FINANCIAL MANAGEMENT

Introduction to Financial Management

Financial Management is concerned with the planning and controlling of the firm’s financial resources.

Financial Management deals with the procurement of funds and their effective utilization in the business.

Thus there are two basic aspects of financial management

o procurement funds and

o effective use of funds

in order to achieve business objectives.

Procurement of Funds

Since funds can be procured from different sources, the procurement of funds is considered to be a complex issue by business concerns.

Funds procured from different sources have different characteristics in terms of risk, cost, control and flexibility.

The funds raised by the issue of equity shares poses no risk to the company since equity shares are not repayable except when the company is under liquidation. From the cost point of view, however, equity capital is the most expensive source of funds, since the return expectation of the equity shareholders are higher than that of debt investors. Also the issue of new shares may dilute the control of existing shareholders.

Debenture is relatively cheaper source of funds, but involves high risk as they are to be repaid in accordance with the terms of agreement. Also interest payment has to be made whether or not the company makes profits.

Funds procured from banks and financial institutions generally carry certain restrictive covenants impairing the flexibility of the borrower to raise funds from other sources.

Thus there are risk, cost, control and flexibility considerations, which must be taken into account before raising funds. The financial manager should ensure that

the cost of funds procured is minimum with least risk and dilution of control and maximum flexibility.

Effective Utilization of Funds

Since all the funds are procured at certain cost and after entailing a certain amount of risk, it is necessary for the finance manager to take appropriate and timely actions so that the funds do not remain idle.

If these funds are not utilized in the manner so that they generate an income higher than the cost of procuring them then there is no point in running the business.

Hence it is crucial to employ the funds properly and profitably. The funds are to be invested in the manner so that optimum production is

obtained without endangering the financial solvency. The financial implication of each capital investment decision is to be properly

analyzed to ensure adequate return from the project. The financial manager must also keep in view the need of adequate working

capital and ensure that while the firm enjoys an optimum level of working capital it does not maintain excess funds blocked in inventories, book debts and cash.

Objectives of Financial Management

Financial Management involves making certain crucial decisions like investment decision, financing decision and dividend decision. In order to make these crucial decisions, the firm must have a financial goal. Although various goals have been cited for financial management, the following two are often considered as the objective of financial management:

1. Maximization of the profits of the firm, and2. Maximizing the wealth of the shareholders.

Profit maximization

Traditionally it has been argued that the objective of a business firm is to earn profit, hence the objective of financial management is also profit maximization. This implies that the finance manager has to make his decisions in a manner so that the profits of the firm are maximized. However, profit maximization, as the objective of financial management, has certain limitations. If profit maximization is considered as the sole objective for financial management, several problems may arise. Some of these are:

1. Profit maximization as an objective ignores Risk: There is a direct relationship between risk and profit. Higher the risk, higher will be the profit. If profit maximization is the only goal, finance managers may accept all profitable investment opportunities without regard to the associated risk. In practice,

however, risk is an important consideration and has to be balanced with the profit objective.

2. Profit maximization ignores timing of the return: Profit maximization as an objective ignores the timing of return thereby ignoring the time value of money. For example, proposal A may give higher profit compared to proposal B. Yet, if the returns for proposal A flows only later, say 10 years hence, proposal B may be preferred for which return flows more early despite lower profit.

3. Profit is a vague term: The term profit is vague. It conveys different meaning to different people. For example, profit may be short term or long term, or it may be absolute profit or rate of profit, etc.

4. Profit maximization as an objective is short sighted: If profit maximization is the only goal, a firm may adopt financial policies yielding exorbitant profits in the short run which may be detrimental to the long-term growth, survival and interests of the company. For example a firm may not undertake preventive maintenance, Research and Development and employee training programs in order to maximize its profits in the short run, which would affect the long term survival and interests of the company.

5. Profit maximization ignores the financial risk of the company: Another limitation of the profit maximization is that it ignores the financial risk of the company by not considering the amount of debt in relation to equity in the capital structure. For example, in order to finance a profitable investment, a firm may even borrow beyond capacity.

6. Profit maximization does not take into account the interests of all stakeholders: Profit maximization as an objective of financial management is too narrow in the sense that it often does not take into account the interests of lenders, employees, customers and society. In order to maximize the profit, a company may adopt unethical trade practices which would be against the interests of these stakeholders.

Wealth Maximization

Because of the above limitations of the profit maximization as an objective, it is generally agreed that the financial goal of a firm should be to maximize the wealth or value of its shareholders.

The objective of a company should be to create value for its shareholders. The value for the shareholders is represented by the market price of the shares of the company. The market price of the shares of a company, on the other hand, is the present value of the future cash flows expected to be received by the shareholders by holding these shares, discounted at the appropriate discount rate reflecting the risk of these cash flows. It takes into account both, the operating risk and financial risk of the firm. In other words, the wealth maximization is a wider objective in the sense that it takes into account the present as well as the future earnings of a firm and the timing and risk of these earnings. Wealth maximization as an objective encompasses a firm’s investment, financing and dividend decisions since the market price of a firm’s stock is a function of these decisions.

Profit Maximization Versus Wealth Maximization

Profit Maximization Wealth Maximization1. Emphasizes short-term goal of a firm

which may be in conflict with the long-term objectives of a firm.

Emphasizes long term goal of a firm which is consistent with the long-term objectives of a firm.

2 Ignores the risk of investment. Recognizes the risk of investment.3 Ignores the timing of returns. Recognizes the timing of return.

Functions of Finance

The traditional approach to the financial management defined the finance function as procurement of funds. But, the modern approach views the finance function in a broader sense, covering both, procurement of funds as well as their effective allocation to value maximizing investment projects.

The functions of finance involve three major decisions a company must make: the investment decision, the financing decision and the dividend decision. Each decision must be made in relation to the corporate objective of creating value to the shareholders.

Investment (Capital Budgeting) Decision

The investment decision is the most important of the three decisions when it comes to the creation of value to the firm. The investment decision involves deciding on which specific capital investment projects to be undertaken and how much to invest in these capital investment projects. Investment decision starts with the identification of investment opportunities often referred to as capital investment projects. The investment decision is also called capital budgeting decision. Capital investments include investment in tangible assets (such as investment in a production plant by an automobile manufacturing company like Toyota) as well as investment in intangible assets (for example, investment in Research and Development (R & D), advertising and marketing of new products, or acquisition of patents and trademarks).

As already stated, investment decision involves allocation of funds to capital investment projects whose benefits are realized in the future. Because the future benefits are not known with certainty, capital investment projects essentially involve risk. Consequently, they should be evaluated in relation to their expected return and risk. Effective investment decision involves using appropriate capital budgeting techniques as well as setting appropriate criteria for acceptance of project proposals. Investment decision also involves a decision by a company to grow externally by mergers and acquisition.

Apart from such strategic decisions as investment in a new capital investment project and growing through mergers and acquisitions, investment decision also involves such tactical decisions as allocation funds to working capital.

Financing Decision

The second major decision made by a firm is financing decision. Financing decision involves procurement of funds for the investment and operations needs of a firm. Financing decision has two central issues. These are:

Determination of the optimal capital structure (i.e., debt-equity mix) for the firm, which would maximize its value, and

Selection of the appropriate source of finance after taking into account the risk, cost, control and flexibility considerations of the sources.

Capital Structure decision:o The debt-equity mix of a firm is known as its capital structure.o The financial manager must strive to obtain the best financing mix or the

optimum capital structure for his firm.o The optimal capital structure is that capital structure which will maximize

the value of the firm or shareholder’s wealth, as measured by the market value of shares.

o The use of debt in capital structure will affect the return and risk of the shareholders. It may increase the return on equity, but it will also increase the risk.

o The optimal capital structure is arrived by striking a proper balance between risk and return of shareholders’ of the firm.

Selection of appropriate source of finance:o Once the financial manager is able to determine the best combination of

debt and equity, he must raise the appropriate amount through the best available sources.

o Since funds can be procured from different sources, the procurement of funds is considered to be a complex issue by business concerns.

oo The choice of appropriate source of finance depends on such factors as

risk, cost, control and flexibility of the source of finance.

o Funds procured from different sources have different characteristics in terms of risk, cost, control and flexibility.

o The funds raised by the issue of equity shares poses no risk to the company since equity shares are not repayable except when the company is under liquidation. From the cost point of view, however, equity capital is the most expensive source of funds, since the return expectation of the equity shareholders are higher than that of debt investors. Also the issue of new shares may dilute the control of existing shareholders.

o Debenture is relatively cheaper source of funds, but involves high risk as they are to be repaid in accordance with the terms of agreement. Also

interest payment has to be made whether or not the company makes profits.

o Funds procured from banks and financial institutions generally carry certain restrictive covenants impairing the flexibility of the borrower to raise funds from other sources.

o Thus there are risk, cost, control and flexibility considerations, which must be taken into account before raising funds. The financial manager should ensure that the cost of funds procured is minimum with least risk and dilution of control and maximum flexibility.

Dividend Decision

The profit earned by a company can be either retained in the business for financing new investment opportunities or distributed to shareholders as dividend. The dividend decision is concerned with how much of the total earnings of a company should be retained for financing future investment projects and how much should be distributed as dividend to shareholders. As long as the company has investment opportunities which would provide more return than the required rate of return by the investors, the company should retain the earnings. In other words, the dividend decision should be evaluated in the light of the objective of maximizing shareholder’s wealth.

Functions of Financial Manager

So, the chief task of a financial manager in the modern enterprises is to make good investment and financing decisions. Superior investment and financing decisions can put these companies a step ahead of their competitors.

The functions of finance manager in the modern enterprises involve the following activities:

Investment decision

The financial manager has to help the firm identify promising projects and decide how much to invest in each project.Financing Decision

The second major decision made by a firm is financing decision. Financing decision involves procurement of funds for the investment and operations needs of a firm.

The Finance Manager has to plan for and mobilize the required funds from various sources when they are required at an acceptable cost. This decision is called Financing Decision.

For the mobilization of funds, he would be liaising with banks and financial institutions.

Further, he would also be dealing with Merchant Banking agencies for procuring funds from the public through issue of shares, debentures and fixed deposits.

The Financing decision is mainly concerned with when, where and how to acquire funds to meet the firm’s investment needs.

The central issues in financing decision are o determination of the optimum debt-equity mix for the firm, which is

otherwise known as Capital structure decision, ando selection of the appropriate source of finance after taking into account the

risk, cost, control and flexibility considerations of the sources. Capital Structure decision:

o The debt-equity mix of a firm is known as its capital structure.o The financial manager must strive to obtain the best financing mix or the

optimum capital structure for his firm.o The optimal capital structure is that capital structure which will maximize

the value of the firm or shareholder’s wealth, as measured by the market value of shares.

o The use of debt in capital structure will affect the return and risk of the shareholders. It may increase the return on equity, but it will also increase the risk.

o The optimal capital structure is arrived by striking a proper balance between risk and return of shareholders’ of the firm.

Selection of appropriate source of finance:o Once the financial manager is able to determine the best combination of

debt and equity, he must raise the appropriate amount through the best available sources.

o Since funds can be procured from different sources, the procurement of funds is considered to be a complex issue by business concerns.

oo The choice of appropriate source of finance depends on such factors as

risk, cost, control and flexibility of the source of finance.

o Funds procured from different sources have different characteristics in terms of risk, cost, control and flexibility.

o The funds raised by the issue of equity shares poses no risk to the company since equity shares are not repayable except when the company is under liquidation. From the cost point of view, however, equity capital is the most expensive source of funds, since the return expectation of the equity shareholders are higher than that of debt investors. Also the issue of new shares may dilute the control of existing shareholders.

o Debenture is relatively cheaper source of funds, but involves high risk as they are to be repaid in accordance with the terms of agreement. Also

interest payment has to be made whether or not the company makes profits.

o Funds procured from banks and financial institutions generally carry certain restrictive covenants impairing the flexibility of the borrower to raise funds from other sources.

o Thus there are risk, cost, control and flexibility considerations, which must be taken into account before raising funds. The financial manager should ensure that the cost of funds procured is minimum with least risk and dilution of control and maximum flexibility.

Time Value Of Money

Money has a time value. The time value of money implies that the worth of a rupee received today is different from the worth of a rupee to be received in future. Money, which is received today, has more value than equivalent amount of money, which is to be received in future.

If a rational person if offered the choice between receiving Rs.100 today or Rs.100 one year from now, he would prefer to receive the money now. This is because he has an option to invest the money, say at 10 percent interest, so that in one year’s time it would be worth Rs.110. This ‘time preference for money’ of an individual for possession of a given amount of cash now, rather than the possession of the same amount at some future time, is called time value of money.

Time value of money establishes the financial equivalence between money received in future and the present value of that money. For instance, in the above example, an individual will be indifferent between receiving Rs.100 today and Rs.110 next year provided he can earn 10 per cent interest on money invested. So, at 10 percent interest per annum, Rs.100 today is the same as Rs.110 one year from today. That is, Rs.100 today is financially equivalent to Rs.110 one year from now at 10 percent interest rate.

Thus, time value of money suggests that earlier receipts have more value than later receipts, because earlier receipts can be reinvested to generate additional returns.

Money has time value because of the following reasons:

Risk: There is uncertainty about the receipt of money in future.

Preference for present consumption: An individual has higher preference for present consumption than future consumption.

Purchasing power of money: Purchasing power of money declines with time due to inflation.

Investment opportunities: Money received today can be invested elsewhere to earn suitable returns.

Importance of Time Value of Money

Time value of money is a central concept in finance. It states that money has a time value. Money received today has more value than an equivalent amount of money to be received in future. In other words, the time value of money implies that the worth of a rupee received today is different from the worth of a rupee to be received in future.

For any investment project, costs and benefits occur at different points of time. The costs and benefits of an investment project can be measured in terms of cash flows associated with the project. For any typical investment project, cost is incurred upfront and benefits accrue over a period of time. Since, money received at different points of time has different values, how do we determine whether a project is providing adequate return to the investors? In other words, how do we establish financial equivalency among cash flows obtained at different points of time? For this, we use the concept of time value of money determined by the techniques of compounding and discounting.

The cash flows of a project, in general, take place at different periods over the life of the project. The cash flows of a project fall into three categories:

1) The initial investment2) The cash inflows over the life of the project and3) The terminal cash flow.

As these cash flows occur in different periods of time, they are not comparable. These absolute cash flows of different time periods can be made comparable by applying the concept of Time Value of Money.

The cash flows arising at different periods of time can be made comparable by using any one of the following two methods:

1) By compounding the periodic cash flows to a future date, or2) By discounting the future cash flows to present date.

In finance, the concept of time value of money is used to value any financial asset, be it be a bond or share or derivative instrument.

Methods for Determination of Time Value of Money

There are two methods for determination of time value of money:

Compounding and Discounting

To understand the concepts of compounding and discounting, consider a project which involves an immediate cash outflow of Rs 1,000 and the following pattern of inflows:

Year 1: Rs 250Year 2: Rs 500Year 3: Rs 750Year 4: Rs 750

The initial outflow and the subsequent inflows can be represented on a time line as given below:

0 1 2 3 4

Rs: -1000 250 500 750 750

Process of Compounding

Under the method of compounding, the future values (FV) of all the cash flows at the end of a time horizon at a particular rate of interest are determined. Therefore, in this case, the future value of the initial outflow of Rs.1,000 as at the end of year 4 is compared with the sum of the future values of the yearly cash inflows at the end of year 4. This process can be schematically represented as follows:

0 1 2 3 4 -1000 250 500 750 750 + FV (750) + FV (500) + FV (250) Compared with FV (1000)

Process of Discounting

Under the method of discounting, the present values (PV) of all the cash flows at time zero at a particular rate of interest are determined. So the initial outflow is compared with the sum of the present values of the future inflows at a given rate of interest. This process can be schematically represented as follows:

0 1 2 3 4

-1000 250 500 750 750Compared with the sums of PV (250)+PV (500)+PV (750)+PV (750)

Future Value of a Single Cash Flow (Lump Sum)

The future value of a single cash flow compounded annually at an interest rate ‘k’ after ‘n’ years is

FVn = PV (1+k)n

Where,FVn = Future value of the initial flow n years hence.PV = Initial cash flow k = Annual rate of interestn = number of years

In the above formula, the expression (1+k)n, which represents the future value of an initial investment of Re.1 (one rupee invested today) at the end of n years at a rate of interest k, is referred to as Future Value Interest Factor (FVIF). So the future value of an investment compounded annually at an interest rate ‘k’ after ‘n’ years is

FVn = PV x FVIFk,n

The value of FVIFk,n can be obtained from the FVIF table.

The above formula is used when interest compounded annually. If interest is compounded more frequently than once a year, say ‘m’ times a year, then the following formula shall be used to determine the future value of an investment:

FVn = PV (1+k/m)n x m = PV x FVIFk/m, n x m

Where,

FVn = Future value after ‘n’ yearsPV = Present value of investment.k = Interest rate per annum

m = Number of times compounding is done during a yearn = Number of years for which investment is made.

For example, in the case of semiannual compounding (m=2), the above formula becomes

FVn = PV (1+k/2)2n = PV x FVIFk/2, 2n

Future Value of Multiple Cash Flows

The future value of a series of cash flows at the end of a specified time horizon is the sum of the future values of the individual cash flows.

Suppose an investor invests Rs. 1,000 at the beginning of year 1, Rs. 2,000 at the beginning of year 2 and Rs. 3,000 at the beginning of year 3. The future value of these multiple cash flows at the end of year 3 at a rate of interest of 12% will be,

0 1 2 3 1000 2000 3000 Accumulation FV (3,000) + FV (2000) FV (1000)

FV3 = FV (Rs.1,000) + FV (Rs.2,000) + FV (Rs.3,000)

At k = 12% = 0.12, the above sum equal to

FV3 = Rs.1,000 x FVIF (12,3) + 2000 x FVIF (12,2) + 3000 x FVIF (12,1)

From FVIF table,

FVIF (12,3) = 1.4049 FVIF (12,2) = 1.2544 FVIF (12,1) = 1.1200

FV3 = Rs.[(1,000 x 1.4049) + (2,000 x 1.2544) + (3,000 x 1.1200)] = Rs.7274

If the multiple cash flows are of equal amounts, the future values of cash flows can be determined by the Annuity method.

Annuity

An annuity is a stream of regular payments (or receipts) of a fixed amount for a specified number of periods.

Types of Annuities

An annuity can be either an ordinary annuity or an annuity due. An ordinary annuity is an annuity for which the payments occur at the end of each year, whereas an annuity due is one for which the payments occur at the beginning of each year.

Future Value of an Ordinary Annuity

The future value of an ordinary annuity is a compounded annuity which involves depositing or investing an equal sum of money at the end of each year for a certain number of years.

The future value of an ordinary annuity for a period of ‘n’ years at a rate of interest ‘k’ is given by:

FVAn = A x FVIFAk,n

where,

FVAn = Future value of an ordinary annuity for n yearsA = Amount deposited at the end of every year for n yearsk = Rate of interest (expressed in decimals) FVIFAk,n = Future value interest factor for an n-year annuity at an interest rate of k

Future Value of an Annuity Due

The future value of an annuity due is a compounded annuity which involves depositing or investing an equal sum of money at the beginning of each year for a certain number of years.

The future value of an annuity due for a period of ‘n’ years at a rate of interest ‘k’ is given by:

FVAn = A x FVIFAk,n x FVIFk,1

where,

FVAn = Future value of an annuity for n yearsA = Amount deposited at the end of every year for n yearsk = Rate of interest (expressed in decimals) FVIFAk,n = Future value interest factor for an n-year annuity at an interest rate of k

Present Value of a Single Cash Flow

Present value is the present worth of future sums of money. The process of calculating present values, or discounting, is the inverse of finding the compounded future value. The present value formula can be readily obtained from the compounding formula

FVn = PV (1+k)n

Or FVn 1

PV = = FVn (1+k)n (1+k)n

The factor 1/(1+k)n is called the discounting factor or present value interest factor (PVIF), the value of which can be obtained from PVIF table. PVIFk,n is the present value of Re.1 received after ‘n’ years at a rate of interest ‘k’.

The above formula can be written as

PV = FVn x PVIFk,n

Present Value of Multiple Cash Flows

The present value of a series of cash flows is the sum of the present value of each individual cash flow.

Suppose a project invoves an initial investment of Rs.10 lakh and generates net inflows as follows:

End of year → 1 Rs.2 lakh→ 2 Rs.4 lakh→ 3 Rs.6 lakh

If the rate of return to be earned on the project (which is the same as the cost of capital) is 12 percent per annum, then the present value of the cash flows is determined using the following two-step procedure:

Step 1:

Evaluate the present value of each individual cash inflow independently. In this case, the present value of individual cash flow will be as follows:

Year Cash Flow (Rs. in lakh) Present Value (Rs. in lakh)1 2 2 x PVIF(12,1) = 2 x 0.8929 = 1.792 4 4 x PVIF(12,2) = 4 x 0.7972 = 3.19

3 6 6 x PVIF(12,3) = 6 x 0.7118 = 4.27 Step 2:

Determine the sum of the present values of individual cash inflows obtained in step 1 to arrive at the present value of the multiple cash flow stream.

The present value of the cash inflows associated with the project

= Rs.(1.79 +3.19 + 4.27) lakh= Rs.Rs.9.25 lakh.

A project is said to be financially viable if the present value of the cash inflows exceeds the present value of the cash outflow. In this case, the project is not financially viable because the present value of the net cash inflows (Rs.9.25 lakh) is less than the initial investment of Rs. 10 lakh. The difference of Rs.0.75 lakh is called the net present value.

The above procedure to determine the present value of multiple cash flows is applied when the individual cash flows are uneven. When the individual cash flows are equal, the stream of cash flows can be regarded as an annuity. In such a case, the following method for determination of the present value of an annuity can be applied to make the calculation easier.

Present Value of an Annuity

As stated earlier, annuity is a series of periodic cash flows of equal amounts. These periodic cash flows can be either receipts or payments. This equal amount of cash flows can occur either at the end of each period or at the beginning of each period. If the equal amounts of cash flows occur at the end of each period, such an annuity is known as ordinary annuity. If the equal amounts of cash flows occur at the beginning of each period, such an annuity is known as an annuity due.

Interest received from bonds and the periodic payments of insurance premium are examples of annuity. The equal amounts of cash flow are assumed to occur at the end of each period over the specified time horizon.

The present value of an annuity ‘A’ receivable at the end of every year for a period of ‘n’ years at a rate of interest ‘k’ is equal to

A A A A PVAn = + + + ………….+ (1 + k)1 (1 + k)2 (1 + k)3 (1 + k)n

1 1 1 1 PVAn = A + + +…………….+ (1 + k)1 (1 + k)2 (1 + k)3 (1 + k)n

or

n 1

PVAn = A . Σ t = 1 (1 + k)t

i.e.,

PVAn = A x PVIFAk,n

where PVIFAk,n represents the Present Value Interest Factor for an Annuity discounted at k percent for n years, the value of which can be obtained from the table.