Financial Management (Introduction to Financial Management - I)

Financial Management (Introduction to Financial Management - I) (As Per the Revised Syllabus of F.Y. B.A.F, 2016-17, Semester I, University of Mumbai) Rajiv Mishra M.Com., MBA, M.Phil., UGC NET, Assistant Professor at N.E.S. Ratnam College of Arts, Science & Commerce for BBI & Coordinator for M.Com., Bhandup (W), Mumbai-400078. Visiting Faculty at Nitin Godiwala, Chandrabhan Sharma, S.M. Shetty College, N.G. Acharya, V.K. Menon College, Sikkim Manipal University & Vikas College for M.Com., MBA, BBI, BMS, BFM & BAF. Sunita Sherifani M.Com., M.Phil., MBA, SET Head, Dept of Accountancy and Associate Professor, V.E.S. College of Arts, Science and Commerce, Chembur. Dr. Shraddha Mayuresh Bhome Ph.D. in Commerce, Professional MBA, M.Phil. (Gold Medalist), M.Com. (University of Mumbai), Research Guide (Supervisor), Shri JJT University, Rajasthan, Assistant Professor and Coordinator of BAF, Satish Pradhan Dnyansadhana College, Thane Manoj Wagh M.Com., B.Ed. Assistant Professor, Satish Pradhan Dnyansadhana College, Thane. Asif Baig M.Com., B.Ed., M.Phil., MBA, NET HOD, Accounts at Gurukul College, Ghatkopar & Visiting Faculty at NES Ratnam College for M.Com. Mukesh C. Kanojia M.Com., M.Phil., B.Ed. & NET Co-ordinator, R.D. & S.H. National College, Bandra (W).. Neha Bhatia M.Com., M.Phil., SET Assistant Professor, S.M. Shetty College, Powai ISO 9001:2008 CERTIFIED

Authors No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the publisher. First Edition : 2016 Published by : Mrs. Meena Pandey for Himalaya Publishing House Pvt. Ltd., Ramdoot, Dr. Bhalerao Marg, Girgaon, Mumbai - 400 004. Phone: 022-23860170/23863863, Fax: 022-23877178 E-mail: himpub@vsnl.com; Website: www.himpub.com Branch Offices : New Delhi : Pooja Apartments, 4-B, Murari Lal Street, Ansari Road, Darya Ganj, New Delhi - 110 002. Phone: 011-23270392, 23278631; Fax: 011-23256286 Nagpur : Kundanlal Chandak Industrial Estate, Ghat Road, Nagpur - 440 018. Phone: 0712-2738731, 3296733; Telefax: 0712-2721215 Bengaluru : Plot No. 91-33, 2nd Main Road Seshadripuram, Behind Nataraja Theatre, Bengaluru-560020. Phone: 08041138821, 9379847017, 9379847005 Hyderabad : No. 3-4-184, Lingampally, Besides Raghavendra Swamy Matham, Kachiguda, Hyderabad - 500 027. Phone: 040-27560041, 27550139; Mobile: 09390905282 Chennai : New-20, Old-59, Thirumalai Pillai Road, T. Nagar, Chennai - 600 017. Mobile: 9380460419 Pune : First Floor, "Laksha" Apartment, No. 527, Mehunpura, Shaniwarpeth (Near Prabhat Theatre), Pune - 411 030. Phone: 020-24496323/24496333; Mobile: 09370579333 Lucknow : House No 731, Shekhupura Colony, Near B.D. Convent School, Aliganj, Lucknow - 226 022. Mobile: 09307501549 Ahmedabad : 114, SHAIL, 1st Floor, Opp. Madhu Sudan House, C.G. Road, Navrang Pura, Ahmedabad - 380 009. Phone: 079-26560126; Mobile: 09377088847 Ernakulam : 39/176 (New No: 60/251) 1st Floor, Karikkamuri Road, Ernakulam, Kochi - 682011, Phone: 0484-2378012, 2378016; Mobile: 09344199799 Bhubaneswar : 5 Station Square, Bhubaneswar - 751 001 (Odisha). Phone: 0674-2532129, Mobile: 09338746007 Kolkata : 108/4, Beliaghata Main Road, Near ID Hospital, Opp. SBI Bank, Kolkata -700 010, Phone: 033-32449649, Mobile: 09883055590, 07439040301 DTP by : Rakhi Printed at : Rose Fine Arts, Mumbai. On behalf of HPH.

Preface It is a matter of great pleasure to present the first edition of this book on Financial Management to the students and teachers of First Year Bachelor of Commerce Accounting and Finance (F.Y. BAF), Semester I course started by University of Mumbai. We have tried to make and present the book in simple language and precise. We are hoping that the diagrams and step-by-step answers put up will be helpful to understand the subject clearly. We are thankful to our all family members for constant support and motivation. We are also grateful to our Principal, Vice-Principal, Co-ordinator, Colleagues, Library Staff and my dear students and friends for encouraging us to write the book. Special thanks to Himalaya Publishing House Pvt. Ltd. for publishing our book. Any constructive suggestions from the students and teachers for improving the text in future are welcome. Authors

Syllabus Financial Management (Introduction to Financial Management - I) Sr. No. Modules No. of Lectures 1 Introduction to Financial Management 12 2 Concepts in Valuation 12 3 Leverage 12 4 Types of Financing 12 5 Cost of Capital 12 Total 60 Sr. No. 1 Introduction to Financial Management Introduction Meaning Importance Scope and Objectives Profit vs. Value Maximization 2 Concepts in Valuation The Time Value of Money Present Value Internal Rate of Return Bonds Returns The Returns from Stocks Annuity Techniques of Discounting Techniques of Compounding 3 Leverage Introduction EBIT and EPS Analysis Modules/Units Types of Leverages: Operating Leverage, Financial Leverage and Composite Leverage Relationship between Operating Leverage and Financial Leverage (Including Practical Problems) 4 Types of Financing Introduction Needs of Finance and Sources: Long Term, Medium Term and Short Term Long Term Sources of Finance Short Term Sources of Finance 5 Cost of Capital Introduction Definition and Importance of Cost of Capital Measurement of Cost of Capital WACC (Including Practical Problems)

Question Paper Pattern Scheme of Examination Credit Based Grading System Scheme of Examination Internal Assessment 25% 25 Marks Semester End Examinations 75% 75 Marks Duration: 2 1 / 2 Hours Maximum Marks: 75 Questions to be Set: 05 Question Paper Pattern All questions are compulsory carrying 15 marks each. Particulars Q.1 Objective Questions (a) Sub-questions to be asked (10) and to be answered (any 08) (b) Sub-questions to be asked (10) and to be answered (any 07) (*Multiple Choice/True or False/Match the Column, Fill in the Blanks) Marks Q.2 Q.2 Q.3 Q.3 Q.4 Q.4 Q.5 Q.5 Full Length Practical Question OR Full Length Practical Question Full Length Practical Question OR Full Length Practical Question Full Length Practical Question OR Full Length Practical Question (a) Theory Questions (b) Theory Questions OR Short Notes To be asked (05) To be answered (03) 08 Marks 07 Marks Note: Full length question of may be divided into two sub-questions of 08 and 07 Marks.

Contents 1. Introduction to Financial Management 1 8 2. Concepts in Valuation 9 22 3. Leverage 23 58 4. Types of Financing 59 86 5. Cost of Capital 87 127

Chapter 1 Introduction to Financial Management MEANING OF FINANCIAL MANAGEM ENT Financial Management is broadly concerned with the mobilization and deployment of funds by a business organization. For efficient operation of business, it is necessary to obtain and utilize the funds effectively. This job is done by Financial Management. According to Warren Buffet, Finance is simply the art and science of managing money. Basically, therefore, financial management centers around fund raising for business in the most economical way and investing these funds in optimum way so that maximum returns can be obtained for the shareholders. Practically, all business decisions have financial implication. Hence, financial management is interlinked with all other functions of business. SCOPE OF FINANCIAL MA NA GEMENT Scope of Financial Management Forecasting Financing Coordination and Control Analysis of Economic Trends Acquiring Funds Financial Adjustment Costing Measuring Cost of Capital Decision Making Financial Decision Others Tax Management Analysis of Industry Trends Allocation of Funds Accounting Budgeting Preparing Cost Sheet Investment Decision Fixed Assets Management Forecasting Financial Requirement Profit Planning Estimating ROI Investment of Funds Ensuring Availability of Funds Reporting Marginal Costing Management of Income Dividend Decision Meeting Contingent Liability Inventory/ Receivable Management Corporate Governance Employment Benefits

2 Financial Management Financial management is one of the important part of overall management, which is directly related with various functional departments like personnel, marketing and production. Financial management covers wide area with multidimensional approaches. The following includes important scope of financial management. 1. Financial Management and Economics Economic concepts like micro economics and macroeconomics are directly applied with the financial management approaches. Investment decisions, micro and macro environmental factors are closely associated with the functions of financial manager. Financial management also uses the economic equations like money value, discount factor, economic order quantity etc. Financial economics is one of the emerging area, which provides immense opportunities to financial and economical areas. 2. Financial Management and Accounting Accounting records includes the financial information of the business concern. Hence, we can easily understand the relationship between financial management and accounting. In the olden periods, both financial management and accounting were treated as a same discipline and then were merged with Management Accounting because this part is very much helpful for finance manager to take decisions. 3. Financial Management and Mathematics Modern approaches of financial management applied large number of mathematical and statistical tools and techniques. They are also called as econometrics. Economic order quantity, discount factor, time value of money, present value of money, cost of capital, capital structure theories, dividend theories, ratio analysis and working capital analysis are used as mathematical and statistical tools and techniques in the field of financial management. 4. Financial Management and Production Management Production management is the operational part of the business concern, which helps to multiply the money into profit. Profit of the concern depends upon the production performance. Production performance needs finance, because production department requires raw material, machinery, wages, operating expenses, etc. 5. Financial Management and Marketing Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements. The finance manager or finance department is responsible to allocate adequate finance to the marketing department. 6. Financial Management and Human Resource Financial management is also related with human resource department, which provides manpower to all the functional areas of the management.

Introduction to Financial Management 3 7. Financial Management and Ethics With growing number of SCAMS, ethics is playing increasingly very important role in various financial management decisions (Corporate Governance). FUNCTIONS OF FINANCIAL MANAGEM ENT Functions/Role of Financial Management/Finance Manager and how have they changed in recent years? Ans: 1. Proprietor s Funds Share Capital Reserves & Surplus Sources/Mobilization of Funds (Financial Decisions) 2. Borrowed Funds (Capital Structure) (Leverage) (Cost of Capital) (Sources of Finance) (Dividend Policy) Role of Financial Management/Manager Application/Deployment of funds (Investment Decisions) 1. Fixed Assets (Capital Budgeting) 2. Investments (Treasury Management) Business Restructuring 3. Net Current Assets (Working Capital Management) The twin aspects of procurement and effective utilization of funds are the crucial tasks, which the financial manager faces. The finance manager is required to look into financial implication of any decision in a firm. The finance manager has to manage funds in such a way as to make their optimum utilization and to ensure that their procurement is in a manner so that the risk, cost and control considerations are properly balanced under a given situation. Rule No. 1: Never Loose Money Rule No. 2: Never Forget Rule No. 1 Functions of Financial Manager 1. Estimating the requirement of fund. 2. Decision regarding capital structure. 3. Investment decision. 4. Dividend decision. Warren Buffet 5. Working capital management/liquidity function. 6. Maintaining financial procedures and systems etc.

4 Financial Management 1. Estimating the Requirement of Funds: In a business, the requirements of funds have to be carefully estimated. Certain funds are required for long-term purposes, i.e., investments in fixed assets etc. Certain funds are required for short-term purposes, i.e., Working Capital. A careful estimation of such funds and the timing of requirement must be made. Forecasting the requirements of funds involves the use of technique of budgetary control. Estimates of requirements of fund can be made only if all physical activities of the organization have been forecasted. 2. Decisions Regarding Capital Structure: Once the requirements of funds have been estimated, decisions regarding various sources from where these funds would be raised have to be taken. Finance manager has to carefully look into existing capital structure and see how the various proposals of raising funds will affect it. He has to maintain a proper balance between long-term funds and shortterm funds. Long-term funds raised from outsiders have to be in a certain proportion with the funds procured from the owner. He has to see that the capitalization of company is such that the company is able to procure funds in future also. All such decisions are financing decisions. 3. Investment Decision: Funds procured from different sources have to be invested in various kinds of assets. Investments of funds in a project have to be made after careful assessment of the various projects through capital budgeting. A part of long-term funds is also to be kept for financing working capital requirement. The production manager and finance manager keeping in view the requirement of production, future price estimates of raw material and availability of funds would determine inventory policy. 4. Dividend Decision: Finance manager is concerned with the decision to pay or declare dividend. He has to assist management in deciding as to what amount of profit should be retained in business and this depends on whether the company can make a more profitable use of funds. But in practice, trend of earning, share market prices, requirement of funds for future growth, cash flow situation, expectation of shareholders has to be kept in mind while deciding dividend. 5. Working Capital Management/Liquidity Function: The finance manager has to properly manage current assets such as cash, inventory and accounts receivable. He has to ensure a trade-off between liquidity and profitability. He has to ensure efficient utilization of every current assets and also overall working capital involved in current assets. Adequate level of current assets is necessary to maintain required level of liquidity of funds. On the other hand, if the funds are idle, the profitability may be low. Therefore, the finance manager has to maintain a proper balance between liquidity and profitability. It includes cash management and receivable management. 6. Maintaining Financial Procedures and Systems: This includes procedures established for the effective execution of the other functions. Budgetary accounting, record keeping, Management Information System (MIS) and corporate governance are integral part of any organization. In the last few years, the complexion of the economic and financial environment has altered in many ways. Therefore, the role of finance manager has changed from mobilization and deployment of funds to profit planning, maximizing shareholder wealth, understanding capital markets and good corporate governance.

Introduction to Financial Management 5 These changes have made the job of the finance manager more important, complex and demanding. Department - 1 Forecasting Funds Department - IV Managing Funds Financial Manager Acquiting Funds Department - II Investing Funds Department - II OBJECTIVES OF FINANCIAL MANAGEM ENT Discuss wealth maximization and shareholder value maximization as objectives of financial management. Or corporate houses today are increasingly moving towards wealth maximization. Comment on this movement. Or the objective of financial management is wealth maximization and not profit maximization. Comment. Ans: Wealth Profit Objectives Objectives of Financial Management Clear objectives are required for wise decision-making. Objectives provide a framework for optimum financial decision-making. Two of the most widely discussed approaches are: 1. Profit maximization approach 2. Wealth maximization approach Profit Maximization Decision Criterion Under this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided. In specific operational terms, the profit maximization criterion implies that

6 Financial Management the investment, financing and dividend policy decisions of a firm should be oriented towards the maximization of profits. The rationale behind profit maximization as a guide to financial decisionmaking, is due to following reasons: 1. Profit is a test of economic efficiency. It provides the yardstick by which economic performance can be judged. 2. It leads to efficient allocation of resources tend to be directed to uses, which in terms of profitability are the most desirable. 3. It ensures maximum social welfare. This is so because the quest for value drives scarce resources to their most productive uses and their most efficient users. The more effectively resources are deployed, the more robust will be the economic growth and the rate of improvement in the standard of living. The profit maximization criterion, however, has been questioned and criticized on several grounds. It suffers from the following limitations: 1. Profit in absolute terms is not a proper guide to decision-making. It has no precise connotation. It can be expressed either on a per share basis or in relation to investment. Also, profit can be long term or short term, before tax or after tax, it may be the return on total capital employed or total assets or shareholder s equity and so on. If profit maximization is taken to be the objective, which of these variants of profit should a firm try to maximize? Therefore, a loose term like profit cannot form the basis of operational criterion for financial management. 2. It leaves considerations of timing and duration undefined. There is no guide for comparing profit now with profit in future or for comparing profit streams of different durations. 3. It ignores risk factor. It cannot, for example, discriminate between an investment project, which generates a certain profit of ` 50 lakhs and an investment project, which has a variable/uncertain profit outcome of ` 50 lakhs. It does not take into account level of risk. Wealth Maximization Decision Criterion This is also known as value maximization or net present worth maximization. The focus of financial management is on the value to the owners or suppliers of equity capital. The wealth of the owners is reflected in the market value of the shares. So, wealth maximization implies the maximization of the market price of shares. It has been universally accepted as an appropriate operational decision criterion for financial management decisions as it removes the technical limitations, which characterize the earlier profit maximization criterion. Its operational features satisfy all the three requirements of a suitable operational objective of financial courses of action, namely exactness, quality of benefits and the time value of money. Maximization of the wealth of shareholders (as reflected in the market value of equity) appears to be the most appropriate goal for financial decision-making. Wider than profit maximization is the principle of corporate governance. The fundamental objective of corporate governance is the the enhancement of the long-term shareholder value while at

Introduction to Financial Management 7 the same time protecting the interests of other stakeholders. As such, this definition emphasizes the need for a company to strike a balance at all times between the need to enhance shareholders wealth and protecting the interest of other stakeholders in the company such as suppliers, customers, creditors, bankers, employees of the company, government and society at large. If these factors are ignored, a company cannot survive for long. Profit maximization at the cost of legal, social and moral obligations is a short-sighted policy [e.g., Sahara]. Hence, it is commonly agreed that the objective of a firm is to maximize its value or wealth. Value is represented by the market price of the company s common stock. The market price of a firm s stock represents the judgement of all market participants as to what the value of the particular firm is. The market price serves as a performance index of the firm s progress; it indicates how well management is doing on behalf of shareholders. [On 13.6.14, Infosys Ltd. stock hit all-time high on appointment of Vishal Sikka as CEO]. An increasingly popular measure of wealth is EVA (Economic Value Added). Economic Value Added (EVA) can be defined as the net operating profit that a company earns above its costs of capital. It is a trademark of Stern Stewart & Co. EVA can be calculated as follows: EVA = Net operating profit after taxes (Weighted average cost of capital Capital invested) = NOPAT (WACC Capital) Conceptually, EVA is superior as a measure of value creation because it recognizes the cost of capital and, hence, the riskiness of a firm s operations. There is a strong correlation between EVA and the market price of a company s stock. Maximizing any accounting profit or accounting rate of return as a way of increasing shareholder s wealth often leads to an undesired outcome. A company should aim at long-term wealth maximization and not short-term. Ans: Therefore, wealth maximization should be the objective of financial management since it: 1. Considers risk. 2. Uses cash flows and not profits. 3. Considers time value of money. 4. Implies taking care of interest of both shareholders and other stakeholders (corporate governance). Agency Problem in Achievement of Objectives of Financial Management A characteristic feature of corporate enterprise is the separation between ownership and management as a corollary of which the latter enjoys substantial autonomy in regard to the affairs of the firm. With widely diffused ownership, scattered and ill-organized shareholders hardly exercise any control/influence on management, which may be inclined to act in its own interests rather than those of the non-promoter owners. However, shareholders as owners of the enterprise have the right to change the management. Due to the threat of being dislodged for poor performance, the management

8 Financial Management would have a natural inclination to achieve a minimum acceptable level of performance, to satisfy the shareholder s requirements/goals, while focussing primarily on their own personal goals. Thus, in furtherance of their objective of survival, management would aim at satisfying instead of maximizing shareholders wealth. Anil Agarwal (Vedanta), Mukesh Ambani (Reliance), Anil Ambani (Reliance) etc. are guilty of Agency Problem. However, the conflicting goals of management objective of survival and maximizing owner s value/wealth can be harmonized by: 1. Incentives to Management: The incentives to management are of various types. Some of them are follows: (i) (ii) (iii) Stock options: Confer on management the right to acquire shares of the enterprise at a special/concessional price. Performance shares are given based on the performance of the management. Cash bonus: Linked to specified performance targets. 2. Monitoring of Managers: (i) (ii) (iii) (iv) Auditing financial statements and limiting decision-making by the management. The Audit Control procedures and limiting managerial decisions are intended to ensure that the actions of management subserve the interests of shareholders. Shareholder activism, specially of financial institutions to safeguard interest of non-promoter shareholders. Rotation of Audit Partners. Overview by CAG, PAC, SEBI, IT. Department, CVC etc. is also required to overcome agency problem.