OSN ACADEMY. LUCKNOW

Transcription

1 OSN ACADEMY LUCKNOW

2 SUBJECT COMMERCE SUBJECT CODE 08 UNIT - VII

3 CONTENT Ch.No. Chapter Name 1. Financial functions 2. Cost of capital 3. Weighted average cost of capital (WACC) 4. Capital structure 5. Leverages 6. Dividend decision 7. Working capital management 8. The value of money 9. Capital Budgeting & Statistical point of view 10. Discount cash flow & Investment valuation 11. DuPont analysis 12. Money & Capital markets 13. International financial management 14. Financial services 15. Portfolio Construction 16. Selection of Portfolio 17. The Form of Acquisition 18. Taxation 3

4 CHAPTER 1 FINANCIAL FUNCTIONS In this discussion we will focus our attention on the various spheres of financing activities. The finance function centres around activities. The finance function centres around the following areas: 1) Establishing Asset Management Policies Any finance function must always attempt to establish clear policies with respect to the assets of the organisation. The policy should cover an efficient method of managing assets to ensure that optimum returns are derived therefrom. However it should be noted that this is not the responsibility of the finance manager alone. It is generally an activity where all the divisions of the organisation contribute and decide what assets must be kept keeping in view their requirements. For example, the production department specifies the level of finished goods that are required to be carried. 2) Cash Flow Management This is a vital sphere of the finance function. This revolves around the identification of the cash flow requirement of the company and then exact timing. This will ensure that the finance manager will be prepared to arrange for such finances at the time of necessity. A smooth cash flow management can be achieved by developing a strong cash budgeting system which will also acts as a control mechanism for the finance department. 3) Establishing of the financing requirements of the enterprise For this the finance manager should be in a position to have all information about the activities of the organisation, specially the expansion (Diversification activities). This will arm the finance manages with all inputs that he require to estimate the needs of the enterprise. 4) Identifying and negotiating the sources of Financing Another area closely linked to finance functions is this, involves the finance department to identify all possible avenues of financing, selecting the best source keeping in view the cost of procurement thereof. Further the finance department is also involved in satisfying the documentation aspects with regard to the selected sources. 5) Allocation of Profits This involve the dividend decision. As mentioned earlier the finance function also has a big say in deciding the percentage of the dividend to be distributed and the amount to be retained in the company. 6) Keeping Tab on the Financial Performance It is the finance function which is given the job of keeping a track of the progress of the company as also of the other departments. In this respect the finance department takes the help of the techniques of Ratio analysis, Budget, variance analysis etc. 7) Compliance of Statutory Requirements The finance function has also to ensure that the various legal and statutory requirements during the course of business like, submission of the various statutory returns, 4

5 payment of the various taxes etc, are complied with in time and there are no violation in this regard. 8) Miscellaneous Functions Apart from the important activity areas the finance department is also responsible for the following activities: custodial of investment documents and securities Reporting to the top management on the various aspects of the business. Maintenance of Routine accounts data etc. The following diagram gives a clear picture of the activities of the finance function. Activities of Finance Function 5

6 CHAPTER 2 COST OF CAPITAL 1. Cost of Debt a. Cost of Perpetual Debt :- It is the rate of return which the lender expects. The coupon interest rate or the market yield on debt can be said to represent an approximation of the cost of debt. = Before tax cost of debt = Tax adjusted cost of debt = Annual interest payments = Sale proceed of the bond / debenture = tax rate. A company has 10% perpetual debt of Rs. 1,00,000. The tax rate is 35%. Determine the cost of capital (before tax as well as after tax) assuming the debt is issued at (i) par, (ii) at 10% discount, (iii) 10% premium. (i) (ii) (iii) Debt issued at par Before tax cost, After tax cost = = 10(1-0.35) = 6.65% Issued at Discount Before tax cost, After tax cost = 11.11%(1-0.35) = 7.22% Issued at Premium Before tax cost, After tax cost = 9.09%(1-0.35) = 5.91% b. Cost of Redeemable Debt :- In this case, account has to be taken in addition to interest payments, of the repayment of the principal. When the amount of principal is repaid in one lump sum at the time of maturity, the cost of debt would be given by: where : = Net cash proceeds from issue of debentures or from raising debt. = Cash outflow on interest payments in time period 1,2 and so on. = Principal Repayment in the year of maturity. = Cost of Debt. Shortcut Method : where I = Annual interest payment RV = Redeemable value of debentures / debt. SV = Net sales proceed from the issue of debenture. Nm = Term of debt 6

7 f = flotation cost d = Discount on issue of debenture Pi = premium on issue of debentures Pr = premium on redemption of debentures. T = tax rate. A company issues a new 10% debentures of Rs face value to be redeemed after 10 years. The debenture is expected to be sold at 5% discount. It will also involve flotation cost of 5% of face value. The company's tax rate is 35%. What would be the cost of debt? = 7.9% A company issues 11% debentures of Rs. 100 for an amount aggregating Rs. 1,00,000 at 10% premium redeemable at par after 5 years. The company's rate is 35%. Determine the cost of debt. 2. Cost of Preference Shares :- Cost of preference shares which has no specific maturity date is given: where = Cost of preference capital = Constant annual dividend payment = Expected sale price of preference shares = flotation cost of preference shares = Tax on preference dividend A company issues 11% irredeemable preference shares of the face value of Rs. 100 each. Flotation costs are estimated at 5% of the expected sale price. (a) What is the Kp, if preference shares are issued, (i) at par, (ii) at 10% premium and (iii) at 5% discount? (b) Also compute Kp in there situation assuming % dividend tax. (a) Issued at par (b) Issued at par (ii) Issued at Premium (ii) Issued at Premium (iii) Issued at Discount (iii) Issued at Discount Cost of Redeemable Preference shares:- where = Expected sale price of preference shares. = flotation cost as percentage of = Dividend paid on preference shares = Repayment of preference capital amount. 7

8 CHAPTER 3 WEIGHTED AVERAGE COST OF CAPITAL (WACC) It is defined as the weighted average of the cost of various sources of finance, weight being the market value of each source of finance outstanding. Cost of various sources of finance refers to the return expected by the respective investors. WACC can be calculated as follows: WACC =(Cost of Equity x % Equity) + (Cost of debt x % debt) ABC Ltd. has a 40% debt in its total capital its cost of equity is 21% and the cost of debt is 15%/ Calculate company's WACC. WWACC = (21% x 60%) + (15% x 40%) = 12.6% + 6% = 18.6% Market Value of Funds and WACC The market value is more realistic for the reasons given below: The cost of funds invested at market prices is familiar with the investors. Investments are generally rated by their earnings, yields and the company has the responsibility to maintain yield. Historic book values have no relevance in calculation of real cost of capital. The market value represents near to the opportunity cost of capital. Amarnath Cements Ltd. has the following capital structure: Particulars Market Values Book Values Cost % Equity share capital % Preference share capital % Fully secured Debentures % Calculate the company's WACC based on both Market Value and Book Values. WACC Based on Market Values Source of capital Equity capital preference capital debentures WACC Based on Book Values Source of capital Equity capital preference capital debentures Market values (Rs. Lacks) Weight Cost (%) Weighted Cost (%) WACC = 16.33% Market values (Rs. Lacks) Weight Cost (%) Weighted Cost (%) WACC = 16.78% 8

9 CHAPTER 4 CAPITAL STRUCTURE Capital structure is the proportion of debt and preference and equity shares on a firm's balance sheet. Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby maximum value of the firm. Capital Structure Theories Before going into the capital structure theories, we should first understand the need of these theories. We all know that the objective of financial management is maximisation of shareholders wealth in the form of the value of the firm. Value of the firm is derived by capitalizing the earnings at the rate of cost of capital. Value of the firm = We can say that value of the firm depends upon two factors, first is earnings and second is cost of capital. Earning is the subject matter of investment decision because investment decision decides level of earnings. Cost of capital or WACC, depends upon the proportion of individual sources in capital structure and their individual cost of capital. As we change the proportion of different sources in capital structure, WACC also changes. Now we can say that with every change in capital structure, WACC also changes and due to change in WACC, value of the firm also changes. Now the key issue here is, "Is there any relationship between value of the firm and its capital structure."? This understanding of the relationship between value of the firm and its capital structure is explained through these capital structure theories. There are two extreme and dramatically opposite viewpoints of capital structure theories. On one hand there is a view of "relevance" which says that capital structure does affect the value of a firm. The other extreme is "Irrelevance" which says that capital structure does not affect the value of a firm. Capital structure theories include the following assumptions: There is no corporate tax. There are only two long term sources of finance viz. equity and debt. All the earnings are distributed among shareholders. Capital Markets are perfect. There is no change in the total assets of the firm. Net Income Theory (Approach) (Relevance) This theory works on the assumption that Kd (cost of debt) is less than Ke (cost of equity). Now if a firm starts increasing low cost debt financing then return to the shareholders will result increase in value of equity. Due to introduction of more low cost debt, WACC will also decrease and decrease WACC means increase in the value of the firm. Now if, we reverse the situation, the WACC will increase resulting a decrease in the value of the firm. WACC / Cost o capital = According to NI Approach value of the firm and value of equity are determined as follows: Value of the firm, V = E + B where E = Value of equity, where Market value of Equity = E = B = Value of debt. where, Net Income = Earnings available to share holders. Ke = Cost of equity. Illustration A company's expected EBIT is Rs. 50,000. The company has Rs. 2,00,000, 10% debentures. The equity capitalisation rate is 12.5%, with no taxes, calculate the value of the firm and WACC. Value of the firm (NI Approach) Amt. Net Operating Income (EBIT) 50,000 Less: Interest on Debentures (I) 20,000 9

10 Earning available to shareholders (NI) 30,000 Cost of equity (Ke) Market value of Equity (E) 2,40,000 Market value of Debt (B) 2,00,000 Value of the Firm (V) 4,40,000 WACC / Cost of capital EBIT / V 11.36% Increase in Value Now if the firm increase its debt by Rs. 1,00,000 the value of the firm and WACC will be: Net Operating Income EBIT Rs. 50,000 Less : Interest (1) 30,000 Earnings Available to 20,000 Equity shareholders (NI) Cost of Equity (Ke) Market value of Equity (E) 1,60,000 Market value of Debt (B) 3,00,000 Value of the firm (V) 4,60,000 WACC / Cost of capital EBIT / V 10.9% Traditional Approach It is also a relevance theory. According to this approach, a firm can achieve an optimal capital structure level by choosing the rational mix of equity and debt. AAs per this approach, as the proportion of debt in the capital structure is increased value of the firm also increases and there will be a point where WACC will be minimised and value of a firm will maximum. This is the point of optimal capital structure. Net Operating Income Approach (NOI) This approach proclaims that there is no relationship between capital structure and the value of the firm. According to this approach the value of the firm depends upon the net operating profit (EBIT) of the firm. This means that WACC and value of the firm are independent. This approach works on the assumption that cost of debt and overall cost of capital (WACC) are constant. As the debt financing increases or the financial leverage increases cost of equity also increases. In case of all equity firm K 0 = Ke or Ke = K 0 and when debt is introduced cost of equity increases but over all of cost of debt remains constant or unchanged because increase in cost of equity is offset by benefit of low cost debt financing. In this approach the value of the firm is Also: Also: EBIT = Net Operating Income Ko = Overall cost of capital E = V B, or E = Market Value of Equity V = Value of the firm B = Market value of debt where I = Interest on debt. Assume the previous example of NI approach operating Income of Rs. 50,000, Cost of debt 10%, and outstanding debt Rs. 2,00,000. If the overall capitalisation rate is 12.5%. What would be the total value of the firm and the equity capitalisation rate? Value of the Firm (NOI Approach) Amt. Net Operating Income (EBIT) 50,000 Overall Capitalisation (Ko)

11 Value of the firm (V) 4,00,000 Less: Total Market Value of Debt (B) 2,00,000 Total Market Value of Equity (E) 2,00,000 Equity capitalisation Rate Ke = = The WACC to verify the validity of the NOI Approach. Ko = Ki (B/V) + Ke (E/V) = = or 12.5% In order to study the effect of leverage let us assume that the firm increases the amount of debt from Rs. 2,00,000 to Rs. 3,00,000. Value of the Firm (NOI Approach) Amt. Net Operating Income (EBIT) Rs. 50,000 Overall Capitalisation Rate (Ke) Value of the firm (V) 4,00,000 Less: Total Market Value of Debt (B) 3,00,000 Total Market Value of Equity (E) 1,00,000 Equity capitalisation Rate Ke = = WACC to verify the validity of NOI. Ko = 0.10 (3,00,000/4,00,000) (1,00,000/4,00,000) = = or 12.5% Let us further suppose the firm retires debt by Rs. 1,00,000 by issuing fresh equity share capital of the same amount. Net Operating Income (EBIT) Rs. 50,000 Overall Capitalisation Rate (Ke) Value of the firm (V) 4,00,000 Less: Total Market Value of Debt (B) 1,00,000 Market Value of Equity (V-B) = (E) 3,00,000 Equity capitalisation Rate Ke = = WACC to verify the validity of NOI. Ko = 0.10 (1,00,000/4,00,000) (3,00,000/4,00,000) = = or 12.5% 11

12 CHAPTER 5 LEVERAGES Leverage can be defined as the employment of assets and sources of funds having fixed costs by the firm. In other words, if a firm has presence of fixed costs in its expenses, we can say that the firm is having "leverage". Leverage can be categorised in two categories viz. financial leverage and operating leverage. Financial leverage refers presence of fixed cost in the firm (eg: interest, preference dividends etc.) operating leverage refers to presence of fixed operating cost in the firm. Essential Background Some Basic Financial Relationships Suppose Q = Quantity of a product sold by a firm (in units) P = Price per unit F = fixed cost of the firm V = Variable cost per unit of the firm I = Interest paid by the firm T = Tax rate D = Dividend paid to equity shareholders Dp = Preference dividend paid to preference shareholders. From above we can write :- Sales Revenue = Q x P = QP Total variable cost = Q x V = QV Contribution = Sales Revenue Total variable cost = QP QV or Contribution = Q (P - V).(1) Operating Profit = Contribution Fixed Cost = Q (P - V) - F.(2) Operating Profit is also known as "Earnings before interest and taxes" or EBIT Therefore EBIT = Q (P - V) F.(3) Profit / Earning before tax (PBT or EAT) EBIT Interest = Q (P - V) F 1.(4) Profit / Earning After Tax = PBT Tax = Profit before Tax PBT x Tax Rate. = [Q (P V) F 1] {[Q (P V) F I] x t} Profit after Tax = {Q (P V) F 1} {1 T}.(5) Profit available to shareholders = Profit after tax Preference dividend {Q (P V) F 1} (1 T) Dp.(6) It may be emphasised here that dividend on preference shares is paid from after tax profits but before paying and dividend to equity shareholders. If no. of equity shareholders = N Then, Earning per share (EPS) = Profit available to Equity shareholders / N EPS = [{Q (P V) F 1} (1 T) Dp] / N.(7) Operating Leverages Operating leverage can be defined as presence of fixed operating cost in the cost structure of a firm. We know that firms operating profit (EBIT) depends on sales. If there is a change in sales then the operating profit will also change. But if operating leverage is present, then the change in EBIT will be larger than the change in firm's sales. In other words, presence of operating leverage magnifies the change in EBIT due to a change in sales. Q. Suppose a company ABC Ltd. sells 10,000 units of its product of 101 per unit. It increase a variable cost of Rs. 5 per unit and a fixed cost of Rs. 30, What is change in its operating profit (EBIT) if sales (1) decreases by 20% and (2) Increase by 20%. Table A Effect of operating leverage Sales -20% Current sales Sales change by + 20% 1) Sales 80,000 1,00,000 1,20,000 2) Variable cost 40,000 50,000 60,000 3) Contribution (1-2) 40,000 50,000 60,000 4) Fixed cost 30,000 30,000 30,000 12

13 5) EBIT (3-4) 10,000 20,000 30,000 6) Change in EBIT -50% +50% As we can see the EBIT has changed by 50% for a change of 20% in the sales. That means, EBIT has changed more than change in sales. This has happened due to the presence of fixed cost or operating leverages. Now the question arises. If a firm does not have fixed operating cost in its cost structure, then by definition, it should not have operating leverage. In this case the change in EBIT will be equal to change in sales. Let's demonstrate this for the previous example. Table B Effect of operating leverage (with Sales change Current sales Sales change by + 20% no fixed cost) by -20% 1) Sales 80,000 1,00,000 1,20,000 2) Variable cost 40,000 50,000 60,000 3) Contribution 40,000 50,000 60,000 4) Fixed cost ) EBIT 40,000 50,000 60,000 6) Change in EBIT -20% +20% Degree of operating leverage DOL = Here it may be noted that DOL will always be more than 1 whenever there is presence of fixed operating costs in the cost structure of the firm's and vice versa. DOL = or DOL = = DOL enables as to compute the possible change in EBIT for a given charge in sales. The value of DOL represents % change in EBIT, for 1% change in sales. For example if DOL is 3 then it means that for one percent change in sales, EBIT will change by 3%. For example using values from table A DOL = = or 13

14 CHAPTER 6 DIVIDEND DECISIONS Dividends are the corporate profits that are distributed among shareholders of the firm. A major decision of financial management is the dividend decision in the sense that the firm has to choose between distributing the profits to the shareholders and ploughing them back into the business. The choice would obviously huge on the effect of the decision on the maximisation of shareholders wealth. Given the objective of financial management of maximising present values, the firm should be guided by the consideration as to which alternative use is consistent with the goal of wealth maximisation. That is, the firm would be well advised to use the net profits for paying dividends to the shareholders if the payment will lead to maximisation of wealth of the owners. If not, the firm should rather retain them to finance investment programs. The relationship between dividends and value of the firm should, therefore, be the decision criterion. Dividend decision theories The value of the firm can be maximised if the shareholders' wealth is maximised. There are conflicting views regarding the impact of dividend decision on the valuation of the firm the two views of the two school of thoughts are as under: The irrelevance concept of dividend or the theory of irrelevance. The relevance concept of dividend or the theory of relevance. Irrelevance Concept of Dividend 1) Residual Approach According to this theory, dividend decisions have no effect on the wealth of the shareholders or the prices of shares and hence it is irrelevant so far as the valuation of the firm is concerned. This theory regards dividend decision merely as a part of financing decision because earning available may be retained in the business for reinvestments. But if the funds are not required in the business they may be distributed as dividends. Thus, the decision to pay dividends or return the earnings may be taken as a residual decision. This theory assume that the investors do not differentiate between dividends and retention by firm. Their basic desire is to earn higher return on their investments. In case the firm has profitable investment opportunities giving a higher rate of return than the cost of retained earnings the investors would be content with the firm retaining the earnings to finance the same. However, if the firm is not in a position to find profitable investment opportunities, the investors world prefer to receive the earnings in the form of dividends. 2) Modigliani and Miller Approach (MM Model) Modigliani and Miller have expressed in the most comprehensive manner in support of the theory of irrelevance. They maintain that dividend policy has no effect on the market price of share and the value of the firm. Value of the firm is determined by its basic earning power and its business risk. In other words, they argued that the value of the firm depends solely on its earning power and is not influenced by the manner in which it splits its earnings between dividends and retained earnings. Assumptions 1) There are perfect capital markets. 2) There are no taxes. 3) A firm has fixed investment policy. 4) There is no risk. MM argument is based on arbitrage arguments. The term arbitrage refers to involving simultaneously in two transaction which exactly balance each other. The investors are indifferent between dividend and retention of earnings, hence the share price or wealth would not be affected by the payment of current dividends and retention of earnings decision of a firm. Prof of MM Hypothesis MM have proved their arguments in the followings ways: Firm value when dividends are paid 1) Market Price of share at the end of period 1 : 14

15 the market price per share (P 0 ) in the beginning of the period is equal to the present value of dividends paid at the end of the period plus market price of share at the end of the period. 2) The total capitalisation value of outstanding equity shares of the firm at period 'o' is obtained by the use of the following formula: 3) Amount needed to be raised by the issue of new shares. where = Amount raised by the sale of new shares. I = Total funds required for investment. E = Total earnings of the firm during the period = Total dividend period = Retained Earnings 4) No. of addition shares to be issued : 5) Value of the firm Q. Dream well Co. Ltd. belongs to a risk class for which the approximate capitalisation rate is 10%. It currently has an outstanding 30,000 shares, which are selling in the market at Rs. 80. The company is expecting a net income of Rs. 4,00,000 and it has a profitable investment project that cost Rs. 6,00,000. The company is interested to declare a dividend of Rs. 4 per share at the end of financial year. Show that under MM hypothesis the payment of dividend does not affect the value of the firm. (a) Value of company when dividends are paid: (i) Calculation of share price at the end of year 1 P 1 = P 0 (1+Ke) D 1 = 80 ( ) 4 = (Rs. 80 x 1.1) 4 = 84 (ii) Amount required to be raised from outside by issue of new shares: np 1 = 6,00,000 [400,000 (30,000 x 4)] = Rs. 3,20,000 (iii) No. of additional shares to be issued: n = (iv) Value of firm: np 0 = np 0 = = = = = 24,00,000 (b) If dividends were not paid (i) P 1 = P 0 (1 + Ke) D 1 P 0 = P 0 = 80 D = 0 Ke = 10% P 1 =? 15

16 P 0 = = 80 = = Rs. 88 (ii) Amount required to be raised by issue of new shares : np 1 = I (E nd 1 ) nd 1 = 0 np 1 = (6,00,000 4,00,000) = Rs. 2,00,000 (iii) (iv) No. of new shares to be issued: n = Value of firm = = = = 24,00,000 Q.2 ABC Ltd. belong to risk class for which the appropriate rate is 10%. It currently has outstanding 5000 shares selling at Rs. 100 each. The firm is contemplating the declaration of dividend of Rs. 6 per share at the end of the current financial year. The company expects to have a net income of Rs. 50,000 and has a proposal for making new investments of Rs. 1,00,000. Show that under the MM hypothesis, the payment of dividend does not affect the value of the firm. (A) Value of the firm when dividend is paid: (i) Price of share at the end of year 1 (ii) P 1 = P 0 (1+Ke) D 1 = 100 (1+1) 6 = Rs. 104 No. of shares to be issued and additional capital amount to be raised by issue of new shares. np 1 = I (E-nD 1 ) = 1,00,000 (50,000 30,000) = 80,000 n = (iii) Value of the firm np 0 = 16

17 CHAPTER 7 WORKING CAPITAL MANAGEMENT Management of current asset held by a firm is known as working capital management. It involves the administration, control, procurement and financing of current assets. Current assets include cash, marketable securities, short-term investments, accounts receivables, inventory and so on, and financing of current assets include current liabilities and bank borrowings. Thus, working capital management deals with funds involved in the day to day operations of the firm. We know that the value of the current assets goes on changing continuously, ie; it increases or decreases during the year as the firm continues its operations. Hence, management of working capital becomes increasingly important in order to protect the firm from liquidity problems. Total current Assets (TCA) of the firms are termed as the gross working capital (GWC) of the firm. GWC = TCA Net working capital = Total current asset Total current liabilities NWC = TCA TCL Liabilities are the economic obligations of the company to pay cash or provide goods or services to outsiders including shareholders. Current liabilities are the obligations of the firm that are to be paid within an accounting year. Objective of Working Capital Management The basic objective of working capital management for a given firm is to provide itself adequate liquidity so that the firm is able to carry on its normal operations smoothly. Every firm thus has to decide for itself the optimum level of working capital which is to be maintained by it. If current assets are excessive then the firm is said to have idle funds, because they do not earn any profits for the firm. On the other hand, scarcity of working capital may result in interrupted and inefficient production process. It also leads to certain problems, for example, the seasonal firms are not able to procure adequate current assets for smooth manufacturing. In case of contingent requirement of funds, the firm may be forced to borrow money from outside. Most probably at a higher cost than the existing cost. Thus, the overall cost of funds may increase. There may be regular stoppage and interruption in production processes. Which again affect the quality of the final product: Regular interruption in manufacturing processes. May also lead to wastage of labour and other manufacturing expenses such as fuel, power, water etc. the firm may also not be able to meet its product demand, which may also leads to destruction of firm's goodwill in the market. Scarcity of fund investment in current asset may also imply lack of confidence of investors in the firm. Hence, firms need to determine their optimum requirement of working capital as shown in the following figure. Conservative working capital policies When the firm maintain huge investments in its current assets, then its liquidity will be very high as current assets can be easily converted into cash. Thus, the greater the level of current assets, the greater the liquidity of the firm, provided all other things remaining equal. The greater the level of current assets, the greater the funds blocked in current assets, thereby reducing the opportunity of investing the same funds into profitable investment opportunities available to the firm. Hence, the productivity of such firms will be 17

18 comparatively less due to its low earning capacity. As funds are blocked in the existing current assets and are not invested to produce future benefits, the risk and uncertainty component is also low for the firm. Such a firm has a tendency of relying more on long term funds for financing purpose. Aggressive Working Capital Policies The scenario reverse if the firm has ample amount of funds, which instead of being invested in current assets are invested in profitable investment opportunities available to the firm, resulting in increasing yield to the firm, hence the total profitability of the firm increases. As the firm invest scarcely in the current assets, the risk of production blockage or stoppage is very high as the supply to the production may be hampered due to the scarcity of current assets as well as funds available with the firm. If during such a situation of shortage of funds, the firm has to borrow funds externally to allow smooth manufacturing, and then the funds may carry extra cost as compared to the existing funds. These extra costs will lead to an increase in the total cost of funds for the firm. Another possibility can arise related to risk and uncertainty of future benefits of the profitable investment opportunities; eventually. The risk and uncertainty of such a firm is very high. Such a firms are said to adopt an aggressive investment policy. These firms have a tendency to use more short term funds for their financing needs. 18

19 CHAPTER 8 TIME VALUE OF MONEY Conceptually, time value of money 'Means that the value of a unit of money is different in different time period. The value of an sum of money received today is more than its valve received after some time. Conversely, the sum of money received in future is less valuable than it is today. In other words, the present worth of a rupee received after sometime will be less than a rupee received after sometime will be less than a rupee received today. Since a rupee received today is more valuable or has more value, rational investor should prefer the current receipts to future receipts. The time value of money can also be referred to as the time preference for money. The time preference for money is these with most of the investors because of the various other investment opportunities lying ahead for the funds received earlier. The funds so invested will generally expected yield a return, which would not be possible if they are received at a later period of time. The time preference for money is therefore, expressed generally in terms of rate of return or popularly known as discount rate. The expected rate of return as also the time value of money will vary from individuals to individual depending upon the interlace of higher perception. The time value of money can be illustrated using a simple example: Suppose Mr. X is given the choice of receiving Rs either now or one year later. His choice world obviously be the first alternative as he can deposit the same amount in the saving bank account and earn a nominal late of interest say 5% pa on the some money at the end of the year, the amount will accumulate to 1050 Rs. In other words, the choice before Mr. X is between Rs and Rs at the end of the year. As a rational person Mr. X should be prefer or expected the larger amount (ie: Rs. 1050). Here we can say that the time value of money that is the rate of interest is 5%. It may, thus, be seen that future cash flows are less valuable because of the investment opportunities of the present cash flows. Business firms usually make decisions which have results extending beyond the period in which it has been taken. For instance the capital budgeting decision generally involves the current cash outflow in terms of amount required for purchasing a new machine or launching a new project and the execution of the scheme generates future cash inflows during its useful life. Let us assume that the project cost is Rs. 10,00,000. The life of the project is one year in which it is estimated to generate a cash outflow of Rs. 10,80,000. At first instance the project appears to be accepted as it gives the profit of 80,000 but when we consider a rate of interest on such project cost say of 10% pa then the project will cost 11,00,000. Thus the time value of money is of crucial significance. This requires the development of produces and techniques for evaluating future incomes in term of the present value. There are two technique for doing this (1) compounding and (2) discounting (1) Compounding It is the interest earned on a given deposit principal that has become a part of the principal at the end of a specified period interest is compounded. When the amount earned on an initial deposit becomes part of the principal at the end of the first compounding period. The term principal refers to the amount of money on which interest is received. For example : If Mr. X invest in a saving bank A/c Rs at 5% interest compounded annually, at the end of the first years, he will have Rs. 1,050 in his account. This 19

20 amount constitute the principal for earning interest for the next year. At the end of the next year there would be Rs in the A/c. This would represent the income for the third year the amount of interest earned would be Rs The total amount appearing in his A/c would be Rs Annual Compounding Year Beginning amount Interest rate Amount of Interest Beginning Principal Ending principal This compounding procedure will continue for an indefinite number of years (The compounding of interest can be calculated by following equation). A = P ( 1 + i) n Where A = amount at the end of the period. i = rate of interest. P = Principal at the beginning of the period. n = number of years. The amount of money in the account at the end of various years is calculated by using the previous example. Amount it the end of one year. 1 = Rs ( ) = 1000 (1.050) = = Rs ( ) = 1050 (1.050) = = Rs ( ) = (1.050) = Similarly, the amount at the end of year 3 can be determined in the following way: Rs (1+.05) (1+.05) (1+.05) = Rs We can get the computed in the respective takes. In the above examples we have assumed annual compounding of interest at the end of the year. Very often the interest later are compounded more hence once in a year. Saving institutions particularly, compounded interest, semi-annually, quarterly and even monthly. Semi-annual Compounding It means that are two compounding period with the year. Interest is actually paid after every six months at a rate of one-half of the annual rate of interest. For example Mr. X invest has saving in a bank for two years of Rs he could be getting which is compounded semiannual. So he will be getting or paid 3 percent interest compounded over a period six months. The table follows will clear the up. This can also be calculated as by the formula A = P (l + i) For Semi-annual compounding we have to P = 1000 e = 0.06/2 = 0.03 i = 0.06 n = 2 x 2 = 4 ie, A = 1000(1+0.03) 4 = 1000(1.126) =

21 CHAPTER 9 STATISTICAL POINT OF VIEW Standard Deviation Risk refers to the desperation of returns around an expected value. The most common statistical measure of risk of an asset is the standard deviation from the mean or expected value of return. It represents the square root of the average squared deviations of the individual returns from the expected returns. Symbolically, the standard deviation,. Table following presents the calculation of the standard deviation for the return of asset x and asset y. Asset X i R % 16% (-2)% 4% % 2 16% 16% % 16% Asset Y i R (-8) The greater the standard deviation of returns the greater the variability / dispersion of returns and the greater the risk of the asset/ investments. However, standard deviation is an absolute measure of dispersion and does not consider variability of return in relation to the expected value. It may be misleading in company the risk surrounding the alternative assets if they differ in size of expiated returns. Coefficient of variation It is measure of relative dispersion (risk) or a measure of risk per unit of expected return. It converts standard deviation of expected values into relative values to enable comparison of risk associated with assets having different expected values. The coefficient of variation (CV) is computed by dividing the standard deviation, for an asset by its expected value,. Symbolically, 21

22 The coefficient of variation for assets X and Y are respectively (1.26% 16%) and (5.06% 16%). The larger the CV the larger the relative risk of the asset. As a rule, the use of coefficient of variation for. Comparing asset risk is the best since it considers the relative size (expected value) of assets. Financial Functions 1. Investment or long-term asset mix decision 2. Financing or capital mix decision 3. Dividend or profit allocation decision 4. Liquidity or short-term asset-mix decision Environment of finance in organization of finance function The responsibilities of financial management are spread throughout the organisation in the sense that financial management is to an extent, and integral part of the job for the managers involved in planning, allocation of resources and control. Financial Management is highly specialised in nature and is handled by specialists. Financial decisions are of crucial importance. It is therefore, essential to set up an efficient organisation for financial management functions. Since finance is a major / critical functional area, the ultimate responsibility for carrying out financial management function lies with the top management that is, board of directors / managing director / chief executive or the committee of the board. 22

23 However the exact nature of the organisation of the financial management function differ from firm to firm depending upon factors such as size of the firm, nature of its business, type of financing operations, ability of financial officers and the financial philosophy and so on. Similarly, the designation of the chief executive of the finance department also differs widely in case of different firms. In some cases, they are known as finance managers while in others as Vice President (finance) director (finance) and financial controller and so on. He reports directly to the top management various sections within the financial management area are headed by managers such as controller and treasurer. The job of the chief financial executive does not cover only routine aspects of finance and accounting. As a member of top management, he is closely associated with the formulation of policies as well as decision making. Under him are controllers and treasurers, although they may be known by different designations in different firms. The task of financial management and allied areas like accounting are distributed between these two key financial officers. Their functions are described below: The main concern of the treasurer is with the financing activities of the firm. Included in the range of his functions are: (i) obtaining finance (ii) banking relationship, (iii) investor relationship, (iv) short-term financing, (v) cash management, (vi) credit administration, (vii) investments and (viii) insurance. The functions of the controller are related mainly to accounting and control. The typical functions performed by him include (i) financial accounting (ii) internal audit, (iii) taxation, (iv) Management accounting and control, (v) budgeting, planning and control, and (vi) economic appraisal and so on. Capital Budgeting Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the goal of shareholders (owners) wealth maximisation. In other words the system of capital budgeting is employed to evaluate expenditure decisions which involve current outlays but are likely to produce benefits over a period of longer time usually over an year. The term capital budgeting is used interchangeably with capital expenditure decision, capital expenditure management, long-term investment decision, management of fixed assets and so on. Capital Budgeting decisions are of paramount importance in financial decision making. In the first place, such decisions affect the profitability of the firm. They also have a bearing on the competitive position of the enterprise mainly because of the fact that they relate to fixed assets. The fixed assets represents in a sense, the true earnings assets of the firm. They enable the firm to generate finished goods that can ultimately be sold for profit. The methods of appraising capital expenditure proposals can be classified into two broad categories: (i) traditional and (ii) time-adjusted or discounted cash flow technique 23

24 CHAPTER - 10 DISCOUNT CASH FLOW AND INVESTMENT VALUATION The discounted cash flows are popularly known as cost of capital. This is defined as the minimum discount rate that must be earned on a project that leaves the firm's market value unchanged. Discounted cash flows are thus the present value of the future cash flows. The concept of present value can be explained by considering an example. We know that a rupee received this year is not equal to a rupee received next year. This is because the rupee can be deposited in a bank, say at 6% and it becomes Rs next year. Therefore if somebody offers to give a rupee this year in exchange for a rupee next year. We would ask him to give us Rs next year or Re 1 now. In other words, Rs is the future value of Re 1 at the rate of 6% for one year or Re 1 is the present value of Rs at the rate of 6% for one year. To calculate the present value of various inflows we should refer to the present value table with the help of this table we can work out the present value of each cash inflow. This is also a good technique to evaluate various investment alternative available to an investors. We can value an investment through present value method also called NPV which means that if the present value of the cash inflows during the working life of the investment is greater than the present value of all the cash outflows. We can say that the NPV is positive and the project is worth taking or investing. This can be better explained with the help of the following example. Q. National Electronic company if considering two mutually exclusive projects X and Y costing Rs. 120 Lakh each. Project X has a useful life of 8 years and Project Y has a useful life of 6 years/ The cash flows for both the projects are given below: the company's cost of capital is 15% p.a. Net Cash Inflows Year Project X Project Y Present value factor at 15% Advise the company regarding the selection of the project. The company is already making profits and its tax rate is 50%. The company follows straight line method of depreciating asset. Project X Year CF Dep. PBT Tax PAT Net CF PV PV (PAT+Dep) Factor

25 PV of cash inflows Initial Investments Net Present Value 8.23 Project Y Year CF Dep. PBT Tax PAT Net CF PV PV (PAT+Dep) Factor PV of cash inflows Initial Investments Net Present Value Project Y has a higher net present value, it has to be taken up. 25

26 CHAPTER 11 DUPONT ANALYSIS Financial Statement Analysis is employed for a veriety of reasons outside investors are seeking information as to the long run viability of a business and its prospects for providing an adequate return in consideration of the risk being taken. Creditors desire to know whether a potential borrower or customer can service loans being made. Internal analyst and management utilize financial statement analysis as a mean to monitor the outcome of policy decisions, predict future performance targets, develop investment strategies, and assess capital needs. As the role of the credit manager is expanded cross functionally, he or she may be required to answer call to conduct financial statement analysis under any of these circumstances. The DuPont ratio is a useful tool in providing both an overview and a focus for such analysis. The DuPont ratio is a good place to begin a financial statement analysis because it measures the return on equity (ROE). A for profit business exists to create wealth for its owners. ROE, is therefore, arguably the most important of the key ratios, since it indicates the rate at which owner wealth is increasing. While the DuPont analysis is not an adequate replacement for detailed financial analysis, it provides an excellent snapshot and starting point. The product of the net profit margin and total assets turnover equals return on assets (ROA). This was the original DuPont Model which can be written as: Maximizing ROA was a major concern till 1970, which later changed to maximising return on equity, and so Thomas J Liesz suggested the modified DuPont Analysis, This model is explained as: Definition of 'DuPont Analysis' A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are measured at their gross book value rather than at net book value in order to produce a higher return on equity (ROE). It is also known as "DuPont identity". DuPont analysis tells us that ROE is affected by three things: Operating efficiency, which is measured by profit margin Asset use efficiency, which is measured by total asset turnover Financial leverage, which is measured by the equity multiplier ROE = Profit Margin (Profit/Sales)* Total Asset Turnover (Sales/Assets)* Equity Multiplier (Assets/Equity) Graphical representation of DuPont Analysis 26

27 CHAPTER 12 MONEY AND CAPITAL MARKETS FINANCIAL MARKETS Financial markets are a mechanism for the exchange trading of financial products under a policy framework. The participants in the financial markets are the borrowers (issues of securities), the lenders (borrowers of securities), and financial intermediaries. Financial market comprise two distinct types of markets: the money market the capital market Money Market A money market is a market for short-term debt instruments. It is a highly liquid market wherein securities are bought and sold in large denomination to reduce transaction costs. Call money market, certificates of deposits, commercial papers, and treasury bills are the major instruments / segments of money market. Capital Market A capital market is a market for long-term securities (equity and debt). The purpose of capital market is to: o o o o o o Mobilise long-term savings to finance long-term investments. Provide risk capital in the form of equity or quasi-equity to entrepreneurs. Encourage broader ownership of productive assets. Provide liquidity with a mechanism enabling the investor to sell financial assets; Lower cost of transactions and information, Improve the efficiency of capital allocation through a competitive pricing mechanism. A capital market can be further divided into Primary Market and Secondary Market. The primary market is meant for new issues and the secondary market is one where outstanding issues are traded. In other words, the primary markets creates long-term instruments for borrowings, where as the secondary market provides liquidity through the marketability of these instruments. The secondary market is also known as stock market. CLASSIFICATION OF FINANCIAL MARKETS 1. Organised and Unorganised Markets :- Organised Markets is that poet of the financial markets, which operates under a defined set of rules, regulations and legal provisions and the statutory authorities such as the Central Government, the Central Bank the exchange commission (such as SEBI in India) etc. Unorganised markets is that part of the financial market which is not standardised and it is outside the purview of government control. 2. Money and Capital Markets :- Money markets are short term debt markets. Money markets are mostly wholesale markets for financial instruments money market transactions are highly liquid to meet the requirements of short-term surplus fund holders and fund borrowers. Call money market is a major segment of the Indian money market where transactions are entered into an overnight maturity. Call money is an amount borrowed or lent on demand for a very short period. If the period is more than one day and upto 14 days it is called 'notice money'. Otherwise the amount is called call money. Intervening holidays and / or Sundays are excluded for computing the holding duration. No collateral securities are required to cover these transactions. On the other hand capital markets is a market for long term financial assets ie; the shares, mutual funds units, debentures etc. corporates issue there securities in the capital markets and investors can subscribe 27