FINANCIAL MANAGEMENT:

Scope/Goal/Objectives - Finance

1 Scope : The effective management of finance function is the scope of the Financial Management.

a) To design and create a plan based on the business model b) To source out funds at an affordable costc) To monitor the usage of funds to achieve the objectivesd) To take proper investment decisions based on short/long term requirements

e) To effectively control to achieve profit/wealth maximization

2. Objectives:

While profit maximization is one of the main objectives the other important objective is to increase the shareholder’s value. In short the key objective of a company is to maximize the value of the company based on

(i)Proper planning (ii) prudent and timely financing/investing decisions (iii) effective monitoring and control

To achieve the objectives, the finance manager should take careful decisions of

(i) Arranging for finance (ii) Liquidity Management (iii) Using good investment opportunities (iv) arrange for payment of dividends

Source of funds:

Source of capital – Equity capital or Debt

Equity capital, is the share capital raised through issuance of shares and the owners of such shares are considered part owners of the company.

Debt: Public invest in companies through capital market on long term basis, by means of debentures. In this case, the investor not only invests in the company but also lends money against security or without security. The debenture holders are creditors of the company.

Source of funds – Bank loans – Short term and Long term (fund based)

Letters of credit/Bank guarantees (Non fund based)

A finance manager’s responsibility is not only to raise capital funds (equity/debt) but also to arrange for loan (borrowed) funds from banks and Financial Institutions and investing public in company deposits/bonds.

The combination of various options, would reflect in the efficient financing decision.

Investment decision:

The decision to the acquisition of assets is based on various factors. Assets are classified as financial assets such as shares, debentures, bonds, and real assets are the immovable properties like land, building, plant, machinery, etc.,

Financial decisions of a company results in sourcing out the best possible mix of financial options to manage the company’s affairs, investment in project is dealt by the Capital Budgeting which is based on the concept “Net Present Value” (NPV) of the assets.

Further the investment decisions deals with issues relating to mergers, acquisition, restructuring to achieve economy of scale in operation and also to increase the market share

Dividend decision:

While the cost of equity capital is the payment of dividend, as it is a pay out, it is a financing decision. However, the dividend decision is a trade off between paying reasonable dividend (to the shareholders) and retaining the balance profit as a retained earnings or Reserve.

Liquidity Management decision:

The crucial skill of a finance manager is to take a decisions re: liquidity management. It refers to maintenance of a balance between current assets and current liability:

Wealth/Value/Profit maximization :

The objective of financial management is to maximize the value of the companies. i.e., (a) to maximize the value of share price which is an internal requirement (environment) To achieve this the company need to have efficient, well organized operations to meet with the customer’s demands. The company need to be innovative, better managed utilization of resources through new technologies and proper monitoring and control.

(b) Companies are more social conscious as regards Corporate Social Responsibility re: external economic environment.

To meet with the companies financial/investment decisions, issues like pollution, social responsibility about the community/society, product safety and employee’s safety needs to be taken care, while taking these decisions.

(c) Profit maximization is a short term concept, which does not recognize the time factor ie., the earning of stocks over a period of time, as against wealth maximization which increases the value by discounting the figure of cash flows.

Let us understand the difference by the following example:

If the EPS (earning per share) in simple terms = total profits/total o/s shares.

If the company earned Rs 10,00,000.00 and the total o/s is 1,00,000 shares, the EPS

is Rs10.00. Assuming the finance manager is to select from two alternative investment

opportunities:

Investment in A ---------------------------------------------------------------------------------------------------------

Year 1 2 3 9 10

EPS 10 10 10 10 10

---------------------------------------------------------------------------------------------------------

Investment in B ---------------------------------------------------------------------------------------------------------

Year 1 2 3 9 10

EPS 0 12 12 12 12

---------------------------------------------------------------------------------------------------------

Investing in A would give higher return in the I year (EPS of Rs.10 against an EPS of ( 0) In case of B, for the remaining 9 years it gives higher EPS. The better alternative (if other things being equal ) would be option B

Risk Vs Return: The finance manager’s responsibility is to ensure wealth maximization, which can be achieved if the target of the company is met by increasing the profitability and reducing the risks.

ii) Capital Structure – Features/Issues A capital project gives opportunities for investing resources that can be analysed appraised reasonably.

The features of a capital project is that it incurs current/future outlay of funds, with an expectation of a stream of benefits in the short and long term.

One of the most important decisions is capital expenditure decision. A company’s present performance is the impact the earlier capital expenditure decisions, and the current expenditure decisions guides the future performance/ results

Irreversibility: A careful capital expenditure decision is very important, because a wrong decision would, not only, result in substantial loss, but also create more problems, this is mainly due to the fact, that the market for used capital equipment is generally not available.

Huge funds required: Capital expenditures results in huge outlay of funds. An integrated steel plant, require huge outlay of funds, running into several crores.

Capital budgeting: A company needs to take several decisions. If a company decides should they invest in fixed assets or in long term projects, such decisions are known as capital budgeting. While the process is a complex one, we shall try to understand the same in a simpler method . The process is reflected in the form of :

Capital Budgeting

I

Generation

I

Planning

I

Analysing

I

Selection

I

Execution

I

Review

Project generation: The generation of project/s may take place any or all ot the following:

(a) Expansion of the capacity of the existing product line(b) Additions to the present product line(c) To reduce the costs of the existing product lines without affecting the scale of operations

Planning: The planning phase of a firm’s capital budgeting deals with the investment

strategy including the types of investment opportunities. After planning stage the analysis exercise is undertaken.

Analysis: There are many aspects that require a proper analysis. Some of the important aspects to be covered are: financial, technical, marketing, economic and environmental analysis. For example the financial analysis (cash flows and funds flows) assists the financial manager to take decision on estimated benefits/costs.

Selection: The selection of a project is based on various factors and a final decision will be taken by the top management, based on the benefits and costs, other merits/demerits of the proposed project. However there are two important methods used to either accept or reject a project. They are (a) Pay Back Period (PBP)and (b)Accounting Rate of Return (ARR), both are examples of non-discounting method

The other method, i.e., discounting method consists of (i) Net Present Value (NPV) (ii)Internal Rate of Return (IRR) and (iii) Benefit Cost Ratio (BCR)

Some guidelines (either to accept or reject a project) are :

Method Accept Reject

PBP PBP < target period PBP > target period

ARR ARR > target rate ARR < target rate

NPV NPV > 0 NPV < 0

IRR IRR > cost of capital IRR < cost of capital

BCR BCR > 1 BCR < 1

Execution: After a final selection of a project, the required funds are appropriated and the execution of a project is carried out, involving various stages viz.,

Project and engineering designs, negotiations and awarding contracts, construction training and plant commissioning.

Review: Once the project is completed and commissioned a review process is necessary. The review system helps to compare actual performance against the projected performance. The review would be useful in many ways., like

(a) comparison of estimates and actual (b) serves as a guide for future projects(b) assists in taking corrective steps and also decision making in future projects.

Capital Budgeting is a process which shows the schedule of investment project/s selected to be executed over some interval of time.

Capital budgeting, which involves a large outlay of funds and a longer period. The commitments for large outlay of funds would result either in profit or loss and benefits or drawbacks. Hence the capital budget discussions are crucial for a firm.

Cash flows: The significance of cash flows both inflows and outflows are important factors. The cash inflows from an investment are the effect of incremental changes in after tax in operating cash flows. The cash outflows are the cost of investment less salvage value received on an old machine.

Investment Proposals:

Payback method is the number of years required to return the original investment

Return on Investment: This is the average annual cash inflow divided by the original capital outlay. Both pay back and ROI are examples of non discounted cash flows.

Net Present Value (NPV): The present value of future returns discounted at the cost of capital minus cost of investment.

Internal Rate of Return(IRR): The interest that = the present value of future cash flow to the investment outlay. NPV and IRR are discounted cash flows

Time Value of Money:

The evaluation of capital expenditure proposals involves the comparison between cash outflows and cash inflows.

Since the capital expenditure can be effected in future, it would be ideal if the evaluation is done as on today, based on the future cash inflows and cash outflows expressed in terms of today.

Two methods are used : (i) Compounding (ii) Discounting

(i)Compounding: If Mr Anand deposits Rs 10,000 in a fixed deposit @10% on a cumulative (compounding) basis, at the end of the first year Rs.10,000 will earn interest 1,000, and the investment will be = Rs 11,000.00 (10,000+1,000)

If Rs11,000 is reinvested in the same fixed deposit at the end of 2nd year will be = Rs 12,100 (Rs,11,000+interest of Rs 11,000 (@10% p.a.)

This is an example of compounding method of Time value of Money

The equation:

A= P(1+i)n where

A= Amount receivable at the end of the period

P = Principal amount at the beginning of the period

i = Rate of interest

n = Number of Years

In the above example :A = 10,000 x (1+0.10)2

= 10,000 x 1.21

= 12,100

(ii)Discounting: This method is used to find out the present value of Rs1 received

at the end of the period of investment at a particular rate of interest

The equation:

P = A/(1+i)n

P= Present value received or spent

A=Sum received or spent in future

i = Rate of interest

n = Number of Years

If Rahesh expected to receive Rs10,000 after two years for an investment made @10%, what amount should Rahesh invest today.

P= A/(1+i)n

= 10,000/(1+0.10)2

= 10,000/1.21

= Rs 8,264.46

Working Capital Finance (WC):

The requirement of regular flow of cash/finance is called as “Working Capital Finance”.This is also known as either “changing” or “circulating” capital.

Working capital is defined as the difference between current assets and current liabilities. Working capital is frequently used to measure a company’s ability to manage the current obligations. A high level of working capital indicates significant liquidity. WC is calculated as current assets – current liabilities.

Three important components used for calculation of WC are:

- accounts receivable (current asset)- inventory (current asset) and - accounts payable (current liability)-

Since WC is mainly concerned with the short term financing, generally a period of 12 months is considered as short term. The increase in working capital may be either due to working capital management by the company, increase in current assets (receipt of cash) or reduction in current liabilities (payment to short term creditors)

A company’s working capital management objective is to ensure that the company is able to manage on an ongoing basis, that the company has sufficient cash flow to cover both maturing short term debt and expected operational expenses.

Assessment of Working Capital:

Some of the methods used to assess WC are:

(a)Net Working Capital: This worked out based on the total current assets and total current liabilities. The difference between the total current assets and the total current liabilities is the net working capital.

(b)Operating or Working Capital Cycle: The operating or working capital cycle is the length of time between a company’s drawing down of the bank fiancé (cash) till the time the bank borrowing is repaid. The various stages of the operating cycle are : Bank > Cash > Raw Materials > Semi finished goods > Finished goods > Credit Sale > Bills receivables > Cash > Bank

The working capital requirement is calculated based on the following formula:

WC requirement = Total Operating expenses expected during the year/No of operating cycles in a year

Sources of WC: Internal and external sources,

(i) Net gains from operations L Net profits/cash accrual(inflows)(ii) Sale of fixed assets: This is an occasional and irregular source (iii) Issue of shares: Funds raised from the sale of shares may be permanent

Source of working capital funds in addition to net profit

(iv) Bank borrowings: One of the important source of WC is the bank loan availed against hypothecation/pledge of movable assets (inventories)

Working Capital ratios reflects the company’s efficiency in managing its rResources with special reference to cash flow.

WC is basically the investment in current assets like raw materials, semi finished goods,finished goods, sundry debtors,etc.,

WC consists of pre sales financing also known as inventory financing and post sales financing also called as receivables financing. The non fund based financing also constitute a portion of overall WC financing.

Working Capital Management

Working Capital Finance:

One of the main concerns of a Finance Manager is to manages his resources to ensure that the liquidity management (cash/funds) on an ongoing basis. There are many ways through which he can raise funds, and the popular method is : “ Working Capital Finnace”

The features are:

Period :Short term Finance

Security :Inventories and Receivables

Purpose: Ongoing funds floe for liquidity management

Banks grant working capital finance against inventories and receivables.

Inventory finance is also known as pre sales finance and the receivables finance is called as

post sales finance.

To grant the working capital finance, the company or corporate needs to have a line of credit with the lending banker. The lending banker will grant the finance based on certain evaluation of the firm, based mainly on the performance of the company.

The process of granting a lona/finance by the banker is called as credit appraisal. As part of the process, banks generally check, verify by applying different norms to decide upon the quantum of finance and other terms and conditions for the sanction of working capital finance.

Capital Budgeting:

Capital budgeting is a process of planning expenditures whose returns are expected to go beyond one year, and may extend to three or five years, depending upon the investments. A number of factors are involved and different divisions of a company are also affected by the capital budgeting.

Methods of Capital Budgeting:

Payback method is the number of years required to return the original investment . Pay back method is an important factor in decision making in respect of investment in fixed assets ex: buying a machinery. Payback period is useful in capital budgeting decision to find out the financial viability of a project.

Let us understand the payback method:

A company wants to invest maximum of Rs.500,000 in new fixed assets. The finance manager of the company has three options , and expects the life span will be for 4 years. As per the finance manager’s views after 4 years the company needs to go in for further investments.

Payback method Peoject X Peoject Y Peoject ZRs Rs Rs

Investment 150,000 250,000 500,000Life of investment 4 years 4 years 4 yearsI st year cash inflow 40,000 80,000 200,0002nd year cash inflow 60,000 100,000 300,0003rd year cash inflow 50,000 120,000 150,000

Capital Budgeting

Discounting MethodsNon Discounting

Methods

Net Present Value(NPV)

Pay back Internal Rate of

Return (IRR)Rate of Return

4th year cash inflow 40,000 60,000 90,000

Calculation of pay back time from an investmentPeoject X Peoject Y Peoject ZRs Rs Rs

Investment 150,000 250,000 500,000

Cash inflow1st year 40,000 80,000 200,0002nd year 60,000 100,000 300,0003rd year 50,000 120,000

150,000 300,000 500,000

Payback time 3 years 2 Year & 2 years

7 months Notes: To calculate how quickly the investment will take to pay for itself, by adding up the inflows and then dividing it by the initial investment.

Project X:Cash inflow for three years is Rs.150,000 is = investment and hence will be recoved at the end of three years.

Project Y: Cash in flow for 3 years is 300,000. It has covered the investment of Rs.250,000 between 2 and 3rd year. Since the cash flow for the 3rd year is Rs 10,000 per month , the short fall of 70,000 (Investment Rs.250,000-180,000 (2 years cash inlow) = 70,000, is payable at the end of 7 months.

Hence the payback period is 2 years and 7 months

Project X:Cash inflow for 2 years is= to investment of Rs.500,000

Hence Project Z has the quickest payback time

Return on Investment(ROI): This is the average annual cash inflow divided by the original capital outlay. Both pay back and ROI are examples of non discounted cash flows.

ROI method is used as a decision making tool by prescribing minimum ROI. This is an average rate of return calculated by expressing average profit as percentage of average capital employed as investment.

Here profit is considered, as profit after depreciation charges but before taxation and of course dividends.

To understand let us take an examples:

Year Profit (Rs)

1 15,000

2 12,500

3 25,000

4 30,000

5 20,000

Total profit: Rs 102,500

Assuming the capital employed is Rs 200,000, then the average capital employed = 200,000/2=Rs100,000

Average annual profit 102,500/5 = 20,500

ROI = Estimated average profit/estimated average investment x100

ROI = 20,500x100/100,000 =20.5%

Net Present Value (NPV): The present value of future returns discounted at the cost of capital minus cost of investment.

Internal Rate of Return(IRR): The interest that = the present value of future cash flow to the investment outlay. NPV and IRR are discounted cash flows

Role of a Finance ManagerConcerns the acquisition, financing, and management of assets with some overall goal in mind.

Finance is a set of tools that helps FM (Finance Manager) to answer the following questions…

Firms:

• What projects do FM invest in?

• How to raise money?

• How much money should be return to investors?

• What’s the best way to return that money?

Investment Function:

• How much is a corporation worth?

• How should a company raise money?

• How should corporations structure and pay for acquisitions?

Commercial Function:

• From whom should the Company borrow?

• At what interest rate should be borrowed from market?

• How does it manage the risk of its loan portfolio?

Trading functions:

• What stocks to buy?

When/how best to trade?

• Caretaker of the shareholder’s money

• Determines which projects the firm should invest in

• Decides how to pay for these projects (debt vs. equity) and what firm’s mix of debt and equity should be

– Debt is tax advantaged but introduces possibility of bankruptcy and may distort investment decisions

Also ensures that is there the firm has enough cash to meet its obligations and invest in profitable projects

Principal Decisions in Financial Management

1. Capital Budgeting Decisions (real assets)

• Which projects should company invest in?

• Should company expand, shutdown or diversify?

2. Financing Decisions (financial assets)

• How should company raise cash?

• What types of financial claims should company issue?

– Common stock? Preferred stock? Convertible bonds?

• How much cash should company return to investors?

3. Cost Management

4. Preparing Budgets

5. Preparing Forecasts

6. Tax Planning

7. Focus on cost minimization & profit maximization

8. Wealth maximization of the shareholders of the company

9. Determine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet)

What is the best type of financing?

What is the best financing mix?

What is the best dividend policy (e.g., dividend-payout ratio)?

How will the funds be physically acquired?

How do we manage existing assets efficiently?

Financial Manager has varying degrees of operating responsibility over assets.

Greater emphasis on current asset management than fixed asset management.

What is the optimal firm size?

What specific assets should be acquired?

What assets (if any) should be reduced or eliminated?

How do we manage existing assets efficiently?

Financial Manager has varying degrees of operating responsibility over assets.

Greater emphasis on current asset management than fixed asset management.

Maximize accounting profits

Which year’s profits? Cutting R&D will increase stated profits today at the expense of profits tomorrow.

Maximize growth or increase market share

Growth and increased market share are only desirable to the extent that current (or future) sales are profitable

Survive or avoid financial distress

While managers may be content to just keep their jobs, investors will prefer to earn higher returns elsewhere

Attempting to avoid financial distress may make matters worse (e.g., Enron)

Maximize shareholder wealth

Therefore, maximizing shareholders wealth is equivalent to maximizing today’s stock price

An increase in shareholder wealth means that firm’s assets have created value for its shareholders (and possibly that the wealth of society has increased)

Equivalent (or nearly equivalent) objectives

Maximize the market value of assets

Maximize the market value of financial claims

Maximize the present value of free cash flows

Wealth maximization does not preclude the firm from being socially responsible.

Assume we view the firm as producing both private and social goods.

Then shareholder wealth maximization remains the appropriate goal in governing the firm.

Default Risk

Political Risk

Economic Risk

Piracy, sea pirates, accidents insurance

Financial Risk

Business Risk

Foreign Exchange Risk

Fund Raising

Investment Decision

Dividend Decision

Minimizing risk