current period or in future period.  If the consumers prefer to consume in current period, they spend larger portion of their earnings in current consumption. It leads to the lower saving. Lower saving reduces the supply of money causing the cost of money increase. Therefore, as much as the consumers give high preference to current consumption, the cost of money will increase and vice versa.

3. Risk

Risk refers to the chance of loss. In the context of financial markets, risk means the chance that investment would not produce promised return. The degree of risk perceived by investors and the cost of money has positive relationship. If an investor perceives high degree of risk from a given investment alternative, he or she will demand higher rate of return, and hence the cost of money will increase.

4. Inflation

Inflation refers to the tendency of prices to increase over periods. The expected future rate of inflation also affects the cost of money, because, it affects the purchasing power of investors. Increasing in rate of inflation results in decline in purchasing power of investors. The investors will demand higher rate of return to commensurate against decline in purchasing power because of inflation.

Classification Or Types Of Financial Institutions

In financial market there are many types of financial institutions or intermediaries exist for the flow of funds. Some of them involve in depositary type of transactions whereas other involve in non-depositary type of transactions. The type of financial institutions can be divided into two types as follows:

1. Depository Institutions

The depository types of financial institutions include banks, credit unions, saving and loan associations and mutual saving banks

* Commercial banks

Commercial banks are those financial institutions, which help in pooling the savings of surplus units and arrange their productive uses. They basically accepts the deposits from individuals and institutions, which are repayable on demand. These deposits from individuals and institutions are invested to satisfy the short-term financing requirement of business and industry.

* Credit Unions

Credit unions are cooperative associations where large numbers of people are voluntarily associated for savings and borrowing purposes. These individuals are the members of credit unions as they make share investment along with deposits. The saving generated from these members are used to lend the members of the union only.

* Saving And Loan Associations

Saving and loan associations are the financial institutions involved in collecting funds of many small savers and lending these funds to home buyers and other types of borrowers.

* Mutual Saving Banks

Mutual saving banks are more or less similar to saving and loan associations. They primarily accepts savings of individuals and they are lent to the home users and consumers on a long-term basis.

2. Non-depository Institutions

Non-depository institutions are not banks in real sense. They make contractual arrangement and investment in securities to satisfy the needs and preferences of investors. The non-depository institutions include insurance companies, pension funds, finance companies and mutual funds.

* Insurance Companies

Insurance companies are the contractual saving institutions which collect periodic premium from insured party and in return agree to compensate against the risk of loss of life and properties. 

* Pension/Provident Funds

Pension funds are financial institutions which accept saving to provide pension and other kinds of retirement benefits to the employees of government units and other corporations. Pension funds are basically funded by corporation and government units for their employees, which make a periodic deposit to the pension fund and the fund provides benefits to associated employees on the retirement. The pension funds basically invest in stocks, bonds and other type of long-term securities including real estate. 

* Finance Companies

Finance companies are the financial institutions that engage in satisfying individual credit needs, and perform merchant banking functions. In other words, finance companies are non-bank financial institutions that tend to meet various kinds of consumer credit needs. They involve in leasing, project financing, housing and other kind of real estate financing.

* Mutual Funds

Mutual funds are open-end investment companies. They are the associations or trusts of public members and invest in financial instruments or assets of the business sector or corporate sector for the mutual benefit of its members. Mutual funds are basically a large public portfolio that accepts funds from members and then use these funds to buy common stocks, preferred stocks, bonds and other short-term debt instruments issued by government and corporation. 

Concept And Meaning Of Financial Institutions

Financial institutions are organizations that deals with transaction of financial claims and financial assets. They issue financial claims against themselves for cash and use the proceeds from this issuance to purchase primarily the financial assets of others. Financial institutions primarily collect saving from people, business and government by offering accounts and by issuing securities. The savings are lent to the user of the funds. They also work as the intermediaries between issuer of securities and the investing public. Thus, financial institutions are the specialized firms that facilitate the transfer of funds from savers to borrowers. They offer accounts to the savers and in turn the money deposited are used to buy the financial assets issued by other forms.  Similarly, they also issue the financial claims against themselves and the proceeds are used to buy the securities of other firms. Since financial claims simply represent the liability side of balance sheet for an organization, the key distinction between financial institution and other types of organizations involves what is on the assets side of the balance sheet.

For example, a typical commercial bank issues financial claims against itself in the form of debt (for instance, checking and saving accounts) and equity; and so does a typical manufacturing firm. However, structure of assets held by a commercial bank reveals that most of the bank's money is invested in loans to individuals, corporations, and government as well. On the other hand, typical manufacturing firm invest primarily in real assets. Accordingly, banks are classified as financial institutions and manufacturing firms are not. Besides commercial banks, other example of financial institutions are finance companies, insurance companies, credit unions, pension funds, mutual funds savings and loan associations, and so on.

Types Of Financial Markets

Financial markets can be divided into different types. One way to classify the financial markets is to distinguish between primary market and secondary market. Another classification is based on life span of the securities traded in the market. They are money market and the capital market.

1. Primary Market

When securities are issued for the first time, they are traded in primary market. In other words, it is the market in which corporations raise new capital. All proceeds from the issue in this market go to issuing corporation. In issuing securities, the corporation could take the services of investment bankers and securities dealers. They assist issuing corporations selling securities in the market.

2. Secondary Market

A secondary market is the market for already existing securities, where trading between investors to investors take place. The original issuer has no role in secondary markets, and the proceeds from securities transactions do not go to the issuer.

An active secondary market is crucial for any securities once they are sold off in primary market. The existence of secondary market facilitates trading among investors to investors, thus adding to the liquidity of securities. Investors are motivated to buy securities in primary market only if the secondary markets for the securities exist.

3. Money Market

Money market deals with trading of securities with less than one year of life span. It is the market for borrowing and lending for relatively short period of time, usually less than one year. Government, corporations and individuals requiring short-term loan are major participants of money market. Government issues treasury bills to meets its need of short-term funds. Corporations could issue commercial papers or take loan on short-term basis fro banks to satisfy their short-term need of funds. Other money market instruments include bankers' acceptance, certificate of deposits, promissory notes, bills of exchange and any others with less than one year of life. These money market instruments are actively traded in primary as well as secondary market.

4. Capital Market

Capital market is the market for long-term (more than one year) securities. All long-term securities issued by corporations and government such as common stock, preferred stock, corporate bonds, government bonds are the instruments of capital market. These capital market instruments are also traded in both primary as well as secondary market. Capital market instruments are not as liquid as money market instruments because of longer maturity. However, the existence of secondary market adds to the liquidity of these instruments.

Concept And Meaning Of Financial Markets

Financial environment consists of financial markets, financial institutions, financial instruments ans services. Financial markets are the place where transaction of financial instruments and services are take place. Financial markets exists in order to bring buyer and seller of securities and financial services together. They are the mechanism that exists in order to facilitate the exchange of financial assets, thus adding to the liquidity of financial assets. Financial markets facilitate the flow of savings generated from one sector of economy to another, where there is the demand for funds. People and organizations that need to borrow money are brought together with those having surplus funds in the financial markets.

In financial markets, the corporate managers could raise funds by issuing securities or borrowing from banks. Financial markets help in bringing suppliers and borrowers together with the help of financial intermediaries directly or indirectly. Lenders or suppliers of funds exchange money for other financial assets that tend to provide a better future return.

The development of financial markets in any economy determines the degree of success of financial activities. Because financial markets add to the liquidity of financial securities, investors are generally interested to buy those securities for which a market exists.

Relationship Of Corporate Finance With Related Discipline

Finance is concerned with the acquisition and use of the firm's financial resources. It is an integral part of the overall management. Therefore, it should be studied along with other disciplines. It is because finance derives heavily the conceptual and analytic foundations from other disciplines particularly from economics and accountancy.

1. Relationship With Economics

The relationship between corporate finance and economics can be viewed from two basic aspects of economics macroeconomics and microeconomics.

Macroeconomics is concerned with broad aspects of an economy such as output, employment and income. Every business firm operates within the economy. It is imperative for financial managers to understand the broad economic framework. He must also be alert about the consequences of varying levels of economic activities, and recognize and understand the effect of monetary policy on the cost and availability of funds. The financial managers should evaluate various financing and investment alternatives in a macroeconomic framework.

Microeconomics is concerned with the economic issues relating to individual firms operating within the economy. It deals with the economic problems related to individual firms. Many principles associated to microeconomics such as demand and supply analysis, profit maximization strategies, pricing theories have practical application in finance. In this sense, finance is regarded as applied microeconomics. The principle of marginal analysis technique of microeconomics is widely used in finance for decision making.

2. Relationship With Accounting

The relationship between finance and accounting is quite close. Accounting is basically concerned with collecting, presenting and processing necessary financial data, whereas finance is concerned with decision-making. The financial manager, as per the requirements, recasts the statements prepared by accountants, generates additional data, and makes decisions on subsequent analysis.

3. Relationship To Other Disciplines

Besides its direct relationship to economics and accounting, finance is also related to other disciplines, such as mathematics production and quantitative techniques . In fact, it draws heavily on mathematics and quantitative techniques. The use of several quantitative and mathematical techniques have been extremely useful for solving complex financial problems of a firm.

Superior Decision Criterion Of Wealth Maximization Objective Of A Firm

Shareholder wealth maximization should be the basic goal of any corporation. The justification for this goal are as follows:

1. Wealth Maximization Objective Recognizes The Time Value Of Money

Time value of money is an important concept in financial decision making. Wealth maximization goal recognizes this concept. According to this concept, all cash flows generated over the life of the project are discounted back to present value using required rate of return as discount rate, and the decision is based on the present value of future returns.

2. Consideration Of Risk

Wealth maximization objective also considers the risks associated to the streams of future cash flows. The risk is taken care of by using appropriate required rate of return to discount the future streams of cash flows. Higher the risk, higher will be the required rate of return and vice versa. 

3.Efficient Allocation Of Resources

Shareholders wealth maximization objective provides guideline for firm's decision making and also promotes an efficient allocation of resources in the economic system. Resources are generally allocated taking into consideration the expected return and risk associated to a course of action. The market value of stock itself reflects the risk return trade-off associated to any investor in the capital market. In other words, shareholder wealth , maximization considers the riskiness of the income stream. Therefore, if a firm makes financing decisions considering market price of share maximization, it will raise necessary capital only when the investment ensures the economic use of capital. In the absence of pursuing the goal of shareholders wealth maximization, there is danger of sub-optimal allocation of  resources in an economy that leads to inadequate capital formation and low rate of economic growth.

4. Residual Owners

Shareholders are residual claimants in earnings and assets of the company. Therefore, if shareholders wealth is maximized, then all others with prior claim than shareholders could be satisfied.

5. Emphasis On Cash Flow

Wealth maximization objective uses cash flows rather than accounting profit as the basic input for decision making. The use of cash flows is less ambiguous because it represents means profit after tax plus non-cash outlays to all.  

Concept Of Wealth Maximization Objective Of The Firm

The wealth maximization objective is almost universally accepted goal of a firm. According to this objective, the managers should take decisions that maximize the shareholders' wealth. In other words, it is to make the shareholders as rich as possible. Shareholders' wealth is maximized when a decision generates net present value. The net present value is the difference between present value of the benefits of a project and present value of its costs. A decision that has a positive net present value creates wealth for shareholders and a decision that has a negative net present value destroys wealth of shareholders. Therefore, only those projects which have positive net present value should be accepted. For example, suppose a firm invests $ 10,000 in a project that generates net cash flow $ 3,000 each year for five years. If the firm requires 10% return on its capital, the net present value of the project is $ 1,372. Project like this should be accepted because the net present value accruing from the project belongs to shareholders, hence increases their wealth. Investors pay higher price for shares of a company which undertakes projects with positive net present value. As a result, wealth maximization is reflected in the market price of shares. Based on this logic, stock price maximization is   equivalent to shareholders wealth maximization. It is because, market price of firm's stock takes into account present and expected earnings per share; the timing, duration, and risk of these earnings; the dividend policy of the firm; and other factors that bear on the market price of the stock. Stock price maximization is considered superior goal to profit maximization goal.

Criticisms Or Drawbacks Of Profit Maximization Objectives

Although profit maximization objective is widely known objective of a firm, some theorists have raised doubts on the validity of this objective. They have criticized the profit maximization objective on the following grounds:

1. The profit maximization objective ignores the timing of returns. It equates a dollar received today with a dollar received in the future. In fact, $ 100 today is valued more than $ 100 received after one year. It is because the money received in earlier period may be reinvestable to earn more.

2. The critics of profit maximization objective argue that it ignores the risk associated with stream of cash flow of the project. For example, the total profit from two projects may be same but the profit from one project may be fluctuating widely than the profit from the other project. The firm with wider fluctuation in profit is riskier. This fact is ignored by profit maximization objective.

3. The profit maximization objective has greater relevance to a perfectly competitive firm than to a monopoly firm. Critics argue that a monopoly firm would be earning super normal profit more or less automatically.

4. Today large-scale corporate type of organizations exist. Different stakeholders such as owners, managers, customers, creditors, and employees are directly connected with the organization. The interest of each member in this organizational collusion cannot be achieved with the sole objective of profit maximization.

5. The profit maximization objective of the firm has greater relevance to short-run. In long-run, a firm cannot survive with this objective.

6. If all firms keep profit maximization as the primary objective, they may commit unfair practice to maximize profit.

Concept Of Profit Maximization Objective Of The Firm

In the conventional theory of the firm, the principle objective of a business firm is to maximize profit. Under the assumptions of given taste and technology, price and output of a given product under competition are determined with the sole objective of maximization of profit.

Profit maximization refers to the maximization of dollar income of the firm. Under profit maximization objective, business firms attempt to adopt those investment projects, which yields larger profits, and drop all other unprofitable activities. In maximizing profits, input-output relationship is crucial, either input is minimized to achieve a given amount of profit or the output is maximized with a given amount of input. Thus, this objective of the firm enhances productivity and improves the efficiency of the firm.

The conventional theory of the firm defends profit maximization objective on the following grounds:

* In a competitive market only those firms survive which are able to make profit. Hence, they always try to make it as large as possible. All other objectives are subjected to this primary objective.

* Profit maximization objective is a time-honored objective of a firm and evidence against this objective is not conclusive or unambiguous.

* Though not perfect, profit is the most efficient and reliable measure of the efficiency of a firm.

* Under the condition of competitive market, profit can be used as a perfermance evaluation criterion, and profit maximization leads to efficient allocation of resources.

* Profit maximization objective has been found extremly accurate in predicting certain aspect of firm's behaviour and trends; as such the behaviour of most firms are directed towards the objective of profit maximization.

Routine Finance Functions

Routine finance functions are those financial functions which generally do not require managerial involvment to carry out. Routine finance functions are performed for the effective execution of managerial finance functions. These functions are carried out by the people at lower levels. Routine finance functions include the following tasks as follows:

1. Supervision of cash receipts and cash payment

2. Custody and safeguarding cash balances and valuable papers such as securities, insurance policies, certificates of property, contract paper etc.

3. Taking care of mechanical details regarding all new outside financing employed by the firm.

4. Maintaining records of firm's activities which have financial implications 

5. Timely reporting to facilitate financial manager

The financial manager's involvment in these functions are only limited to the extent of setting up rules and regulations and procedures, establishing standards for the employment of personnel and evaluating the performance to ensure that rules are properly followed.

Managerial Finance Functions Or The Functions Of Financial Manager

Managerial finance functions are functions that require managerial skills in their planning, execution and control. The managerial finance functions are as follows:

1. Investment Decision

Investing decision is the managerial decision regarding investment in long-term proposals. It includes the decision concerned with acquisition, modification and replacement of long-term assets such as plant, machinery, equipment, land and buildings. Long term assets require huge amount of capital outlay at the beginning but the benefits are derived over several periods in the future. Because the future benefits are not known with certainty, long-term investment proposals involve risks.The financial manager should estimate the expected risk and return of the long-term investment and then should evaluate the investment proposals in terms of both expected returns and risk. The financial manager accepts the proposal only if the investment maximizes the shareholders wealth.

2. Financing Decision

Financing decision which is also known as capital structure decision, is concerned with determining the sources of funds and deciding upon the proportionate mix of funds from different sources. It calls for raising of funds from different sources maintaining appropriate mix of capital. The sources of long-term funds include equity capital and debt capital. A particular combination of debt and equity may be more beneficial to the firm than any others. The financial manager should decide an optimal structure of debt and equity capital.

3. Dividend Decision

Dividend decision is the decision about the allocation of earnings to common shareholders. It is concerned with deciding the portion of earnings to be allocated to common shareholders. The net income after paying preference dividends belongs to common shareholders. The financial manager has three alternatives regarding dividend decision:

* Pay all earnings as dividend

* Retain all earnings for reinvestment

* Pay certain percentage of earning and retain the rest for reinvestment.

The financial manager must choose among the above alternatives. The choice should be optimum in the sense that it should maximize the shareholders wealth. While taking dividend decisions, the financial manager should consider the preferance of shareholders as well as the investment opportunities available to the firm.

4. Working Capital Decision

Working capital decisions refers to the commitment of funds to current assets and deciding on their financing pattern. It refers to the current assets investment and financing decision. Investment in current assets affects firm's profitability and liquidity. More investment in current assets enhances liquidity. Liquidity refers to the capacity to meet short-term obligation of the firm. At the same time more investment in current assets negatively affects the profitability because current assets earn nothing or they earn much less than their cost of capital. Similarly, less investment in current assets negatively affects the firm's liquidity and the firm may lose its profitable opportunities. So, a financial manager should achieve a proper trade-off between liquidity and profitability which requires maintaining optimal investment in current assets.

Functions Of Finance Or Finance Functions

Generally, finance functions are carried on to achieve the goals of the firm. Finance functions are mainly viewed from two approaches; 'raising of funds' and 'raising and allocation of funds'. The first approach confines the finance functions to the procurement of funds only and ignores the use of funds. It was the major finance function at the early stage of the development of finance. The second approach is comprehensive and universally accepted. Nowadays, we follow the second approach. Alternatively, finance functions may be viewed on the basis of level of managerial attention required to get them performed. On this basis, finance functions may be classified as managerial finance functions and routine finance functions as below.

1. Managerial finance functions

* Investment decisions

* Financing decisions

* Dividend decisions

* Working capital decisions

2. Routine finance functions

* Supervision of cash receipts and disbursement

* Safeguarding of cash balances

* Custody and safeguarding of valuable documents like securities and insurance policies

* Taking care of mechanical details of financing

* Record keeping of the financial performance of the firm

* Reporting to the top management

* Supervision of fixed assets and current assets.

Note: These two finance functions are elaborated in further posts.

Concept And Meaning Of Corporate Finance

Business firms and government organizations do need to implement various programs to achieve their goals. Implementing programs require resources such as natural resources, human resources and financial resources. Effectiveness in the management of financial resources is key to optimize the use of natural and human resources.In the case of individual, management of financial resources or funds is known as personal finance. The same is called by public finance in government organizations. Corporate finance is used to refer to the management of funds in the context of business firm. Thus, finance as a discipline is classified into three domains: public finance, business finance and personal finance. Public finance is the management of funds for governments: both local government and central government. Traditionally, it deals with the management of revenue and expenditure of government. Personal finance refers to the management of funds of and individual. 

Generally, business finance, corporate finance and financial management, and managerial finance are used as synonym of each other. At the early stage of the development of finance as a separate discipline, academics and practitioners used business finance. Later on, they used corporate finance instead of business finance. The rationale behind the use of corporate finance was the dominance of corporate form of business organization in the business world. Traditionally, corporate finance used to focus only on the procurement of funds required to set up a company or corporation and expansion of its activities. Accordingly, the responsibility of the financial manager was limited only to estimate the financial requirements of a corporation and raise funds to meet the projected financial requirement.

Now, corporate finance is not limited to the fund raising activities; it has widened to cover the acquisition, financing and management aspects of a corporation's assets. This approach to the concept of corporate finance is known as modern concept. 

In short, corporate finance is the study of the ways to address the following issues in a firm.

1. What long-term investments should a firm take on ?

2. Where the firm will get the long-term fund to pay for investment ?

3.How the firm will manage its everyday financial activities such as collecting from customers and paying to suppliers.

4. How the firm should go about deciding upon payment to stockholders ?

Therefore, corporate finance deals with acquisition and financing management of a firm's assets that leads to shareholders wealth maximization.

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