types of financial markets within the financial system

1. the money uersus capital markets

the flow of funds through the financial markets may be divided into different segments depending on the charactersitice of financial clains beingf traded and the needs of different investors one of the most improtant divisions in the finanacial system is between the money markets and the capital market.

the money markets is designed for the making of short-term loans. it is the institution through which individuals and institutions with temporary surplus of funds meet the needs of borrowers who have temporary fund shortages. thus, the money markets enables economic units to manage their liquidity positions.by convention a security or loan maturity within one year or less is considered to be a money market instruments. one of the proncipal functions of the money markets governments with short term function view of fulfilling budget deficit and regulate monetary policy. the money market also supplies funds for speculative buying of securities and commodities. capital markets is desined to finance long term investments by business, government and households. teading of funds in the capital market makes possible the construction of fare highways, schools and homes, investment made in plant and machine etc. financial instruments in the capital market have a original maturities of more than one year and range in size from small loans to multimillion rupees credits.

2. open versus negotiated markets

another distraction between markets in the financail system that is often useful focuses in open market versus negotiated markets. for example,some corporate bonds are sold in the open market to the highest bidder and bought and sold any number of time before they matures and a repaid off. in contrast in the negotiated market for corporate bonds securities generally are sold to one or a few buyers under private contract.

an individual who goes to his or her local banker to secure a loan for a new car enters the negotiated market for auto loans. in the market for corporate stocks operataing the same time, however is the negotiated market for stock in which a corporation may sell its entire stock issur to one or a handful of buyers.

3. primary versus secondary markets

the financial markets mat also be divided into primary markets and secondary markets. the primary market is for the trading of new securities which are never being issued before. its principal function is raising financial capital to support new investment in building, equipment inventories and to meet capital adequacy.

the secondary market deals in securities previously issued. its chief function is to provide liquidity to security investors-that provide an avenue for convertion financial instruments into ready cash. the volume of trading in the secondary market is for larger than trading in the primary market. however, the secondary market does not support new investment.

4. spot versus future funcion and option markets

a sopt market is one in which securities or financial services are traded for immediate delivery. if you pick up the telephone and instruct your broker to purchase share at today's price this is spot market transaction. you expect to acquire ownership of shares with in a matter of minutes or hours.

a future or forwards market is designed to bid contracts calling for the future delivery of financial instruments. for example , you may call your broker and ask to purchase a contract from another investors calling for delivery to you of Rs. 1million in treasury bonds six months from today. the purpose of such contract would be to reduce risk by agreeing on a price today rather than waiting six months, when treasury bond price might have risen.

options markets also offer investors in the money and capital markets an opportunity to reduce risk. these markets make possible the trading of option on selected stocks and bonds, which are agreement's that provide an investor's the right to either buy from or sell designated securities to the writer of the option at a guaranteed price at any time during the life of the contract.

functio preformed by the financial system and the financial markets

the financial system in a modern economy has saver basis function.

1. saving function

financing ACT provides a profitable, low risk outlet for the public saving, which flow through the financial market in to investment so that goods services can be produced and increased society's standard of living.

2. wealth function

wealth is the sum of the values of all assets held by any individuals business firm or government. financial market provides a means to store purchase goods power until needed for future spending on goods and services. wealth can be stored in either purchasing real assets or purchasing financial assets. storing wealth in real assets has more risk associated than that off storing wealth in financial assets because the real assets may exist the loss of assets depreciation etc. the term net wealth is the excess if total value of assets over the total value of debt to be owed. both the net wealth and wealth are built up by a combination of current saving plus income earned on previously accumulated wealth.

3. liquidity function

financial markets provide conversion function for financial securities whenever needed of money with little risk of loss. money consists mainly of deposits held in banks and financial instruments with perfect liquidation. money can be spent without conversion in to some other form. however, money earns the lowest rate of return of all assets traded in financial system and its purchasing power is seriously earned by inflation. that is why savers generally minimize their holdings of money and hold other financial instruments until they really need spendable funds.

4. credit function

credit consists of a loan of funds in return for a promise of future payment. consumers business firms, and government need credit for their own purpose. thus, financial market provides the credit to support consumption and investment spending in economy.

5. payment function

financial market provides a mechanism for making payment for goods and services. checking account, plastic card and other electronic means. serve as a medium of exchange in making payments.

6. risk function

financial markets provides protection to consumers, business and government against risk . this is accomplished by the sale of insurance policies.

7. policy function

financial markets have been the Principal channel through which government has carried out its policy of attempting to stabilize the economy and avoid inflation. by manipulating interest rates and the availability of credit government can affect the borrowing and spending plans of the public, which , in turn influence the growth of jobs. production and prices.

factors affecting dividend policy

many considerations may affect a firm's decision about its dividends, some of them are unique to that company, and some of the more general considerations are given subsequently.
1. desire of shareholders
shareholder may be interested either in dividend incomes or capital gains. wealthy shareholders in a high income tax bracket may be interested in capital gains as against current dividends. a retired and old person, whose sources of income is dividend, would like to get regular dividend in a closed held company, management usually knows the desire if shareholders. so, they can easily adopt a dividend policy that satisfies all shareholders. but in a widely held company, number of shareholders is very large and they have diverse desire regarding dividend and capital gains, some shareholder want cash dividends, while other prefers bonus share.
2. legal rules
certain legal rules may limit the amount of dividends a firm may pay. these legal constants fall in to two categories. first, statutory restrictions may prevent a company from paying dividends. while specific limitations very by state, generally a corporation may not pay a dividend (1) if the firm's liabilities exceed its assets , (2) if the amount of the dividend excesses the accumulated profits, and (3) if the dividend is being paid from capital invested in the firm. the second types of legal restrictions is unique to each firm and result from restrictions in debt and preferred stock contracts.
3. liquidity position
the cash or liquidity position of the firm influences its ability to pay dividends. a firm may have sufficient retained earnings. buy it they are invested in fixed assets, cash may not be available to make dividend payment. thus, the company must have adequate cash available as well as retained earning to pay dividends.
4. need to repay debt
the need to repay debt also influence the availability of cash flow to pay dividend.
5. restrictions in debt contracts
restrictions in debt contracts may specify that dividends may paid only out of earnings generated after signing the loan agreement and only when net working capital is above a specified amount. also preferred dividends take precedence over common stock dividends.
6. rate of assets expansion
a high rate of assets expansion creates a need to retain funds rather than to pay dividends.
7. profit rate
a high rate of profit on net worth makes it desirable to retain earning rather than to pay them out if the investor will earn lesson them.
8. stability of earning
a firm that has a stable earning trend will generally pay a larger portion of its earnings in dividends. if earnings fluctuate significantly, a larger amount of the profits may be retained to ensure that enough money is available for investment projects when needed.
9. tax position of shareholders
the tax position of stockholders also affects dividend policy. corporations owned by largely taxpayers in high income tax brackets tend to ward lower dividend payout where as corporations owned by small investors and tend to ward higher dividend payout.
10. control
for many small firms and certain large ones, maintaining the controlling vote is very important. these owners would prefer the use of debt and retained profits to finance new investments rather than issue new stock . as a result dividend payout will be reduced.
11. access to the capital markets
a firm's access to capital market will be influenced by the age and size of the firm, therefore a well established firm is likely to have a higher payout ration than a smaller, newer firm.

dividend payout schemes

stability or regularity of dividends is considered as a desirable policy by the management of companies. most of the shareholders also perter stable dividends because all other things being the same stable dividends have a positive impact on the market price of the share . by stability we mean maintaining its position in relation to a trend live preferably one that is upward sloping. three of the commonly used dividend policies are:
1.constant dividend per share
constant dividend policy is based on the payment of a fixed rupee dividend in each period. a number of companies follow the policy of paying fixed amount per share as dividend every period, without considering the fluctuation in the earning of the company.this policy does not imply that the dividend per share or dividend rate will never be increased when the company reaches new level of earning and expects to maintain it the annual dividend per share may be increased. investors who have dividends as the only sources of their income prefer the constant dividend policy.
2. constant payout ration
the ration of dividend to earning is known as payout ration. when fixed percentage of earning is paid as dividend in every period, the policy is called constant payout ration. since earnings fluctuate, following this policy necessarily means that the rupee earned, and avoided when it incurs losses.
3. low regular dividends plus extras
the policy of paying a low regular dividend plus extras is a compromise between a stable dividend and a constant payout rate. such a policy give the firm flexibility, yet investors can count on receiving at least a minimum dividend. it is often followed by firms with relatively volatile earning from year to year. the low regular dividend can usually be maintain even when earning decline and extra dividends can be paid when excess funds are available.

dividen policy

companies that earn a profit can do one of the three things:pay that profit out to shareholders reinvest it in the business through expansion, debt reduction or share repurchase or both when a portion of the profit is paid out to the shareholders the payment is known as dividend. there is an ongoing debate about weather a company should pay out its earning as dividends or retain therm for firm growth. there is further debate about which policy investors proper. firms that are view and growing generally pay low or no dividends. mature firm that are no longer in a growth phase often pay high and increasing dividends. management must make a decision about retained as opposed to paid out as dividends the process of paying at "what's left" to shareholders in called dividend policy. dividend policy involves the decision to pay out earning versus retaining them for reinvestment in the firm any change in dividend policy has both favorable and unfavorable effects on the firm's stock price higher the dividends mean's higher the immediate cash flows to inventors which is good but lower future growth which is bad. the dividend policy should be optimal which balance the opposing forces and maximizes stock price.
dividend payments
management should try to maintain regular dividend. for regular dividend the firm will have sufficient earning management will set a lower regular dividend rate then firms with the same average earnings but less volatility. management may also declared extra dividends in years when earning are high and funds are available.
payment procedures
firms usually pay dividend on a quarterly basis in accordance with the following payment procedures:
1.declaration data: this is the day on which the board or directors declares the dividend. at the time they set the amount of the dividend to be paid the holder of record data,and the payment data.
2. holder if record date: this is the data the company opens the ownership books to determine who will receive the dividend. the stockholder of record on this data receive the dividend.
3. ex-dividend data: this data is four days prior to the record data. shares purchased after the ex-dividend data are not entitled to the dividend. only investors who hold the share prior to the ex-dividend data receive the dividend.
4. payment data: this is the day when dividend checks are actually mailed to the holders of record.

inventory management

the literary meaning of the word inventory is stock of goods inventories are greatly influenced by the level of sales. since inventories are acquired before sales can take place, inaccurate sales forecast is critical to effective inventory management inventories generally represent the major element in the working capital of as organization and a very significant proportion of total assets. investment in inventory also involves certain risk and costs. therefore the financial manager should try to maintain optimum size of inventory, which maximizes the value of the firm and minimizes the total costs associated with the inventory management inventory related costs include or ding costs, carrying costs and stock out costs. or ding costs include all the costs of placing and receiving as order. carrying costs include the various costs of holding items in inventory, including the cost of funds invested in inventory. stock out cost are the costs incurred when demand exceeds available inventory such as lost profits. raw materials are the inventories purchased from supplies which ultimately will be transformed in to finished goods. work-in process refers to inventory in-various stages of completion. finished goods are inventories that have completed the production process and are ready for sale.
cost of inventories management
the first step in inventory management in to identify all the costs involved in purchasing and maintaining inventories. carrying costs are associated with having inventory and generally increase in proportion to the average amount of inventory held.
- carrying costs associated with inventory include cost of the funds tied up, strong costs, insurance, and depreciation.
- the annual total carrying cost is equal to the product of average inventory in units, annual percentage carrying cost,and price per unit.
ordering costs are the costs of placing an order. the cost of each order generally is fixed regardless of the average size of inventory.

accounts receivable are equal to sales per day and collection period. these two factors sales per day and collection period are influenced by a set of controllable factors called the firm is credit policy. the four credit policy variables are as follows : credit period , credit standard, cash discount, collection policy.
- credit period : length of time for which credit is granted usually measured in days from the date of the invoice. lengthening the credit period stimulates sales, increases cost of receivables increase of debt losses. tightening the credit period tends to lower sales, decrease investment in receivables, and reduce the include of bed debt loss.
- credit standard: credit standards are criteria that determine which customers will be granted credit and what extent. credit standards often revolve the "five C's of credit"
(1)character- a customer's willingness to pay
(2) collateral- security offered by the firm in the form of mortgages.
(3) capacity- a customer's ability to pay.
(4) capital- the general financial position of firms as indicated by a financial ratio analysis.
(5) condition - current economic or business condition.
loose credit standard increase, sales bad debt losses, investment in receivable and collection cost. tight credit standards have opposite effects.
cash discount: firms generally offer cash discounts to make prompt payment increasing to size of discount will attract customers desiring to take discounts. cash discount terms indicate the rate of discount and the period for which discount is available are reflected in the credit terms. for example, credit terms of 3/10 ,net 30 mean that a discount of 3 percent is offered if the payment is made by the tenth day, other wise the full payment is due by the thirtieth day. liberalizing the cash discount tends to enhance sales, reduce the average collection period, and increase the cost of discount . tightening the cash discount policy has the opposite effects.
collection policy: collecting accounts receivable is usually a routine task because most firms pay their bills on time. objective of a collection is not to minimize bad debt losses, it is to maximize the value of the firm. the firm can attempt to collect post due accounts receivable in several ways. for example, letters, telephone calls collection agencies, personal visit and legal action. a tight collection policy tends to decrease sales, shorten the average collection policy reduce baddebt loss, and increase collection expense. a loose collection policy has the opposite effects.

cash management

cash is the most important current assets for the operations of the business. it is and idle and non-earning assets. therefore, the firm should keep sufficient, cash, neither more, nor less more cash balance reduce the rate of return in equity and hence the value of the firms stock the term cash includes coins, currency and cheques held by the firm and balance in its bank accounts. some times near-cash items, such as marketable securities or bank deposits, are also included in cash.

managing cash flows is an extremely important risks for a financial manager, because the primary goal of a financial manager is to maximize a firms value and is based on cash flows. the financial manager's task is determining how much cash a firm should have on hand at any fume to ensure normal business operations continue without interruptions. if a firm holds more cash than it needs shareholder's returns will not be maximized.

function of cash management

there are various functions of cash management they are as follows:

1. to cash planing: cash flows should be planned to project cash surplus or deficit for the period. cash budget is prepared for this purpose.

2. to design and managing cash flows: the cash flows should be properly managed. the inflows of cash should be accelerated and the outflows of cash should be decelerated as possible.

3. to maintain cash and marketable securities in amounts close to optimal level: the firm should try to maintain the appropriate level of cash balance. the cost of excess cash and the danger of cash deficient should be matched to maintain the optimal level of cash balance.

4.to place the cash and marketable securities in the proper institutions and in the proper forms: the idle cash or precautionary cash balance should be properly invested to earn profits. the firm should take the appropriate decision about the division of such balance between bank deposits and marketable securities.

motives for holding cash

the firm holds cash for various motives. they are:

1. transaction motive: the principle motive for holding cash is to conduct day to day operations a cash balance associated with routine payments and collections like purchase of raw material, payment of wages, salaries, interest, dividends, taxed etc.

2. compensating balance: a cash balance that a firm must maintain with a bank to compensate the bank for services rendered or for granting a loan. firm often maintains bank balance in excess of transactions. needs as a means of compensating for the various serious. these balance are called compensating balance, bank provide various services to the firm like payment of check, information of credit, loan etc. so, firm should maintain the compensating balance.

3. precautionary motive: as cash balance held in reserve for random, unforeseen fluctuation in cash inflows and outflows for example, strike, in efficiency in collection of debtors cancellation of order failure of important customers, sharp increase in cost of raw materials etc.

4. speculative motive: a cash balance that is held to enable the firm to purchase that might arise. for example,- purchasing of raw material at a reduced price on payment of immediate cash, falls in price of share and securities, purchasing at favorable price.

financial structure

financial structure refers to the composition of sources and amount of funds collected to use or invest in business. in other words financial structure refers to the capital and liabilities side of balance sheet. so it includes shareholder's funds long-term loans as well as short-term loans it is different from capital structure as capital structure includes only the long term sources of financing while financial structure includes both long term and short term sources of financing. financial structure can mainly be subdivided into ownership financing and borrowed financing ownership financing includes equity share capital and reserve and surplus. joint stock company cannot be established with co equity financing. in Nepal the promoters must hold at least one share for the incorporation of joint stock company in accordance with company act 2053. borrowed financing includes short debt and term loans as well ass the varieties of bond or debentures. preferred stock in nether purely a debt nor a equity. since it contains the characteristics of both debt and equity. it is called a hybrid security. so, there is no unanimous practice about the treatment of preferred stock . however it is said to be equity from legal point of view since the company is not obliged to pay dividends on preference shares.
following factors should be taken in to consideration while designing the capital structure or financial structure.
1.structure or financial structure
firms whose sales are relatively stable can use more debt and incur higher fixed charges than a company with unstable sales. as far as growth rate is concerned. other things remaining the same faster-growing firms must rely more heavily on external capital. thus, rapidly growing firms tend to use some what more debt than slower growing companies.
2.cost of capital
as discussed above optimal capital structure should be less costly. therefore, company should use the sources having lower cost. component cost of capital is compress of using costs and issuing costs. hence, flotation cost of various kinds of securities should also be considered while raising funds. the cost of floating a debt is generally less than the cost of floating equity and hence it may persuade the management to raise debt financing.
3.asset structure
firms whose assets are suitable as security for loans to use debt rather heavily. general-purpose assets, which can be used by many business male good collateral where as special purpose assets do not thus, real state companies are usually highly leveraged, whereas companies involved in technological research employ less debt.
4.management attitude
some management tends to be more conservative than other, and thus use less debt than the average firm in their industry, where as aggressive management use more debt in the quest for higher profits. however, if too little debt is used, management runs the risk of a takeover. thus, control considerations could lead to the use of either debt or equity, because the type of capital that best protects management will very from situation to situation.
5.lender attitudes
lender attitude frequently influence capital structure decisions. lenders emphasize that excessive debt reduces the credit standing of the borrower and the credit rating of the securities previously issued. the corporation discusses. its financial structure with lenders and gives much weight to their advice. if management wants to use leverage beyond norms for the industry , lenders may be unwilling to accept such debt increases.
6. operating leverage
other things remaining the same a firm with less operating leverage is better able to employ financial leverage. interaction of operating and financial leverage determines the overall effect of a change in sale on operating income and net cash flows.
7. taxes
interest is a deductible expense, and deductions are most valuable to firm with high tax rates. hence, the higher a firms corporate tax rate, the greater the advantage of debt.
8.profitability
firms with high rate of return on investment use relatively little debt. for example, Intel, Microsoft and coca-cola simply do not need to use much debt. their high rate of return enables them toe do most of their financing with retained earning.
9. interest rates
at certain point of time, when the general level of interest rates is low the use of debt financing might be more attractive when interest rates are high , the sale of stock may become more appealing.
10. control
the effect of debt versus stock on a management's control position can influence capital structure, if management currently has voting control, but is not in a position to buy any more new stock, it may choose debt for new financing . on the other hand , management may decide to use equity if the firms financial situation is so weak that the use of debt might subject it to serious risk of default because, if the firm goes in to default, the managers will almost surely lose their jobs. however, of too little debt is used management runs the risk of a takeover. thus, control considerations could lead to the use of either debt or equity.
11. flexibility
capital structure of a firm should be flexible i.e., it should be such as to be capable of being adjusted according to the needs of the changing conditions. it should be possible to raise additional funds whenever the need be, without much of difficulty and delay. a firm should arrange its capital structure in such a manner that it can substitute one form of financing by another.
12. nature and size of the firm
nature and size of a firm also influences its capital structure. a public utility concern has a different capital structure as compared to other manufacturing concerns. public utility concerns may employ more of debt because of stability and earning due to the nature of the business will have to rely mainly upon owned capital as it is very difficult for then to raise long term loans at a reasonable rate of interest, while a large company can arrange long term loans at reasonable terms and also can issue equity and preference share at case to the public.
13. legal requirements
the government has also issued certain guidelines for the issue of share and debentures. the legal restrictions are very significant as these lay down a framework with in which capital structure decision has to be made.

risk and return

the return from an investment cannot be through without the risk factors. since the future is uncertain, there is always a change that the returns will be either more or less than anticipated. ther greater the variation in returns the great the involvement of the risk factors,. the terms risk an uncertainty are often used synonymously.however there is difference between two uncertainty is the case when the decision maker knows all the possible outcomes. risk is related to a situation in which the decision maker knows the probabilities of the various outcomes. therefore the risk is a quantifiable uncertainly. the degree of risk may be lower for the conservative financial manager and it is higher for an aggressive financial manager. risk needs to be measured in an objective way in order to know whether it justifies a specific rate of return. an investors requires a higher return from a risky project in order to compensate for the risk. the main aim is to maximize the returns with a given level of risk or to minimize the risk with a given level return. therefore, for this purpose that returns and risks need to be measured.
investors purchase financial assets such as shares or bonds because they desire to increase their wealth, i.e., earn a positive rate of return in their investment, the future is uncertain, investors do not know what rate of return their investments will realize. in finance we assume that individuals base their decisions on what they expect to happen and their assessment of how likely it is that actually occurs will be close to what they expected to happen. when evaluating potential investment in financial assets, these two dimensions of the decision making process is called expected return and risk.
there is the relationship between expected return and the expected level of associated risk. the nature of the relationship is that as the level of expected risk increases, the level of expected return also increase, the opposite is true as well lower levels of expected risk are associated with lower expected returns. this risk-return relationship is characterized as being a direct relationship or a positive relationship this risk-return relationship is characterized as being a direct relationship or a positive relationship.

capital budgeting

the term capital refers to long-term assets used in production, while a budget is a plan which details projected inflows and outflows and outflows during some future period. so, the capital budget is a planned expenditure on long-terms assets, and capital budgeting is the process of evaluating and selecting long-terms investment. capital budgeting may be defined as the decision making process by which firms evaluate the purchase of major fixed assets, including building, machinery and equipment. capital budget describes the firm's formal panning process for the acquisition and investment of capital and results in a capital budget that is the firm's formal plan for the expenditure of money to purchase fixed assets.
example of projects include investment in property, plan and equipment research and development projects, larger advertising companions, or any other project that require a capital expenditure and generates a future cash flow. because capital expenditure can be very large and have a significant impact on the financial performance of the firm great importance is placed on project selection. this process is called capital budgeting. the goal of the firm is to maximize present shareholder value. this goal implies that project should be undertaken that result in a position net present value that is the present value of the expected cash inflow less the present value of the required capital expenditures.
categories of capital budgeting
capital budgeting decisions are assembled on various categories.
1. replacement decision: this category consists of expenditures to replace worn out or become outdated by new technology.
2. expansion decisions: this category consists of expansion of existing product line or expansion into new products.
3. diversification: this category consists of production of various products or to increase the area of business to reduce risk.
4. other categories: pollution control, equipment, safety requirements, social and environmental consideration.

portfolio

here a portfolio is the combination of investment in financial assets. the portfolio is the holding of securities and investment in financial assets. ie. bonds stock. portfolio management is related to the efficient portfolio investment in financial assets. if a person holds the stock of two different companies, such holding is called two stock portfolio. in the previous section of this chapter we studied the riskiness of a stock held in isolation. here, we analyze the degree of risk of stock held in portfolio. a stock held as a part of portfolio is less risky than the same stock held in isolation. so an individual investor can reduce the degree of risk of holding the stock in portfolio. such investors are not interested in the risk and return on a particular single stock. they are interested in risk and return of an individual security, in term's of how it affects the risk and return if the portfolio in which it is held in other words , the investor attempts to minimize the risk by making a portfolio which ultimately raises the value of her/his investment. the basic portfolio model was developed by harry markdown, who drives the expected rate of return for a portfolio of assets an expected risk measure. the markdown model is based on several assumptions regarding investor behavior:
(1) investors consider each investment alternative as being represented by a probability distribution of expected returns over some holding period.
(2)investor maximize one-period expected utility and their utility curves demonstrate diminishing marginal utility of wealth.
(3)investors estimate the risk of the portfolio on the basis of the variability of expected returns.
(4)investors base decisions solely on expected return and risk, so their utility curves are a function of expected return and the expected variance of returns only.
(5) for given risk level, investors prefer higher returns to lower returns. similarly for a given level of expected return, investors prefer less risk to more risk .
under these assumptions , a single assets or portfolio of assets is considered to be efficient if no other assets or portfolio of assets after higher expected return with the same risk, or lower risk with the same expected its risk and return. we must first be able to calculate the risk and return of a portfolio. we will deal with portfolio return first.

cocept of risk and return

the returns from an investment cannot be through without the risk factor. since the future is uncertain, there is always a chance that the returns will be either more or less than anticipated the greater the variation in returns. the greater the involvement of the risk factor.
the terms risk and certainly are often used synonymously. however, there is difference between two uncertainty is the case when the decision maker knows all the possible outcomes of a particular etc. but does not have an idea of the probabilities of the outcomes. risk is related to a situation in which the decision maker knows the probabilities of the various outcomes. therefore, the risk is a quantifiable uncertainty. the degree of risk may be lower for the conservative financial manager and it is higher for an aggressive financial manager. risk need to be measured in an objective way in order to know whether it justifies specific rate of return. an investor requiresa higher return from a risky project in order to compensate for the risk. the main aim is to maximize the returns with a given level of risk or to minimize the risk with a given level return. therefore for this purpose that returns and risk need to be measured. investors purchase financial assets such as share or bonds because they desire to increase their wealth. i.e., earn a positive rate of return on their investment will realize. in finance, we assume that individuals base their decisions on what they expect to happen and their assessment of bow likely it is that actually occurs will be close to what they excepted to happen. when evaluating potential investments in financial assets, there two dimensions of the decision making process is called expected return and risk.
there is the relationship between expected return and the expected level of associated risk. the nature of the relationship is that as the level of expected risk increase the level of expected return also increase .the opposite is true as well lower level of expected risk are associated with lower expected returns. this risk-return relationship is characterized as being a direct relationship. this risk return relationship is characterized as being a direct relationship or a positive relationship.

the finance function

the key finance function are the investment, financing,divided and liquidity decisions of an organization.
investment decision
financial manager is concerned with investment decisions. investment decision financial commonly known as capital budgeting decision or long-term assets mix decisions. capital investment is the allocation of capital to investment proposal whose benefits are to be realized in future. because the future benefit are not known with certainly, investment proposal necessarily involves risk. consequently, they should be evaluated in related to their expected return and risk. an investment decision also includes the decision to reallocate capital when assets no longer economically justifies the capital committed to it. the investment decision determines the total amount of assets held by the firm,the composition of these assets, and the business risk complexion of the firm as perceived by the supplier of capital. the essence of investment decisions is that return from the investment in proposals would exceed the firms required rate of return on capital.

financing decision

financial manager is concerned with financing decisions. financial manager must decide when ,where and how to acquirer funds to meet the firms investment needs. he must to find the best financing mix or optimum capital structure for this firm, which maximizes the market value of share financing decision is one of the important functions of finance. financing is concerned with the identification of the need of funds and collection of the funds from the right sources, in the right time in order to achieve the goal of shareholders values maximization. it is because shareholders value maximization is the one and most important goal of financial management. if the firm can effect the market price of its stock by its financing decision, it will undertake a capital structure that explain the relevance of financing policy. the relevant theory explains that the financial structure affects the value of the firm. in other words, value of the firm can be maximized by using optimal capital structure. the irrelevant theory says that the value of the firm cannot be affected by simply changing capital structure.

liquidity decision

financial manager should manager the liquidity position of his firm. current assets should be managed efficiency for safeguarding the firm against the dangers of liquidate and insolvency. if the firm does not invest sufficient funds in current assets, it may become illiquid, but current assets are non-profit generating assets. therefore, the financial manager estimate firm's needs for current assets and make sure that funds would be made available when needed.

dividend decision

the financial manager is concerned with dividend decision. the financial manager must decide whether the firm should distribute all profits, retain them. or distribute a pertain and retain the

balance. the financial manager most determine the optimum divided payout ratio, which maximized the firms value. distribution of profit among share holders is known as dividend decision. dividend decision is closely related with financing decision. dividend decided includes the decision regarding the retention of profit and profit is retained to meet the need of fund. therefore dividend decision is also considered as internally financing decision. retention of profit OS also made with a view to prevent the fluctuations in dividend. critical part of dividend decision is to decide the dividend pay out ratio. dividend payout ratio is the proportion of retained raring and dividend out of firms net profit. if the dividend OS decided below the earning rate, then certain portion of profit is retained in the business . if the firm has investment opportunity, which earns more than or equal to the cost of fund from retained earning. it must plough back the profit. if the earning is expected below the cost ,dividend distribution is desirable. thus dividend decision has multi-dimensional effects and it has to be made carefully.