CBSE Class 12 Business Studies Financial Management Notes Set 02

ntroduction: –
Money required for carrying out business activities is called business finance. Finance is needed to establish a business, to run it, to modernise it, to expand or diversify it.
Financial management is the activity concerned with the planning, raising controlling and administering of funds used in the business. It is concerned with optimal procurement as well as usage of finance. It aims at ensuring availability of enough funds whenever required as well as avoiding idle finance.
The Main Objective of Financial Management is to maximise shareholder wealth, for which achievement of optimum capital structure and proper utilisation of funds is a must.

Every company is required to take three main financial decisions which are as follow:

1. Investment Decision: –
It relates to how the firm s funds are invested in different assets. Investment decision can be long-term or short term. A long-term investment decision is called capital budgeting decisions which involve huge amounts of investments and are irreversible except at a huge cost while short term investment decisions are called working capital decisions, which affect day to day working of a business.

2. Financing Decision: –
It relates to the amount of finance to be raised from various long-term sources. The main sources of funds are owner s funds i.e. equity / share holder s funds and the borrowed funds i.e. Debts. Borrowed funds have to be repaid at a fixed time and thus some amount of financial risk (i.e. risk of default on payment) is there in debt financing. Moreover, interest on borrowed funds have to be paid regardless of whether or not a firm has made a profit. On the other hand, shareholder funds involve no commitment regarding payment of returns or repayment of capital. A firm mix both debt and equity in making financing decisions.

3. Dividend Decision: –
Dividend refers to that part of the profit which is distributed to shareholders. A company is required to decide how much of the profit earned by it should be distributed among shareholders and how much should be retained. The decision regarding dividend sh ould be taken keeping in view the overall objective of maximising shareholder s wealth.

Financial Planning: –
The process of estimating the fund requirement of a business and specifying the sources of funds is called financial planning. It ensures that enough funds are available at right time so that a firm could honour its commitments and carry out, its plans.

Importance of Financial Planning
1. To ensure availability of adequate funds at right time.
2. To see that the firm does not raise funds unnecessarily.
Factors affecting Investment Decisions / Capital Budgeting decisions

1. Cash flows of the project: The series of cash receipts and payments over the life of an investment proposal should be considered and analysed for selecting the best proposal.
2. Rate of Return: The expected returns from each proposal and risk involved in them should be taken into account to select the best proposal.
3. Investment Criteria Involved: The various investment proposals are evaluated on the basis of capital budgeting techniques. Which involve calculation regarding investment amount, interest rate, cash flows, rate of return etc.
Factors Affecting Financing Decision

1. Cost: – The cost of raising funds from different sources are different. The cheapest source should be selected.
2. Risk: – The risk associated with different sources is different, more risk is associated with borrowed funds as compared to owner s fund as interest is paid on it and it is rapid also, after a fixed period of time or on expiry of its tenure.
3. Flotation Cost: – The cost involved in issuing securities such as broker commission, underwriters’ fees, expenses on prospectus etc are called flotation cost. Higher the flotation ost, less attractive is the source of finance.
4. Cash flow position of the business: – In case the cash flow position of a company is good enough then it can easily use borrowed funds.
5. Control Considerations: In case the existing shareholders want to retain the complete control of business then finance can be raised through borrowed funds but when they are ready for dilution of control over business, equity can be used for raising finance.
6. State of Capital Markets: – During boom, finance can easily be raised by issuing shares but during depression period, raising finance by means of debt is easy.

Factors affecting Dividend Decision:
1. Earnings: – Company having high and stable earning could declare high rate of dividends as dividends are paid out of current and past earnings.
2. Stability of Dividends: Companies generally follow the policy of stable dividend. The dividend per share is not altered/changed in case earning changes by small proportion or increase in earnings is temporary in nature.
3. Growth Prospects: In case there are growth prospects for the company in the near future them, it will retain its earning and thus, no or less dividend will be declared.
4. Cash Flow Positions: Dividends involve an outflow of cash and thus, availability of adequate cash is foremost requirement for declaration of dividends.

Trading on Equity:
It refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest. Trading on equity happen when the rate of earning of an organisation is higher than the cost at which funds have been borrowed and as a result equity shareholder get higher rate of dividend per share.

Introduction

Financial intermediation is the process of allocating funds from saving surplus units (e.g. households) to saving deficit units (e.g. industries, government etc).

• Alternatives = Banks or Financial markets

Financial Markets

These are the institutional arrangements by which savings generated in the economy are channelised into avenues of investment by industry, business and the government. It is a market for the creation and exchange of financial assets.

Functions Of Financial Market

• Mobilisation of savings and channeling them into the most productive uses: A financial market performs the allocative function by linking the savers and investors, thus mobilising savings and channelising them to make the most use of these idle savings.
• Facilitating price discovery: The interaction between the households (supplier of funds) and business firms helps to establish a price for the traded financial asset in the market.
• Providing liquidity to financial assets: Financial assets can be easily converted into cash as financial markets provide facility of purchase and sale of financial assets.
• Reducing the cost of transactions: Financial markets provide information about the traded securities and save time, effort and money of both the buyers and sellers of a financial asset.

Types Of Financial Markets

There are two types of Financial Markets:

• Money Market
• Capital Market

A. Money Market

It is a market which deals in short term securities and whose maturity period is less than one year.

Money Market Instruments

B. Capital Market

It is a market which deals in medium and long term securities with a maturity period of more than one year.

Distinction Between Capital Market And Money Market

Capital Market Divisions

The capital market can be divided into two parts:

• Primary Market
• Secondary Market

1. Primary Market

• New issues markets
• Transfers investible funds from savers to entrepreneurs.
• Funds used for setting up new projects, expansion, diversification, modernization of existing projects, mergers and takeovers etc.

Methods Of Floatation Of New Issues In Primary Market

• Offer through Prospectus: It involves inviting subscriptions from the public through issue of prospectus. A prospectus makes a direct appeal to investors to raise capital through an advertisement in newspapers and magazines.
• Offer for Sale: Under this method, securities are offered for sale through intermediaries like issuing houses or stock brokers. The company sells securities to intermediary/broker at an agreed price and the broker resells them to investors at a higher price.
• Private Placements: It refers to the process in which securities are allotted to institutional investors and some selected individuals.
• Rights Issue: It refers to the issue in which new shares are offered to the existing shareholders in proportion to the number of shares they already possess.
• e-IPOs: It is a method of issuing securities through an on-line system of stock exchange. A company proposing to issue capital to the public through the on-line system of the stock exchange has to enter into an agreement with the stock exchange. This is called an e-initial public offer. SEBI's registered brokers have to be appointed for the purpose of accepting applications and placing orders with the company.

2. Secondary Market

• Secondary market is a market which deals with the sale and purchase of existing securities. It is also called the stock market or stock exchange.
• SEBI prescribes the framework within which all the securities are traded, cleared and settled.
• It provides opportunities of disinvestment and reinvestment to investors by exchange of securities.

Difference Between Primary And Secondary Market

Stock Exchange

It defines as "an organisation or body of individuals, whether incorporated or not established for the purpose of assisting, regulating and controlling of business in buying, selling and dealing in securities."

Functions Of Stock Exchange/Secondary Market

• Economic barometer
• Pricing of securities
• Safety of transactions
• Contributes to economic growth
• Spreading of equity cult
• Providing scope for speculation
• Liquidity
• Better allocation of capital
• Promotes the habits of savings and investment

Trading And Settlement Procedure

• In traditional times: Outcry or auction system.
• In modern times: Electronic trading system for screen based trading. In this system transactions are carried on the computer screen and both the parties are able to see the prices of all shares going up and down all the time during business hours of the stock exchange.

Advantages

• Ensure transparency
• Increases efficiency of operation and information
• Large number of participants, which improves liquidity
• Single trading platform

Steps In Trading And Settlement Procedure

• Selection of Broker: In order to trade on a Stock Exchange first a broker is selected who should be a member of stock exchange as they can only trade on the stock exchange.
• Placing the order: After selecting a broker, the investors specify the type and number of securities they want to buy or sell.
• Executing the order: The broker will buy or sell the securities as per the instructions of the investor.
• Opening Demat Account: It involves opening a demat account with a depository participant and a bank account for cash transactions.
• Settlement: After receipt of contract note and a day before the final settlement, the investor delivers the securities sold or makes payment for securities purchased, which is called pay in day. On T-2 day the broker delivers payment or securities to the exchange.

Dematerialization And Depositories

Dematerialization

It refers to the process of canceling the physical form of securities and converting them into electronic form. It was introduced under the Depositories Act 1966.

Working Of Demat System

• Identify depository participants either bank, broker or financial institution.
• An account opening form and formalities related to other documentation like PAN card details, photograph, etc. is completed.
• The physical certificate related to existing securities is given to the depository along with a dematerialisation form.
• If investors plan to apply for shares in the IPO, then details of depository participant and demat account has to be provided in the application form. The allotted shares automatically get credited to the demat account.
• If shares are sold through to a broker then the depository participant is to be instructed to debit the account with the number of shares the broker then gives instruction to his depository to deliver the shares to the stock exchange the broker receives payment from the buyer and paste them to the seller of securities.
• The entire transaction is completed within a period of 2 days the delivery of shares and receipt of payment from the buyer is on T - 2 basis settlement period.

Depository Services

Just like a bank keeps money in safe custody for customers, a depository also is like a bank and keeps securities (e.g. shares, debentures, bonds, mutual funds etc.) in electronic form on behalf of the investor. In the depository a securities account can be opened, all shares can be deposited, they can be withdrawn/ sold at any time and instruction to deliver or receive shares on behalf of the investor can be given.

Depositories In India

At present there are two depositories in India:

• NSDL (National Securities Depository Ltd.)
• CDSL (Central Depository Services Ltd.)

Depository Participants

Depository participants are intermediaries electronically connected with the depository. They act as a connect point between the depository and the investor.

National Stock Exchange Of India (NSEI)

It was recognised in 1992 and started working in 1994. It launched the capital market segment in November 1994 and option segment in June 2000 for various derivative instruments.

Objectives And Nature Of NSEI

(i) Securities traded - Capital market + Money market

(ii) Payment and delivery in 15 days time period

Market Segments Of NSEI

Exchange provides trading in following segment:

• Wholesale debt market segment
• Capital market segment

Over The Counter Exchange Of India (OTCEI)

The OTCEI was incorporated in 1990. The trading started in this exchange in 1992. This exchange is established on the lines of NASDAQ, the OTC exchange in the USA.

Objectives And Nature Of OTCEI

(i) Compulsory market makers to provide liquidity

(ii) Settlement period of OTCEI is one week

BSE (Bombay Stock Exchange Limited)

It was Asia's first stock exchange and was established in 1875. It provides a platform for raising capital which has contributed to the growth of the corporate sector. Permanent recognition to BSE was granted as per the Securities Contract (Regulation) Act, 1956.

Objectives Of BSE

(i) Efficient and transparent market for trade.

(ii) Trading platform for equities.

(iii) Ensure active trade.

(iv) Services to capital market participants.

(v) Conform to international standards.

Securities And Exchange Board Of India (SEBI)

SEBI was established by the Government of India on 12 April 1988 as an interim administrative body to promote orderly and healthy growth of the securities market and for investor protection. It was given a statutory status on 30 January 1992 through an ordinance which was later replaced by an Act of Parliament known as the SEBI Act, 1992. It seeks to protect the interest of investors in new and second hand securities.

Objectives Of SEBI

• To regulate the stock exchange and the securities market to promote their orderly functioning.
• To protect the rights and interests of investors and to guide & educate them.
• To prevent trade mal practices such as internal trading.
• To regulate and develop a code of conduct and fair practices by intermediaries like brokers, merchant bankers etc.

Functions Of SEBI

1. Protective Functions

(a) Prohibit fraudulent & unfair trade practices in the secondary market (e.g. Price rigging & misleading statement).

(b) Prohibit insider trading.

(c) Educate investors Promote fair practice & code of conduct in the securities market.

2. Development Functions

(a) Promotes training of intermediaries of the securities market.

(b) Investor education.

(c) Promotion of fair practices code of conduct of all SRO's.

(d) Conducting research & publishing information useful to all market participants.

3. Regulation Functions

(a) Registration of brokers and sub brokers & other players in the mkt.

(b) Registration of collective investment schemes & mutual funds.

(c) Regulation of stock bankers & portfolio exchanges & merchant bankers.

The Organisation Structure Of SEBI

SEBI has five operational departments headed by the Executive Director. It is advised or assisted in policy formation by two advisory committees:

• The primary market advisory committee
• The secondary market advisory committee

Objectives Of Advisory Committees

• To advise SEBI on matters related to regulations.
• To advise SEBI on development and regulation of the primary market.
• It advises SEBI on disclosure requirements for the companies as per the provisions mentioned in the Act.
• To advise SEBI in the legal framework for making dealing in the primary market simple and transparent.