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FINANCIAL MANAGEMENT
CLASS NOTES
BBA IV SEMESTER
Unit I Nature of Financial Management : Scope of Financial Management; Profit Maximization, Wealth Maximization - Traditional and Modern Approach; Functions of finance – Finance Decision, Investment Decision, Dividend Decision; Objectives of Financial Management; Concept of Time Value of Money : present value, future value, Risk & Return: Systematic & unsystematic risk.
Unit II Long -term investment decisions: Capital Budgeting - Principles and Techniques; Nature and meaning of capital budgeting; Evaluation techniques - Accounting Rate of Return, Net Present Value, Internal Rate of Return, Profitably Index Method. Concept and Measurement of Cost of Capital : Cost of debt; Cost of Equity Share; Cost of Preference Share; Cost of Retained Earning; Computation of over-all cost of capital (WACC)
Unit III Capital Structure : Approaches to Capital Structure Theories - Net Income approach, Net Operating Income approach, Traditional approach. Dividend Policy Decision – Introduction; Dividend Payout Ratio, Factors affecting Dividend Policy of a firm.
Unit IV Working Capital Management : Brief Overview, Importance, Levels of Working Capital Investment, Classification of Working Capital Inventory Management - ABC Analysis; Minimum Level; Maximum Level; Reorder Level; Safety Stock; Economic Order Quantity Model.
UNIT I
SCOPE AND OBJECTIVE OF FINANCIAL MANAGEMENT
INTRODUCTION
Finance is called ―The science of money‖. It studies the principles and the methods of obtaining, control of money from those who have saved it, and of administering it by those into whose control it passes. It is the process of conversion of accumulated funds to productive use.
Financial Management is the science of money management .It is that managerial activity which is concerned with planning and controlling of the firms financial resources. In other words it is concerned with acquiring, financing and managing assets to accomplish the overall goal of a business enterprise.
MEANING, DEFINITION AND NATURE OF FINANCIAL MANAGEMENT :
Meaning and Definition
Financial Management is that managerial activity which is concerned with the planning and controlling of the firm‘s financial resources. In other words it is concerned with acquiring, financing and managing assets to accomplish the overall goal of a business enterprise (mainly to maximise the shareholder‘s wealth).
―Financial Management is concerned with the efficient use of an important economic
resource, namely capital funds‖ - Solomon Ezra & J. John Pringle.
―Financial Management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient business operations‖- J.L. Massie.
―Financial Management is concerned with managerial decisions that result in the acquisition and financing of long-term and short-term credits of the firm. As such it deals with the situations that require selection of specific assets (or combination of assets), the selection of specific liability (or combination of liabilities) as well as the problem of size and growth of an enterprise. The analysis of these decisions is based on the expected inflows and outflows of funds and their effects upon managerial
objectives‖. - Phillippatus.
'Financial Engineering'
The creation of new and improved financial products through innovative design or repackaging of existing financial instruments.
Financial engineers use various mathematical tools in order to create new investment strategies. The new products created by financial engineers can serve as solutions to problems or as ways to maximize returns from potential investment opportunities.
The management of the finances of a business / organisation in order to achieve financial objectives
Taking a commercial business as the most common organisational structure, the key objectives of Financial Management would be to:
Financial Management
SCOPE AND FUNCTIONS OF FINANCIAL MANAGEMENT :
The scope of Financial Management has undergone changes over the years. Until the middle of this century, its scope was limited to procurement of funds. In the modern times ,the Financial Management includes besides procurement of funds ,the three different kinds of decision as well namely investment, financing and dividend .Scope and importance of Financial Management includes-
Estimating the total requirements of funds for a given period. Raising funds through various sources, both national and international, keeping in mind the cost effectiveness; Investing the funds in both long term as well as short term capital needs; Funding day-to-day working capital requirements of business; Collecting on time from debtors and paying to creditors on time; Managing funds and treasury operations; Ensuring a satisfactory return to all the stake holders; Paying interest on borrowings; Repaying lenders on due dates; Maximizing the wealth of the shareholders over the long term; Interfacing with the capital markets; Awareness to all the latest developments in the financial markets; Increasing the firm‘s competitive financial strength in the market; and Adhering to the requirements of corporate governance. The above scope of activities can be grouped in to three functions-
FUNCTIONS OF FINANCIAL MANAGEMENT:
The modern approach to the Financial Management is concerned with the solution of major problems like investment financing and dividend decisions of the financial operations of a business enterprise. Thus, the functions of Financial Management can be broadly classified into three major decisions, namely:
(a) Investment decisions, (b) Financing decisions, (c) Dividend decisions.
1. Investment decisions : These decisions relate to the selection of assets in which funds will beinvested by a firm .Funds procured from different sources have to be invested in various kinds of assets. Long term funds are used in a project for various fixed assets and also for current assets. The investment of funds in a project has to be made after careful assessment of the various projects through capital budgeting .A part of long term fund is also to be kept for financing the working capital requirements.
Financial Management
2. Financing decision : These decisions relate to acquiring the optimum finance to meet financialobjectives and seeing that fixed and working capital are effectively managed. It includes sources of available funds and their respective cost ,capital structure,i.e. a proper balance between equity and debt capital. It segregate profit and cash flow, financing decisions also call for a good knowledge of evaluation of risk.
3. Dividend decision- These decisions relate to the determination as to how much and howfrequently cash can be paid out of the profits of an organisation as income for its owners/shareholders, and the amount to be retained to support the growth of the organisation .The level and regular growth of dividends represent a significant factor in determining a profit making company‘s market value i.e. the value placed on its shares by the stock market.
All the above three type of decisions are interrelated ,the first two pertaining to any kind of organisation while the third relates only to profit making organisations, thus it can be seen that Financial Management is of vital importance at every level of business activity ,from a sole trader to the largest multinational corporation.
FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT
^ ^ Capital Budgeting
^ ^ Working Capital Management
^ ^ Dividend Policies
^ ^ Acquisitions and Mergers
^ ^ Corporate Taxation
^ ^ Determining Financial Needs
^ ^ Determining Sources of Funds
^ ^ Financial Analysis
^ ^ Optimal Capital Structure
^ ^ Cost Volume Profit Analysis
^ ^ Profit Planning and Control
^ ^ Fixed Assets Management Project Planning and Evaluation.
OBJECTIVE OF FINANCIAL MANAGEMENT :
Financial Management as the name suggests is management of finance. It deals with planning and mobilization of funds required by the firm. Managing of finance is nothing but managing of money. Every activity of an organization is reflected in its financial statements. Financial Management deals with activities which have financial implications. Efficient Financial Management requires the existence of some objectives or goals because judgment as to whether or not a financial decision is efficient must be made in the light of some objectives. It includes-
^ ^ Profit maximisation and wealth /value maximisation
^ ^ Achieving a higher growth rate.
^ ^ Attaining a large market share.
^ ^ Promoting employee welfare
^ ^ Increasing customer satisfaction. Improve community life.
Time Value of Money and maathematics
(1) Compounding: We find the Future Values (FV) of all the cash flows at the end of the time period at a given rate of intereest.
(2) Discounting: We determinne the Time Value of Money at Time ―O‖ by comparing the initial outflow with the sum of the Present Values (PV) of the future inflows at a given rate of interest.
Time Value of Money
Compounding Discounting
(Future Value) (Present Value)
(a) Single Flow (a) Single Flow
(b) Multiple Flows (b) Uneven Multiple Flows
(c) Annuity (c) Annuity
Future Value of a Single Flow
It is the process to dettermine the future value of a lump sum amouunt invested at one point of time.
FVn = PV (1+i)n
Where,
FVn = Future value of initial cash outflow after n years PV = Initial cash outflow i = Rate of Interest p.a. n = Life of the Investmment and (1+i)n = Future Vaalue of Interest Factor (FVIF)
Example
The fixed deposit scheme of Punjab National Bank offers the following interest rates :
Period of Deposit Rate Per Annum 46 days to 179 days 5. 180 days < 1 year 5. 1 year and above 6.
An amount of Rs. 15,000 inveested today for 3 years will be compounded too :
FVn = PV (1+i)n = PV × FVIF (6, 3) = PV × (1.06) = 15,000 (1.191) = 17,
Present Value of a Single Floow : FVn PV=
Where, PV = Present Value FVn = Future Value receivable after n years i = rate of interest n = time period
Example
Calculate P.V. of 50,000 reeceivable for 3 years @ 10%
P.V. = Cash Flows × Annuity @ 10% for 3 years. = 50,000 × 2.4868 = 1,24,340/-
CONCEPT OF RISK AND RETURN
Return expresses the amount which an investor actually earned onn an investment during a certain period. Return includees the interest, dividend and capital gains; while risk represents the uncertainty associated with a particular task. In financial terms, risk is thhe chance or probability that a certain investment may or may not deliver the actual/expected return s.
Investors make investmment with the objective of earning some tangible benefit. This benefit in financial terminology is termed as return and is a reward for taking a speecified amount of risk.
Risk is defined as thee possibility of the actual return being diffeerent from the expected return on an investment over the period of investment. Low risk leads to loow returns. For instance, in case of government securities, while the rate of return is low, the risk of defaulting is also low. High risks lead to higher potential returns, but may also lead to higher losses. Long-term returns on stocks are much higher than the returns on Government securities, but thee risk of losing money is also higher.
The risk and return trade off says that the potential return rises withh an increase in risk. It is important for an investor to deecide on a balance between the desire for the lowest possible risk and highest possible return.
Rate of return on an investment can be calculated using the following form
ula-Return = (Amount received - Amount invested) / Amount invested
The functions of Financial Management involves acquiring funds for meeting short term and long term requirements of the firm, deployment of funds, control over the use of funds and to trade-off between risk and return.
CAPITAL BUDGETING PRROCESS :
A Capital Budgeting decision involves the following process :
(1) Identification of investtment proposals. (2) Screening the proposalls. (3) Evaluation of various proposals. (4) Fixing priorities. (5) Final approval and preparation of capital expenditure budget. (6) Implementing proposal. (7) Performance review. The overall objective of capital budgeting is to maximise the profitability of a firm or the return on investment. There are many methods of evaluating profitability of capital investment proposals.
METHODS OF CAPITAAL BUDGETING OR EVALUATION OF INVESTMENT PROPOSALS (INVESTMENT APPRAISAL TECHNIQUES)
The various commonly used methods are as follows.
I. Traditional methods
(1) Pay back period method or pay out or pay off method.(PBP) (2) Accounting Rate of Return method or Average Rate of Return. (ARR)
II. Time adjusted method or discounted method
(3)Net Present Value method.(NPV) (4)Profitability Index method (PI) (5)Internal Rate of Retturn method (IRR) (6)Net Terminal Valuee method (NTV) (1) Pay back period method or pay out or pay off method.(PBP) The basic element of this method is to calculate the recovery time, by year wise accumulation of cash inflows (inclusive of depreciation) until the cash inflows equal the amount of the original investment. The time taken to recover such original investment is the ―payback period‖ for the project.
―The shorter the payback period, the more desirable a project‖.
The pay back period can be caalculated in two different situation as follows-
(a)When annual cash inflow are equal
Pay back period = Original cost of the project (cash outlay))
Annual net cash inflow (net earnings)
Example-. A project cost 1,00,000 and yields an annual cash inflow of 20,000 for 8 years, calculate pay back period.
Pay back period = Origginal cost of the project (cash outlay)
Annnual net cash inflow (net earnings)
=
years. 200, 000
(b) When annual cash inflowws are unequal
It is ascertained by cumulating cash inflows till the time when the cumulative cash inflows become equal to initial investmment.
Pay back period = Y +
B
C
Y=No of years immediately preceding the year of final recovery. B=Balance amount still to be recovered. C=Cash inflow during the year of final recovery.
Example : Initial Investment = 10,000 in a project
Expected future cash inflows 2000, 4000, 3000, 2000
Solution :
Calculation of Pay Back periood.
Year Cash Inflowss ( ) Cumulative Cash Inflows ( ) 1 2000 2000 2 4000 6000 3 3000 9000 4 2000 11000
The initial investment is recovvered between the 3rd and the 4th year.
Pay back period =Y+ B = 3+ 1000 years = 3+ 1 years= 3year 6months C^2000
Merits of Pay back period :
(1) No assumptions about futuure interest rates.
(2) In case of uncertainty in fuuture, this method is most appropriate.
(3) A company is compelled to invest in projects with shortest payback period, ifcapital is a constraint.
(4) It is an indication for the prospective investors specifying the payback period of their investments.
(5) Ranking projects as per their payback period may be useful to firmms undergoing liquidity constraints.
ARR= Average income or retuurn^ 100=^127805 100== 27.11%
Average investment 471427
Note : Unabsorbed depreciatioon of Yr. 1 is carried forward and set-off against profits of Yr. 2. Taxis calculated on the balance off profits
= 33.99% (90,000 – 500,000) = 13,596/-
Merits of ARR
(1) This method considers all the years in the life of the project. (2) It is based upon profits and not concerned with cash flows. (3) Quick decision can be taken when a number of capital investmeent proposals are being considered.
Demerits of ARR
(1) Time Value of Money is not considered. (2) It is biased against short-term projects. (3) The ARR is not an indiicator of acceptance or rejection, unless the rates are compared with the arbitrary managemennt target. (4) It fails to measure the ratte of return on a project even if there are uniform cash flows.
(3) Net Present Value methood.(NPV)
NPV= Present Value of Cashh Inflows – Present Value of Cash Outflow s
The discounting is done by thee entity‘s weighted average cost of capital.
The discounting factors is given by : n (1+ i)
1
Where
i = rate of interest per annum
n = no. of years over which diiscounting is made.
Example.
Z Ltd. has two projects under consideration A & B, each costing 60 lacs.
The projects are mutually excclusive. Life for project A is 4 years & projeect B is 3 years. Salvage value NIL for both the projectts. Tax Rate 33.99%. Cost of Capital is 15%.
Net Cash Inflow ( in Lakhs)
At the end of the year Project A Project B P.V. @ 155%
1 60 100 0. 2 110 130 0. 3 120 50 0. 4 50 — 0.
Solution :
Computation of Net Present Value of the Projects.
Project A ( in Lakhs)
Yr1 Yr. 2 Yr. 3 Yr. 4
- Net Cash Inflow 60.00 110.00 120.00 50.
- Depreciation 15.00 15.00 15.00 15.
- PBT (1–2) 45.00 95.00 105.00 35.
- Tax @ 33.99% 15.30 32.29 35.70 11.
- PAT (3–4) 29.70 62.71 69.30 23.
- Net Cash Flow 44.70 77.71 84.30 38.
(PAT+Deprn)
- Discounting Factor 0.870 0.756 0.685 0.
- P.V. of Net Cash Flows 388.89 58.75 57.75 21.
- Total P.V. of Net Cash Floww = 177.
- P.V. of Cash outflow (Initial Investment) = 60.
Net Present Value = 117.
Project B
Yr. 1 Yr. 2 Yr. 3
- Net Cash Inflow 100.00 130.00 50.
- Depreciation 20.00 20.00 20.
- PBT (1–2) 80.0 110.00 30.
- Tax @ 33.99% 27.19 37.39 10.
- PAT (3–4) 52.81 72.61 19.
- Next Cash Flow 72.81 92.61 39.
(PAT+Dep.)
- Discounting Factor 0.870 0.756 0.
- P.V. of Next Cash Flows 63.345 70.013 27.
- Total P.V. of Cash Inflows = 160.
- P.V. of Cash Outflows = 60.
(Initial Investment)
Net Present Value = 100.
As Project ―A‖ has a higher Net Present Value, it has to be taken up.
Example.
Project Cost Rs. 1,10,
Cash Inflows :
Year 1 60, ― 2 20, ― 3 10, ― 4 50,
Calculate the Internal Rate of Return.
Solution :
Internal Rate of Return will be calculated by the trial and error method. The cash flow is not uniform. To have an approximate idea about such rate, we can calculate the ―Factor‖. It represent the same relationship of investment and cash inflows in case of payback calculation i.e.
F=I/C
Where F = Factor I = Original investmennt C = Average Cash infllow per annum
Factor for the project =
The factor will be located fRom the table ―P.V. of an Annuity of 1‖ representing number of years corresponding to estimated useful life of the asset.
The approximate value of 3.144 is located against 10% in 4 years.
We will now apply 10% and 12% to get (+) NPV and (–) NPV [Which means IRR lies in between]
Year Cash Inflows P.V. @ 10% DCFAT P.V. @ 12% DCFAT ( ) ( ) ( ) 1 60,000 0.909 54,540 0.893 53, 2 20,000 0.826 16,520 0.797 15, 3 10,000 0.751 7,510 0.712 7, 4 50,000 0.683 34,150 0.636 31,
P.V. of Inflows 1,12,720 1,08,
Less : Initial Investment 1,10,000 1,10,
NPV 2,720 (1,560)
Graphically,
For 2%, Difference = 4,
↓ ↓ 10% 12%
NPV 2,720 (1560)
IRR may be calculated in two ways :
Forward Method : Taking 10%, (+) NPV
NPV at 10% IRR =10%+ Difference in rate Total Difference
IRR =10%+ 2%
Backward Method : Taking 12%, (–) NPV
IRR =12%+ 2%
The decision rule for the internal rate of return is to invest in a project if its rate of return is greater than its cost of capital.
For independent projects and situations involving no capital rationing, then :
Situation Signifies Decision
IRR = Cost of Capital the investment is expected Indifferent between not to change shareholder Accepting & Rejecting wealth.
IRR > Cost of Capital The investment is expected Accept to increase shareholders wealth
IRR < Cost of Capital The investment is expected Reject to decrease shareholders wealth
Solution :
First of all, it is necessary to find out the total compounded sum which wiill be discounted back to the present value.
Year Cash Inflows Rate of Int. (%) Yrs. of Compounding Total ( ) Investment Factor Compounding ( ) Sum ( ) 1 25,000 8 3 1.260 31, 2 25,000 8 2 1.166 29, 3 25,000 8 1 1.080 27, 4 25,000 8 0 1.000 25, 1,12,
Present Value of the sum of coompounded values by applying the discount rate @ 10%
Compounded Value of Cash Inflow = 112650 = (1 i ) n (1.10)
= 1,12,650 × 0.683 = 76,940/ -
[ 0.683 being the P.V. of 1 receivable after 4 years ]
NTV=76,940-40,000.=
Decision: The present value of reinvested cash flows, i.e., 76,940 is greater than the original cash outlay of 40,000.
The project should be accepted as per the Net terminal value criterion.
COST OF CAPITAL
The financing decision relates to the composition of relative proportion of various sources of finance .The sources could be:
- Shareholders fund : Equity share capital, Preference share capital, Accumulated profits.
- Borrowing from outside agencies : Debentures, Loans from Financial Institutions. Whether the companies choose shareholders funds or borrowed funds or a combination of both, each type of fund carries a cost.
The cost of equity is the minimum return the shareholders would have received if they had invested elsewhere. Borrowed funds cost involve interest payment.
Both types of funds incur cost and this is the cost of capital to the company. This means, cost of capital is the minimum return expected by the company.
COST OF CAPITAL AND FINANCING DECISION.
James C. Van Horne: The cost of capital is ―a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock‖.
Soloman Ezra : ―Cost of Capital is the minimum required rate of earnings or the cut-off rate of
capital expenditure‖.
It is the discount rate /minimum rate of return/opportunity cost of an investment.
IMPORTANCE OF COST OF CAPITAL :
The cost of capital is very important in Financial Management and plays a crucial role in the following areas:
i ) Capital budgeting decisions : The cost of capital is used for discounting cash flows under Net Present Value method for investment proposals. So, it is very useful in capital budgeting decisions.
ii ) Capital structure decisions: An optimal capital structure is that structure at which the value of the firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing optimal capital structure.
iii) Evaluation of financial performance : Cost of capital is used to evaluate the financialperformance of top management. The actual profitability is compared to the expected and actual cost of capital of funds and if profit is greater than the cost
of capital the performance may be said to be satisfactory.
iv) Other financial decisions : Cost of capital is also useful in making such other financialdecisions as dividend policy, capitalization of profits, making the rights issue, etc.
Explicit and Implicit Cost : Explicit cost of any source of finance is the discount rate whichequates the present value of cash inflows with the present value of cash outflows. It is the internal rate of return.
