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- 1. Financial management is the operational activity of a business that is responsible for obtaining and effectively utilising the funds necessary for efficient operations Joseph and Massie Financial management is that managerial activity which is concerned with the planning and controlling of the firm’s financial resources
- 2. SCOPE AND FUNCTIONS OF FINANCIAL MANAGEMENT First approach (Traditional approach) Second Approach Third approach (Modern approach) 1. Investment decision 2. Financing decision 3. Dividend decision Capital budgeting working capital decision
- 3. OBJECTIVES OR GOALS OF FINANCIAL MANAGEMENT I . Profit maximisation Reasons a. Profit is the test of economic efficiency b. It is difficult to survive with out profit c. It leads to efficient allocation of resources d. Profit ensure maximum social welfare(i,e maximum dividend to shareholders, timely payment to creditors, more and more wages to employees, more employment opportunities etc)
- 4. DISADVANTAGES OF PROFIT MAXIMISATION I . PROFIT MAXIMISATION 1. Ambiguity It is vague and ambiguous concept 2. Timing of benefit It ignores the time pattern of benefit Alternative (A) Alternative (B) Period I 5000 - Period II 10000 10000 Period III 5000 10000 Total 20000 20000
- 5. 3. Quality of benefits Alternative A AlternativeB Recession Period(I) 900 - Normal Period (II) 1000 1000 Boom Period (III) 1100 2000 Total 3000 3000
- 6. II . WEALTH MAXIMISATION
- 7. TIME VALUE OF MONEY A B10000 loan One Year Market value of interest 10% Reasons 1. More purchasing power 2. An investor can profitably invest which make him to give a higher value
- 8. TIME VALUE OF MONEY Compounding value concept (Future value of present money) Discounting or Present value concept (Present value of future money)
- 9. RISK AND RETURN The chance of future loss that can be foreseenRisk : The unforeseen chance of future loss or damage Eg : Earth quake, Coup Uncertainty : It represents the benefits derived by a business from its operations Return:
- 10. METHODS OF RISK MANAGEMENT Avoidance of risk Prevention of risk Transfer of risk Retention of risk Insurance
- 11. CAPITAL BUDGETING Investment in fixed assets Benefits derived in future which spreads over no: of years NEED FOR CAPITAL BUDGETING Large investments Irreversible nature Difficulties of investment decision Long term effect on profitability
- 12. EVALUATION OF INVESTMENT PROPOSALS Traditional methods Discounted cash flow method 1. Payback period method 2. Average rate of return method 1. Net present value (NPV method) 2. Internal rate of return method (IRR) 3. Profitability index (PI method)
- 13. I. TRADITIONAL METHOD 1. Pay back period method or pay out or pay off period method Representing the no of years required to recover the original investment Under this method projects are ranked on the basis of length of payback period Payback period = Initial investment annual cash inflow Note: Annual cash inflow is the annual earnings (Profit before depreciation and after tax) Payback period = Initial investment cumulated annual cash inflow Un even cash inflow
- 14. Investment proposals are judged on the basis of their relative profitability Projects with higher rate of return is accepted ARR = Average income after tax and depreciation x100 Average investment Average investment = Original investment 2 Average investment = original Cost - Scrap value 2 + additional W.C +Scrap value 2. Average rate of return method or Rate of return method or Accounting rate of return method
- 15. II. DISCOUNTED CASH FLOW METHODS OR TIME ADJUSTED TECHNIQUE 1 Net present value method Best method for evaluating the capital investment proposals It gives consideration to the time value of money Formula=Discounted cash inflow-Discounted cash outflow Note1 : If only in the beginning initial investment is made, then the discounted cash outflow will be the same i.e., initial investment Note2 : Cash inflow means profit before depreciation and after tax If NPV is zero or positive the project can be accepted
- 16. 2. Profitability index method This method is also called benefit cost ratio PI = Present value of cash inflow Present value of cash outflow PI is equal to or more than one the proposal can be accepted
- 17. 3. Internal rate of return (IRR) IRR is that rate at which the sum of discounted cash inflow equals the sum of discounted cash outflows L = Lower discount rate P1 = Present Value at lower rate P2 = Present Value at higher rate Q = Actual investment D = Difference in rate P1 – Q IRR = L+ P1-P2 xD
- 18. COST OF CAPITAL Rate of return expected by the suppliers of capital Importance of cost of capital Capital budgeting decision (Business must earn at least a rate which is equal to its cost of capital in order to make at least a break even) Capital structure decision (Raise capital from different sources which optimizes the risk and cost factors)
- 19. COMPUTATION OF COST OF CAPITAL I. COST OF DEBT (PERPETUAL OR IRREDEEMABLE) a. Debt issued at par = Kd =(1-T)R Kd =Cost of debt, T=Marginal Tax rate R= Debenture interest rate OR R= Annual Interest :- Net Proceeds of Loan or debentures b. Debt issued at premium or discount Formula = Kd = (1-T)R Here R = I Where I = Annual interest payment NP NP = Net proceeds of loan or debentures
- 20. II. COST OF REDEEMABLE DEBT a. Issued at par redeemable at par Kd= I+(Rv-Sv)/nm (Rv +Sv)/2 I = annual interest Rv = Payable value at the time of maturity Sv=Sales price or (face value of debt - Expenses) Nm = Term of debt or no: of years
- 21. b. Debt issued at premium redeemable at par Kd = I + F - P Nm Nm (Rv + Sv)/2 P = premium on debenture F=Flotation cost
- 22. c. Issued at discount redeemable at par D = Discount on debenture F=Flotation cost Kd = I + F + D Nm Nm (Rv + Sv)/2
- 23. III. COST OF PREFERENCE SHARES a. Cost of preference shares : Irredeemable Kp= d P0 (1-F) Where Kp = Cost of preference shares d = Constant annual dividend payment Po= Expected sales price of preference shares F= Flotation cost
- 24. Kp= d+(Rv-Sv)/nm (Rv+Sv)/2 b. Cost of preference share : Redeemable
- 25. IV. COST OF EQUITY CAPITAL a. Dividend approach P0 = face value or market price per share G=growth rate Ke= D1 P0 +g b. Earnings approach Ke = Cost of equity E0 = Current earnings per share or Total earnings Share outstanding P0 = Current net proceeds per share or (net proceeds per share - flotation cost) Ke= E0 P0
- 26. V. COST OF RETAINED EARNINGS Kr = Ke(1-T) ( 1-B) T= Tax B=Brokerage Ke = Shareholders required rate of return Or Ke = D1 +g P0
- 27. WEIGHTED AVERAGE COST OF CAPITALOR OVERALL COST OF CAPITAL It involves the following steps 1. Calculation of the cost of each specific source of funds. 2. Assigning weights to specific cost This involves determination of the proportion of each source of funds in the total capital structure of the company. 3. Adding of the weighted cost of all sources of funds to get an overall weighted average cost of capital.

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