B Com 3 rd YEAR FINANCIAL MANAGEMENT

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1 B Com 3 rd YEAR FINANCIAL MANAGEMENT FINANCIAL MANAGEMENT UNIT I Financial management is concerned with management of fund. It may be defined as acquisition of fundat optimum cost and its utilization with minimum financial risk. Financial management is the application of planning and control to the finance function. It aims at ensuring that adequate cash is on hand to meet the required current and capital expenditure. It facilitates ensuring that significant capital is procured at the minimum cost to maintain adequate cash on hand to meet any exigencies that may arise in the course of business. Financial management helps in ascertainingand managing not only current requirements but also future needs of an organization. GOALS OF FINANCIAL MANAGEMENT Profit Maximisation Traditionally the basic objective of financial management was profit maximization but later on this wasoverruled by shareholders (owners) wealth maximization. Presently wealth maximization is the real objectiveof financial management. Profit maximization was overruled by wealth maximization because of followinglimitations: It is vague: Objective of profit maximization does not clarify what exactly it means e.g. whichprofits are to be maximized short run or long run, rate of profit or the amount of profit. It ignores timing: The concept of profit maximization does not help in making a choice between projects giving different benefits spread over a period of time. It ignores qualitative aspect: The person who wants to expand his market will procure qualitativeinput material which will incur substantial cost, which in turn will bring down margin and henceprofit. Thus the quality aspect is contrary to the concept of profit maximization. Wealth maximization Shareholders wealth maximization is the real objective of financial management because it helpsthe management in financial decisions viz. Financing decision, Investment management and dividend decision. Shareholders wealth maximization is also referred as firm s value maximization. Shareholders wealth maximization i.e. value maximization is also goal of the firm. KEY AREAS OF FINANCIAL MANAGEMENT The key areas of financial management are discussed in the followingparagraphs. Estimating the Capital requirements of the concern. The FinancialManager should exercise maximum care in estimating the financial requirementof his firm. Every business enterprise requires funds not only for long-term purposes for investment in fixed assets, but also for short term so as tohave sufficient working capital. The financial requirements of theenterprise can be estimated by by preparing budgets of various activities. Determining the Capital Structure of the Enterprise. The CapitalStructure of an enterprise refers to the kind and proportion of differentsecurities. The decisions regarding an ideal mix of equity and debt as well as short-termand long-term debt ratio will have to be taken in the light of the cost of raisingfinance from various sources, the period for which the funds are required and soon. Finalising the choice as to the sources of finance. The capital structurefinalised by the management decides the final choice between the varioussources of finance. The important sources are share-holders, debenture-holders,banks and other financial institutions, public deposits and so on Deciding the pattern of investment of funds. The Financial Manager mustprudently invest the funds procured, in various assets in such a judicious manneras to optimise the return on investment without jeopardising the long-termsurvival of the enterprise. He can takeproper decisions regarding the investment of funds only when he succeeds instriking an ideal balance between the conflicting principles of safety,profitability and liquidity. Distribution of Surplus judiciously. The Financial Manager should decidethe extent of the surplus that is to be retained for ploughing back and the extentof the surplus to be distributed as dividend to shareholders. Efficient Management of cash. Cash is absolutely necessary formaintaining enough liquidity. The Company requires cash to (a) pay offcreditors; (b) buy stock of materials; (c) make payments to labourers; and (d)meet routine expenses. It is the responsibility of the Financial Manager to makethe

necessary arrangements to ensure that all the departments of the Enterpriseget the required amount of cash in time for promoting a smooth flow of alloperations.

In practice, managers may maximise their own wealth (in the form of high salaries and perks) at the cost of shareholders.

Managers may avoid taking high investment and financing risks that may otherwise be needed to maximize shareholders wealth.

Agency Costs Agency costs include the less than optimum share value for shareholders and costs incurred by them to monitor the actions of managers and control their behaviour.

2 necessary arrangements to ensure that all the departments of the Enterpriseget the required amount of cash in time for promoting a smooth flow of alloperations. AGENCY CONFLICT: Managers versus Shareholders Goals There is a Principal Agent relationship between managers and shareholders. In theory, Managers should act in the best interests of shareholders. In practice, managers may maximise their own wealth (in the form of high salaries and perks) at the cost of shareholders. Managers may perceive their role as reconciling conflicting objectives of stakeholders. This stakeholders view of managers role may compromise with the objective of SWM. Managers may avoid taking high investment and financing risks that may otherwise be needed to maximize shareholders wealth. Such satisfying behaviour of managers will frustrate the objective of SWM as a normative guide. This conflict is known as Agency problem and it results into Agency costs. Agency Costs Agency costs include the less than optimum share value for shareholders and costs incurred by them to monitor the actions of managers and control their behaviour. TIME VALUE OF MONEY TIME PREFERENCE OF MONEY Time preference for money is an individual s preference for possession of a given amount of money now, rather than the same amount at some future time.three reasons may be attributed to the individual s time preference for money: risk preference for consumption investment opportunities TIME VALUE ADJUSTMENT Two most common methods of adjusting cash flows for time value of money: Compounding the process of calculating future values of cash flows by applying the concept of compound interest, and Discounting the process ofcalculating present values of cash flows. FUTURE VALUE OF LUMPSUM FUTURE VALUE OF ANNUITY

3 PRESENT VALUE Present value of a future cash flow (inflow or outflow) is the amount of current cash that is of equivalent value to the decision-maker. The interest rate used for discounting cash flows is also called the discount rate. PRESENT VALUE OF LUMPSUM PRESENT VALUE OF ANNUITY

4 UNIT II CAPITAL BUDGETING CAPITAL BUDGETING Capital budgeting is the process of planning for purchases of long-term assets. In other words, Capital Budgeting is a process of undertaking Project Decision/Capital Investment Decision/Long-term Investment Decision or Capital Expenditure Decision.The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm s investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision. Features of Investment Decisions The exchange of current funds for future benefits. The funds are invested in long-term assets. The future benefits will occur to the firm over a series of years. Types of Investment Decisions One classification is as follows: Expansion of existing business Expansion of new business Replacement and modernisation Yet another useful way to classify investments is as follows: Mutually exclusive investments Independent investments Contingent investments INVESTMENT EVALUATION CRITERIA Three steps are involved in the evaluation of an investment: 1. Estimation of cash flows 2. Estimation of the required rate of return (the opportunity cost of capital) 3. Application of a decision rule for making the choice Investment Decision Rule It should maximise the shareholders wealth. It should consider all cash flows to determine the true profitability of the project. It should provide for an objective and unambiguous way of separating good projects from bad projects. It should help ranking of projects according to their true profitability. It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones. It should help to choose among mutually exclusive projects that project which maximises the shareholders wealth. It should be a criterion which is applicable to any conceivable investment project independent of others. EVALUATION CRITERIA Discounted Cash Flow (DCF) Criteria Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Non-discounted Cash Flow Criteria Payback Period (PB) Discounted payback period (DPB) Accounting Rate of Return (ARR) 1. Net Present Value Method C C C NPV (1 k) (1 k) (1 k) n Ct NPV C t 0 (1 k) t1 Cn (1 k) n C 0

Acceptance Rule Accept the project when NPV is positive NPV > 0 Reject the project when NPV is negative NPV< 0 May accept the project when NPV is zero NPV = 0 2.

This also implies that the rate of return is the discount rate which makes NPV = 0. Acceptance Rule Accept the project when r > k Reject the project when r < k May accept the project when r = k 3.

5 Acceptance Rule Accept the project when NPV is positive NPV > 0 Reject the project when NPV is negative NPV< 0 May accept the project when NPV is zero NPV = 0 2. Internal Rate of Return The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period. This also implies that the rate of return is the discount rate which makes NPV = 0. Acceptance Rule Accept the project when r > k Reject the project when r < k May accept the project when r = k 3. Profitability Index Profitability indexis the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment. The formula for calculating benefit-cost ratio or profitability index is as follows: Acceptance Rule Accept the project when PI is greater than one. PI > 1 Reject the project when PI is less than one. PI < 1 May accept the project when PI is equal to one. PI = 1 4. Payback Period Payback is the number of years required to recover the original cash outlay invested in a project. If the project generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow. Initial Investment C Payback= 0 Annual Cash Inflow C Acceptance Rule The project would be accepted if its payback period is less than the maximum or standard paybackperiod set by management. 5. Discounted Payback Period The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis. 6. Accounting Rate of Return The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly. Acceptance Rule This method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate. 7. Modified Internal Rate of Return (MIRR) The modified internal rate of return (MIRR) is the compound average annual rate that is calculated with a reinvestment rate different than the project s IRR.

6 UNIT III LEVERAGES Financial Leverage The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners equity in the capital structure, is described as financial leverage orgearingortrading on equity. The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners equity. EPS, ROE and ROI are the important figures for analysing the impact of financial leverage. EPS = Profit after taxes No. of Shares = PAT N ROE = Profit after taxes Value of Equity Effect of Leverage on ROE and EPS Favourable Unfavourable Neutral ROI > i ROI < i ROI = i Operating Leverage Operating leverageaffects a firm s operating profit (EBIT).The degree of operating leverage(dol) is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales. DOL = %Change in EBIT %Change in Sales Degree of Financial Leverage The degree of financial leverage (DFL) is defined as the percentage change in EPS due to a given percentage change in EBIT: DFL = %Change in EPS %Change in EBIT Degree of Combined Leverage % Change in EBIT % Change in EPS % Change in EPS % Change in Sales % Change in EBIT % Change in Sales

7 UNIT IV DIVIDEND DECISIONS Dividend policy involves the balancing of the shareholders desire for current dividends and the firm s needs for funds for growth. Issues in Dividend Policy Earnings to be distributed High Vs Low Payout. Objective Maximize Shareholders Return. Effects Taxes, Investment and Financing Decision. DIVIDEND RELEVANCE THEORIES: 1. WALTER S MODEL Assumptions:Walter s model is based on the following assumptions: Internal financing Constant return and cost of capital 100 per cent payout or retention Constant EPS and DIV Infinite time Optimum Payout Ratio Growth Firms Retain all earnings Normal Firms Distribute all earnings Declining Firms No effect 2. GORDON S MODEL Assumptions: Gordon s model is based on the following assumptions: All-equity firm No external financing Constant return Constant cost of capital Perpetual earnings No taxes Constant retention Cost of capital greater than growth rate Market value of a share is equal to the present value of an infinite stream of dividends to be received by shareholders. DIVIDEND IRRELEVANCE: THE MILLER MODIGLIANI (MM) HYPOTHESIS According to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant as it does not affect the value of the firm. They argue that the value of the firm depends on firm earnings which results from its investment policy. Thus when investment decision of the firm is given, dividend decision is of no significance. Assumptions: It is based on the following assumptions:- Perfect capital markets No taxes Investment policy No risk FACTORS AFFECTING DIVIDEND DECISIONS:

8 Firm s Investment Opportunities and Financial Needs Shareholders Expectations Legal restrictions Liquidity Financial condition and borrowing capacity Access to the capital market Restrictions in loan agreements Inflation Control FORMS OF DIVIDENDS 1. Cash Dividends:Regular cash dividend cash payments made directly to shareholders, usually every year. 2. Bonus Shares (Stock Dividend):Instead of declaring cash dividends, the firm may decide to issue additional shares of stock free of payment to the shareholders years. This stock dividend is popularly known as bonus issue of shares. SHARE SPILIT A share split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share. A share split affects only the par value and the number of outstanding shares; the shareholders total funds remain unaltered. Reasons for Share Split To make trading in shares attractive To signal the possibility of higher profits in the future To give higher dividends to shareholders BUYBACK OF SHARES The buyback of shares is the repurchase of its own shares by a company. As a result of the Companies Act (Amendment) 1999, a company in India can now buy back its own shares.

9 UNIT V WORKING CAPITAL MANAGEMENT CONCEPTS OF WORKING CAPITAL 1. Gross working capital (GWC) GWC refers to the firm s total investment in current assets. Current assets are the assets which can be converted into cash within an accounting year (or operating cycle) and include cash, short-term securities, debtors, (accounts receivable or book debts) bills receivable and stock (inventory). 2. Net working capital (NWC) NWC refers to the difference between current assets and current liabilities. Current liabilities (CL) are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses. NWC can be positive or negative. Positive NWC= CA > CL Negative NWC = CA < CL PERMANENT AND VARIABLE WORKING CAPITAL 1. Permanent orfixedworking capital A minimum level of current assets, which is continuously required by a firm to carry on its business operations, is referred to as permanent or fixed working capital. 2. Fluctuating or variable working capital The extra working capital needed to support the changing production and sales activities of the firm is referred to as fluctuating or variable working capital. DETERMINANTS OF WORKING CAPITAL 1. Nature of business 2. Market and demand 3. Technology and manufacturing policy 4. Credit policy 5. Supplies credit 6. Operating efficiency 7. Inflation ESTIMATING WORKING CAPITAL Current assets holding period: To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the company s experience in the previous years. This method is essentially based on the operating cycle concept. Ratio of sales: To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales. Ratio of fixed investment:to estimate working capital requirements as a percentage of fixed investment. INVENTORY MANAGEMENT Inventory: Stocks of manufactured products and the material that make up the product. Components: raw materials work-in-process finished goods stores and spares (supplies) Need for Inventories Transaction motive Precautionary motive Speculative motive Objectives of Inventory Management To maintain a large size of inventories of raw material and work-in-process for efficient and smooth production and of finished goods for uninterrupted sales operations. To maintain a minimum investment in inventories to maximize profitability.

10 INVENTORY CONTROL SYSTEMS ABC Inventory Control System Just-in-Time (JIT) Systems Out-sourcing Computerized Inventory Control Systems RECEIVABLES MANAGEMENT The basic objective of management of sundry debtors is to optimise the return on investment on these assets known as receivables. Large debtors involve chances of more bad debts while low investment in debtors means restricted sales. Thus, management of receivable is an important issue and requires proper policies and their implementation. MANAGEMENT OF RECEIVABLES There are basically three aspects of management of sundry debtors: 1. Credit Policy: It involves a trade-off between profit on additional sales that arise due to credit being extended on one hand and the cost of carrying those debtors and bad debt losses on the other. It seeks to decide credit period, cash discount etc. 2. Credit Analysis: This requires the finance manager to determine how risky it is to advance credit to a particular party. 3. Control of Receivables:This requires the finance manager to follow up debtors and decide about a suitable credit policy.

University 18 Lessons Financial Management. Unit 2: Capital Budgeting Decisions

University 18 Lessons Financial Management Unit 2: Capital Budgeting Decisions Nature of Investment Decisions The investment decisions of a firm are generally known as the capital budgeting, or capital