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 cost c) To monitor the usage of funds to achieve the objectives d) 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 increasethe shareholder’s value. In short the key objective of a company is to maximize the value of thecompany based on(i)Proper planning (ii) prudent and timely financing/investing decisions (iii) effective monitoring andcontrolTo achieve the objectives, the finance manager should take careful decisions of (i) Arranging for finance (ii) Liquidity Management (iii) Using good investment opportunities (iv) arrangefor payment of dividendsSource 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 areconsidered part owners of the company. Debt: Public invest in companies through capital market on long term basis, by means of debentures. Inthis case, the investor not only invests in the company but also lends money against security or withoutsecurity. 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 forloan (borrowed) funds from banks and Financial Institutions and investing public in companydeposits/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 financialassets 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 tomanage the company’s affairs, investment in project is dealt by the Capital Budgeting which is based onthe concept “Net Present Value” (NPV) of the assets.Further the investment decisions deals with issues relating to mergers, acquisition, restructuring toachieve economy of scale in operation and also to increase the market shareDividend 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 tomaintenance 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 maximizethe value of share price which is an internal requirement (environment) To achieve this the companyneed to have efficient, well organized operations to meet with the customer’s demands. The companyneed to be innovative, better managed utilization of resources through new technologies and propermonitoring and control.(b) Companies are more social conscious as regards Corporate Social Responsibility re: externaleconomic environment.To meet with the companies financial/investment decisions, issues like pollution, social responsibilityabout the community/society, product safety and employee’s safety needs to be taken care, whiletaking these decisions.(c) Profit maximization is a short term concept, which does not recognize the time factor ie., the earningof stocks over a period of time, as against wealth maximization which increases the value by discountingthe 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 ) wouldbe option B Risk Vs Return: The finance manager’s responsibility is to ensure wealth maximization, which can beachieved 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 appraisedreasonably. The features of a capital project is that it incurs current/future outlay of funds, with an expectation ofa stream of benefits in the short and long term. One of the most important decisions is capital expenditure decision. A company’s presentperformance is the impact the earlier capital expenditure decisions, and the current expendituredecisions guides the future performance/ results
Irreversibility: A careful capital expenditure decision is very important, because a wrong decisionwould, 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 investin fixed assets or in long term projects, such decisions are known as capital budgeting. While theprocess is a complex one, we shall try to understand the same in a simpler method . The process isreflected 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 isundertaken. 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 beexecuted over some interval of time.Capital budgeting, which involves a large outlay of funds and a longer period. The commitments forlarge outlay of funds would result either in profit or loss and benefits or drawbacks. Hence thecapital budget discussions are crucial for a firm.Cash flows: The significance of cash flows both inflows and outflows are important factors. The cashinflows from an investment are the effect of incremental changes in after tax in operating cashflows. 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 investmentReturn 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 minuscost of investment.Internal Rate of Return(IRR): The interest that = the present value of future cash flow to theinvestment outlay. NPV and IRR are discounted cash flowsTime Value of Money:The evaluation of capital expenditure proposals involves the comparison between cash outflowsand cash inflows.Since the capital expenditure can be effected in future, it would be ideal if the evaluation is done ason 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 theinvestment 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 amountshould 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 isconsidered as short term. The increase in working capital may be either due to working capitalmanagement by the company, increase in current assets (receipt of cash) or reduction in currentliabilities (payment to short term creditors) A company’s working capital management objective is to ensure that the company is able to manageon an ongoing basis, that the company has sufficient cash flow to cover both maturing short term debtand 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 againsthypothecation/pledge of movable assets (inventories) Working Capital ratios reflects the company’s efficiency in managing its rResources with specialreference 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 calledas receivables financing. The non fund based financing also constitute a portion of overall WC financing.Working Capital ManagementWorking Capital Finance:One of the main concerns of a Finance Manager is to manages his resources to ensure that the liquiditymanagement (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 withthe 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 theprocess, banks generally check, verify by applying different norms to decide upon the quantum offinance 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 oneyear, and may extend to three or five years, depending upon the investments. A number of factors areinvolved and different divisions of a company are also affected by the capital budgeting.Methods of Capital Budgeting: Capital Budgeting Non Discounting Discounting Methods Methods Net Present Internal Rate of Pay back Rate of Return Value(NPV) Return (IRR)Payback method is the number of years required to return the original investment . Pay back method isan 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 thecompany has three options , and expects the life span will be for 4 years. As per the finance manager’sviews after 4 years the company needs to go in for further investments. Payback method Peoject X Peoject Y Peoject Z Rs Rs Rs Investment 150,000 250,000 500,000 Life of investment 4 years 4 years 4 years I st year cash inflow 40,000 80,000 200,000 2nd year cash inflow 60,000 100,000 300,000 3rd year cash inflow 50,000 120,000 150,000
4th year cash inflow 40,000 60,000 90,000 Calculation of pay back time from an investment Peoject X Peoject Y Peoject Z Rs Rs Rs Investment 150,000 250,000 500,000 Cash inflow 1st year 40,000 80,000 200,000 2nd year 60,000 100,000 300,000 3rd 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 andthen 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 endof three years.Project Y: Cash in flow for 3 years is 300,000. It has covered the investment of Rs.250,000 between 2and 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 monthsProject X:Cash inflow for 2 years is= to investment of Rs.500,000Hence Project Z has the quickest payback timeReturn 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 ofreturn 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 coursedividends.To understand let us take an examples:Year Profit (Rs)1 15,0002 12,5003 25,0004 30,0005 20,000Total profit: Rs 102,500Assuming the capital employed is Rs 200,000, then the average capital employed =200,000/2=Rs100,000Average annual profit 102,500/5 = 20,500ROI = Estimated average profit/estimated average investment x100ROI = 20,500x100/100,000 =20.5%Net Present Value (NPV): The present value of future returns discounted at the cost of capital minus costof investment.Internal Rate of Return(IRR): The interest that = the present value of future cash flow to the investmentoutlay. 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 decisionsAlso ensures that is there the firm has enough cash to meet its obligations and invest in profitableprojectsPrincipal 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