Financial Management- module-1

Real knowledge is to know the
extent of one's ignorance.
Knowledge without justice ought to
be called cunning rather than
wisdom.
Module – 1
PPTs by Dr. Kasamsetty Sailatha
Dr.Kasamsetty Sailatha

Contents
• Introduction
• Meaning and definition of financial management;
• Approaches to financial management;
• Scope of financial management;
• Functions of financial management;
• Corporate objectives:
– Profit Maximization and
– Wealth Maximization
– Other objectives
• Social implications of corporate objectives
• Concept of cash flow
• Time value of money

Introduction
• Business concern needs finance to meet their requirements
in the economic world. Any kind of business activity depends
on the finance.
• Hence, it is called as lifeblood of business organization.
Whether the business concerns are big or small, they need
finance to fulfill their business activities.
• In the modern world, all the activities are concerned with the
economic activities and very particular to earning profit
through any venture or activities.
• The entire business activities are directly related with making
profit. (According to the economics concept of factors of
production, rent given to landlord, wage given to labour,
interest given to capital and profit given to shareholders or
proprietors), a business concern needs finance to meet all
the requirements. Hence finance may be called as capital,
investment, fund etc., but each term is having different
meanings and unique characters. Increasing the profit is the
main aim of any kind of economic activity.

• Though it was a branch of economics till 1890, as a
separate activity or discipline it is of recent origin.
• The subject of financial management is of immense
interest to both academicians and practicing mangers.
• It is of great interest to academicians because the
subject gained very important place in the business
world.
• It also gained its importance because there are still
certain areas where controversies exist for which no
unanimous solutions have been reached as yet.
• Practicing managers are interested in this subject
because among the most crucial decisions of the firm
are those which relate to finance, and an
understanding of the theory of financial management
provides them with conceptual and analytical insights
to make those decisions skillfully.

Meaning and Definition of Financial
Management
• Before understanding the word financial management,
let us understand the meaning of finance.
• Meaning of finance: it may be defined as the art and
science of managing money. The major areas of
finance are:
– Financial services and
– Managerial finance/corporate finance/financial
management.
• Meaning of financial management:
– Financial management is that activity which is concerned
ith the pla i g a d o t olli g of the fi s fi a ial
resources.
– Financial management is an integral part of overall
management. It is concerned with the duties of the
financial managers in the business firm.

Definition of Financial
Management:
• The term financial management has been defined by
Solo o , “It is co cer ed with the efficient use of an
i po ta t e o o i esou e a el , apital fu ds .
• The most popular and acceptable definition of financial
management as given by S.C. Kuchal is that “Fi a cial
Management deals with procurement of funds and
their effective use i the usi ess .
• Howard a d Upto : Fi a cial a age e t “as a
application of general managerial principles to the
area of financial decision-making.

• Westo a d Brigha : Fi a cial a age e t “is a
area of financial decision-making, harmonizing
i di idual oti es a d e te p ise goals .
• Joshep a d Massie : Fi a cial a age e t “is the
operational activity of a business that is responsible
for obtaining and effectively utilizing the funds
necessary for efficient operations.
• Thus, Financial Management is mainly concerned with
the effective funds management in the business. In
simple words, Financial Management as practiced by
business firms can be called as Corporation Finance or
Business Finance.

Approaches to financial management
• There are two approaches of financial management
namely (a) traditional approach and (b) modern
approach.
a) Traditional approach: according to this approach
the following functions, that a finance manager of a
business firm will perform:
1. Arrangement of short-term and long-term funds from
financial institutions;
2. Mobilization of funds through financial instruments like
equity shares, preference shares debentures, bonds etc.;
and
3. Orientation of finance function with the accounting
function and compliance of legal provisions relating to
funds procurement, use and distribution.

b) Modern approach: according to this approach
the finance manager is expected to analyze
the firm and to determine the following :
1. The total funds requirement of the firm;
2. The assets to be acquire, and
3. The pattern of financing the assets.

SCOPE OF FINANCIAL MANAGEMENT
Financial management is one of the important parts 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 are the important scope of financial management.
1. Financial Management and Economics: Economic concepts like micro
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 finance, 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 the financial
management and accounting. In the olden periods, both financial
management and accounting are treated as a same discipline and
then it has been merged as Management Accounting because this
part is very much helpful to finance manager to take decisions. But
nowadays financial management and accounting discipline are
separate and interrelated.

3. Financial Management or Mathematics: Modern approaches
of the 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 multiple 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. These
expenditures are decided and estimated by the financial
department and the finance manager allocates the
appropriate finance to production department. The financial
manager must be aware of the operational process and
finance required for each process of production activities.

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 financial manager or finance department is
responsible to allocate the adequate finance to the
marketing department. Hence, marketing and financial
management are interrelated and depends on each
other.
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. Financial
manager should carefully evaluate the requirement of
manpower to each department and allocate the
finance to the human resource department as wages,
salary, remuneration, commission, bonus, pension and
other monetary benefits to the human resource
department. Hence, financial management is directly
related with human resource management.Dr.Kasamsetty Sailatha

Functions of financial management:
It may be difficult to separate the finance functions
from production, marketing and other functions. The
functions of raising funds, investing them in assets and
distributing returns earned from assets to shareholders
are respectively known as financing, investment and
dividend decisions. While performing these functions,
a firm attempts to balance cash inflows and outflows,
this is known as liquidity decision. Hence, the finance
functions are classified as follows:
1. Investment or long-term asset-mix decision;
2. Financing or capital-mix decision;
3. Dividend or profit allocation decision and
4. Liquidity or short-term asset-mix decision.Dr.Kasamsetty Sailatha

1. Investment decision/function (capital
budgeting):
– this involves the decision of allocation of capital or
commitment of funds to long-term assets that would
yield benefits in the future.
– Two important aspects of the investment decision
are:
a) The evaluation of the prospective profitability of new
investment and
b) The measurement of cut-off rate against that the
prospective return of new investments could be
compared.
– Because of the uncertain future, investment
decisions involve risk. Investment proposals should,
therefore, be evaluated in terms of both expected
return and risk. Dr.Kasamsetty Sailatha

• The investment decisions of a financial manager cover
the following areas:
1. Ascertainment of total volume of funds, a firm can
commit;
2. Appraisal and selection of capital investment proposals;
3. Measurement of risk and uncertainty in the investment
proposals;
4. Prioritizing of investment decisions;
5. Funds allocation and its rationing;
6. Determination of fixed assets to be acquired;
7. Determination of levels of investments in current assets
viz. inventory, receivables, cash, marketable securities etc
and its management;
8. Buy or lease decisions;
9. Asset replacement decisions;
10. Restructuring, reorganization, mergers and acquisitions;
and
11. Securities analysis and portfolio management.

2. Financing Decision/ Capital Structure
Decisions or Function:
– Financing decision/function is the second
important function to be performed by the
financial manger.
– The financial manager must decide when, where
and how to acquire funds to meet the fi s
investment needs.
– The central issue before the manager is to
determine the proportion of equity and debt.
– The mix of debt and equity is known as the fi s
capital structure.
– The financial manger must strive to obtain the best
financing mix or the optimum capital structure for
the firm. Dr.Kasamsetty Sailatha

– The fi s capital structure is considered to be optimum
when the market value of share is maximized.
– The use of debt affects the return and risk of
shareholders. It may increase the return on equity funds
but it always increases risk.
– When the sha eholde s return is maximized with
minimum risk, the market value per share will be
maximized and the fi s capital structure would be
considered optimum.
– Once the financial manger is able to determine the best
combination of debt and equity, he or she must raise the
appropriate amount through the best available sources.
In practice, a firm considers many other factors such as
control, flexibility, loan convenient, legal aspects etc. in
deciding it s capital structure.Dr.Kasamsetty Sailatha

• The finance manger involve in the following finance decisions:
1. Determination of degree or level of gearing (Gearing is a
easu e of a o pa s fi a ial le e age a d sho s the e te t
to which its operations are funded by lenders versus
shareholders.);
2. Determination of financing pattern of long-term funds
requirement;
3. Determination of financing pattern of medium and short-term
funds requirement;
4. Raising of funds through issue of financial instruments viz. equity
shares, preference shares, debentures, bonds etc.;
5. Arrangement of funds from banks and financial institutions for
long-term, medium-term and short-term needs;
6. Arrangement of finance for working capital requirement;
7. Consideration of interest burden on the firm;
8. Co side atio of de t le el ha ges a d its i pa t o fi s
bankruptcy;
9. Taking advantage of interest and depreciation in reducing the tax
liability of the firm;
10. Consideration of various modes of improving the earnings per
share and the market value of the share;Dr.Kasamsetty Sailatha

11. Taking advantage of interest and depreciation in
reducing the tax liability of the firm;
12. Consideration of various modes of improving the
earnings per share and the market value of the share;
13. Consideration of cost of capital of individual
components and weighted average cost of capital to
the firm;
14. Analysis of impact of different levels of gearing on the
firm and individual shareholder;
15. Optimization of financing mix to improve return to the
equity shareholders and maximization of wealth of the
fi a d alue of the sha eholde s ealth;
16. Portfolio management;
17. Consideration of impact of over capitalization and
u de apitalizatio o the fi s p ofita ilit ;
18. Consideration of foreign exchange risk exposure of the
firm and decisions to hedge the risk;

19. Study of impact of stock market and economic
condition of the country on modes of financing;
20. Mai te a e of ala e et ee o e s apital
to outside capital;
21. Maintenance of balance between long-term
funds and short-term funds;
22. Evaluation of alternative use of funds;
23. Setting of budgets and review of performance for
control action; and preparation of cash flow and
funds flow statements and analysis of
performance through ratios to identify the
problems areas and its correction, etc.

3. Dividend Decision/function:
– Dividend decision is the third major financial
decision. The financial manger must decide
whether the firm should distribute all profits, or
retain them or distribute a portion and retain
the balance.
– Like debt-equity policy, the dividend policy
should be determined in terms of its impact on
the sha eholde s alue.
– The optimum dividend policy is one that
a i izes the a ket alue of the fi s sha es.
– Thus, if shareholders are not indifferent to the
fi s di ide d poli , the fi a ial a ge
must determine the optimum dividend-payout
ratio.

–The payout ratio is equal to the percentage
of dividends to earnings available to
shareholders. The financial manger should
also consider the questions of dividend
stability, bonus shares and cash dividends
in practice.
–Most profitable companies pay cash
dividends regularly. Periodically, additional
shares, called bonus shares or stock
dividends are also issued to the existing
shareholders in addition to the cash
dividend. Dr.Kasamsetty Sailatha

• The finance manager will involve in taking the
following dividend decisions:
1. Determination of dividend and retention policies of
the firm;
2. Consideration of impact of levels of dividend and
retention of earnings on the market value of the
share and the future earnings of the company;
3. Consideration of possible requirement of funds by
the firm for expansion and diversification proposals
for financing existing business requirements;
4. Reconsideration of distribution and retentions
policies in boom and recession periods; and
5. Considering the impact of legal and cash flow
constrains on dividend decisions.

4. Liquidity Decision/function:
– Cu e t assets a age e t that affe ts a fi s
liquidity is yet another important finance function, in
addition to the management of long-term assets.
– Current assets should be managed efficiently for
safeguarding the firm against the dangers of
illiquidity and insolvency.
– I est e t i u e t assets affe ts the fi s
profitability, liquidity and risk. .
– A conflict exists between profitability and liquidity
while managing current assets.
– If the firm does not invest sufficient funds in current
assets, it may become illiquid. But it would lose
profitability as idle current assets would not earn
anything.

– Thus, a proper trade-off must be achieved between
profitability and liquidity. In order to ensure that
neither insufficient nor unnecessary funds are
invested in current assets, the financial manger
should develop sound techniques of managing
u e t assets. He/she should esti ate fi s eed
for current assets and make sure that funds would
be made available when needed.
– It would thus be clear that financial decisions
di e tl o e the fi s de isio to a ui e o
dispose off assets and require commitment or
recommitment of funds on a continuous basis.

• Finally, a firm performs finance functions
simultaneously and continuously in the normal
course of the business. They do not necessarily
occur in a sequence. Thus, finance functions
call for skillful planning, control and execution
of a fi s a ti ities.

• Corporative Objectives of Financial Management
– Effective procurement and efficient use of finance
lead to proper utilization of the finance by the
business concern. It is the essential part of the
financial manager. Hence, the financial manager
must determine the basic objectives of the
financial management. Objectives of Financial
Management may be broadly divided into four
parts such as:
I. Profit maximization objectives;
II. Wealth maximization objectives;
III. Value maximization objectives and
IV. Other maximization objectives.Dr.Kasamsetty Sailatha

Figure – Corporate Objectives
Others
Wealth
Profit
Corporate
Objectives
Value

I. Profit Maximization
– Main aim of any kind of economic activity is earning profit. A
business concern is also functioning mainly for the purpose
of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit
maximization is also the traditional and narrow approach,
which aims at, maximizes the profit of the concern. Profit
maximization consists of the following important features.
1. Profit maximization is also called as cashing per share
maximization. It leads to maximize the business operation
for profit maximization.
2. Ultimate aim of the business concern is earning profit,
hence, it considers all the possible ways to increase the
profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the
business concern. So it shows the entire position of the
business concern.
4. Profit maximization objectives help to reduce the risk of
the business. Dr.Kasamsetty Sailatha

• Favourable Arguments for Profit Maximization
– The following important points are in support of the profit
maximization objectives of the business concern:
1. Main aim is earning profit.
2. Profit is the parameter of the business operation.
3. Profit reduces risk of the business concern.
4. Profit is the main source of finance.
5. Profitability meets the social needs also.
• Unfavourable Arguments for Profit Maximization
– The following important points are against the objectives of
profit maximization:
1. Profit maximization leads to exploiting workers and
consumers.
2. Profit maximization creates immoral practices such as
corrupt practice, unfair trade practice, etc.
3. Profit maximization objectives leads to inequalities among
the stake holders such as customers, suppliers, public
shareholders, etc. Dr.Kasamsetty Sailatha

• Drawbacks of Profit Maximization:
– Profit maximization objective consists of certain drawback
also:
1. It is vague: In this objective, profit is not defined
precisely or correctly. It creates some unnecessary
opinion regarding earning habits of the business concern.
2. It ignores the time value of money: Profit maximization
does not consider the time value of money or the net
present value of the cash inflow. It leads certain
differences between the actual cash inflow and net
present cash flow during particular period.
3. It ignores risk: Profit maximization does not consider
risk of the business concern. Risks may be internal or
external which will affect the overall operation of the
business concern.

II. Wealth Maximization:
–Wealth maximization is one of the modern
approaches, which involves latest innovations
and improvements in the field of the
business concern. The term wealth means
shareholder wealth or the wealth of the
persons those who are involved in the
business concern.
–Wealth maximization is also known as value
maximization or net present worth
maximization. This objective is an universally
accepted concept in the field of business.

• Favourable Arguments for Wealth Maximization
1. Wealth maximization is superior to the profit
maximization because the main aim of the
business concern under this concept is to improve
the value or wealth of the shareholders.
2. Wealth maximization considers the comparison of
the value to cost associated with the business
concern. Total value detected from the total cost
incurred for the business operation. It provides
extract value of the business concern.
3. Wealth maximization considers both time and risk
of the business concern.
4. Wealth maximization provides efficient allocation
of resources.
5. It ensures the economic interest of the society.

• Unfavourable Arguments for Wealth Maximization
1. Wealth maximization leads to prescriptive (narrow)
idea of the business concern but it may not be
suitable to present day business activities.
2. Wealth maximization is nothing, it is also profit
maximization, it is the indirect name of the profit
maximization.
3. Wealth maximization creates ownership-
management controversy.
4. Management alone enjoy certain benefits.
5. The ultimate aim of the wealth maximization
objectives is to maximize the profit.
6. Wealth maximization can be activated only with
the help of the profitable position of the business
concern.

• Social implications of Profit maximization and
wealth maximization objectives:
– In the large companies, there is a divorce between
management and ownership.
– The decision-taking authority in a company lies in
the hands of managers.
– Shareholders as owners of the company are the
principals and mangers are their agents.
– Thus there is principal-gent relationship between
shareholders and managers.
– In theory, mangers should act in the best interest
of shareholders; that is, their actions and
de isio s should lead to sha eholde s ealth
maximization.

– In practice, mangers may not necessarily act in
the best interest of shareholders, and they may
peruse their own personal goals.
– The conflict between the interests of shareholders
and managers is referred to as agency problem
and it results into agency cost.
– Agency cost include the less than optimum share
value for shareholders and cost incurred by them
to monitor the actions of mangers and control
their behaviour.

– Take the ex. of the 2008 Great Recession and one
of the causes of it - the near big bank failures on
Wall Street. Were those banks being socially
responsible? No. They were worrying about their
investment portfolios instead of loaning money to
customers, which is their charge. Those
investment portfolios were filled with toxic assets
(Toxic assets are largely investments backed by
risky subprime mortgages) and eventually brought
most of the big banks down. Their share prices fell
right along with them. They were not being
socially responsible.

– On the other hand, look at General Motors. After
almost failing in the Great Recession, GM turned
itself around, repaid its debt, and developed
"greener" vehicles. As it did that, it's share price
started climbing. Why? GM was taking on the
mantle of social responsible rather than just
searching for profits. Business firms cannot exist
and profit in the long run without being socially
responsible.

III. Value Maximization Objective:
– The goal of firm is to maximize the present wealth
of the owners i.e. equity shareholders in a company.
– A company's equity shares are actively traded in the
stock markets. The wealth of the equity
shareholders is represented in the market value of
the equity shares.

Dividend
distribution
Fi s ealth a i izatio
Value maximization of equity shareholders
through increase in stock market price of
share
Short term funds Long term funds
Acquire temporary
working capital
Acquire fixed assets and
permanent working
capital
Generate net
cash inflows
from operation
Service debt obligations Retained earnings available
for re-investment
Usedto
Usedto
Figure - Fir s’ Cash flow
and Value Maximization

– The prime goal for company is to maximize the market value of
equity shares of the company.
– The market price of a share serves as an index of the
performance of the company .
– It takes into account present and prospective future earnings per
share, risk associated with the business, dividend and retention
policies of the firm, level of gearing etc.
– The sha eholde s ealth is a i ized o l he the a ket
value of the share is maximized.
– Therefore, the term wealth maximization of financial
management is redefined as value maximization.
– In company form of business, the wealth created is reflected in
the market value of its shares. Therefore, the financial decisions
will cause to create wealth and it is indicated or reflected in
a ket p i e of o pa s sha es.
– Hence, the prime objective of financial management is to
maximize the value of the firm.Dr.Kasamsetty Sailatha

IV. Other maximization objectives
1. Sales maximization objectives;
2. Growth maximization objectives;
3. Maximization of ROI; and
4. Social Objectives;
1. Sales maximization objective: the interest o
the company are best served by the
maximization of sales revenue. Which brings
with it the benefits of growth, market share
and status. The size of the firm, prestige, and
aspirations are more closely identified with
sales revenue than with profit.Dr.Kasamsetty Sailatha

2. Growth maximization objective:
– Managers will seek the objectives which give
them satisfaction, such as salary, prestige, status
and job security. On the other hand, the owners
of the firm are concerned with market values
such as profit, sales and market share.
– These differing sets of objectives are reconciled
by concentrating on the growth of the size of the
firm, which brings with it higher salaries and
status for mangers and larger profits and market
share for the owners of the firm.

3. Maximization of ROI:
– The strategic aim of a business enterprise is to earn a
return on capital.
– If in any particular case, the return in the long-run is
not satisfactory, then the efficiency should be
corrected or the activity be abandoned for a more
favourable one.
– Measuring the historical performance of an
investment centre calls for a comparison of the profit
that has been earned with capital employed. The
rate of return on investment is determined by
dividing net profit or income by the capital employed
or investment made to achieve that profit.
– ROI analysis provides a strong incentive for optimal
utilization of the assets of the company.

4. Social Objective:
– The business enterprise is an integral par t of the
functioning of a country.
– As such, in return for the privileges and rights
granted to it b the state. The business firm should
be made increasingly responsible for social
objectives.

Cashflow Analysis

Cash Flow Analysis
• Introduction
• Meaning
• Meaning of certain terms
• Classification of cash flows
• Procedure in preparation of cash flow
statement
• Direct method
• Indirect method

• Introduction:
– Cash flow statement provides information about
the cash receipts and payments of a firm for a
given period.
– It provides important information that
compliments the profit and loss account and
balance sheet.
– The information about the cash flows of a firm is
useful in providing users or financial statements
with a basis to assess the ability of the enterprise
to generate cash and cash equivalents and the
needs of the enterprise to utilize these cashflows.

• Meaning of Cash Flow Statement:
– Cash flow statement is a statement which shows
the sources of cash inflow and uses of cash out-
flow of the business concern during a particular
period of time.
– It is the statement, which involves only short-
term financial position of the business concern.
– Cash flow statement provides a summary of
operating, investment and financing cash flows
and reconciles them with changes in its cash and
cash equivalents such as marketable securities.
– Institute of Chartered Accountants of India issued
the Accounting Standard (AS-3) related to the
preparation of cash flow statement in 1998.

• Meaning of Certain Terms:
1. Cash o p ises ash o ha d a d de a d deposit
with banks;
2. Cash e ui ale ts a e sho t te , highl li uid
interments that are readily convertible into known
amounts of cash and which are subject to an
insignificant risk of changes in value. Ex. of cash
equivalents are T-bills, commercial paper etc.
3. Cash flo s a e i flo s a d outflo s of ash a d
cash equivalents. It means the movement of cash
into the organization and movement of cash out of
the organization. The difference between the cash
i flo s a d outflo s is k o as et ashflo
which can be either net cash inflow or net cash
outflow.

• Classification of cashflow:
1. Cashflows from operating activities;
2. Cashflows from investing activities and
3. Cashflows from financing activities.
1. Cashflows from operating activities:
a. Cash receipts from the sale of goods and rendering of
services.
b. Cash receipts from royalties, fees, commissions, and other
revenue.
c. Cash payments to suppliers for goods and services.
d. Cash payments to and on behalf of employees
e. Cash receipts and payments of an insurance enterprise for
premiums and claims, annuities and other policy benefits.
f. Cash payments or refunds of income-tax unless they can be
specifically identified with financing and investing activities
and
g. Cash receipts and payments relating to future contracts,
forward contracts, option contracts and swap contracts when
the contracts are held for dealing or trading purposes.

2. Cashflows from investing activities:
– Investing activities are the acquisition and
disposal of long-term assets and other
investments and not included in cash
equivalents.
– Investing activities include transactions and
events that involve the purchase and sale of
long-tem productive assets ex. Land, building
plant and machinery etc not held for resale and
other investments.

• The following are examples of cash flows arising from
investing activities:
a. Cash payments to acquire fixed assets;
b. Cash receipts from disposal of fixed assets including
intangibles;
c. Cash payments to acquire shares, warrants or debt
instruments of other enterprises and interests in joint
venture;
d. Cash receipts from disposal of shares, warrants, or debt
instruments of other enterprises and interests in joint
ventures;
e. Cash advances and loans made to third parties;
f. Cash receipts from the repayments of advances and
loans made to third parties; and
g. Cash receipts and payments relating to futures contracts,
forward contracts, option contracts and swap contracts
except when the contracts are held for dealing or trading
purposes, or the receipts and payments are classified as
financing activities.Dr.Kasamsetty Sailatha

3. Cashflows from Financing Activities:
– Financing activities are activities that result in
change in the size and composition of the
o e s apital a d o o i gs of the e te p ise.
Following are the examples of cash flows arising
from financing activities:
a. Cash proceeds from issuing shares or other
similar instruments;
b. Cash proceeds from issuing debentures, loans
notes, bonds and other short term borrowings;
c. Cash repayments of amounts borrowed, i.e.
redemption of debentures, bonds, etc.
d. Cash payments to redeem preference shares and
e. Payment of dividend.

• Procedure in preparation of cash flow:
– The procedure used for the preparation of cashflow
statement is as follows:
a. Net increase or decrease in cash and cash equivalents
accounts: The difference between cash and cash
equivalents for the period may be computed by
comparing these accounts given in the comparative
balance sheets. The results will be cash receipts and
payments during the period responsible for the increase
or decrease in cash and cash equivalents items;
b. Calculation of the net cash provided or used by operating
activities: It is by the analysis of profit and loss account,
comparative balance sheet and selected additional
information.
c. Calculation of the net cash provided or used by investing
and financing activities. All other changes in the balance
sheet items must be analyzed taking in to account the
additional information and effect on cash may be
grouped under the investing and financing activities.

d. Preparation of a cash flow statement: it may be
prepared by classifying all cash inflows and
outflows in terms of operating, investing and
financing activities. The net cashflow provided
or used in each of these three activities may be
highlighted.
e. Ensure that the aggregate of net cashflow from
operating, investing and financing activities is
equal to net increase or decrease in cash and
cash equivalents.
f. Report any significant investing, financing
transactions that did not involve cash or cash
equivalents in a separate schedule to the
cashflow statement

• Direct Method:
– Under this method, cash receipts from operating
revenues and cash payments for operating
expenses are arranged and presented in the
cashflow statement.
– The difference between cash receipts and cash
payments is the net cash flow from operating
activities.
– In this method, each cash transaction is alyzed
separately and the total cash receipts and
payments for the period is determined.
– we may convert accrual basis of revenue and
expenses to equivalent cash receipts and
payments. Need o follow uniform procedure for
converting accrual base items to cash base items.

• Indirect Method:
– Under this method the net profit/loss is used as
the base and convert it to net cash provided or
used in operating activities.
– This method adjusts net profit for items that
affected net profit but did not affect cash.
– Noncash and non-operating charges in the profit
and loss a/c are added back to the net profit while
noncash and non-operating credits are deducted
to calculate operating profit before working
capital changes.

The Time Value of Money
26th Oct, 2013

• Contents :
– Introduction
– Meaning
– Reasons that are considered for time value of
money
– Terminologies of time value of money

Introduction
• What is Time Value?
– We say that money has a time value because that
money can be invested with the expectation of
earning a positive rate of return
– I othe o ds, a upee e ei ed toda is o th
o e tha a upee to e e ei ed to o o
– That is e ause toda s upee a e i ested so
that we have more than one rupee tomorrow

Meaning
• The ti e alue of o e is the p i iple that
a certain currency amount of money today has
a different buying power than the same
u e a ou t of o e i the futu e.

Reasons that are considered for time value
of money
• An important financial principle is that the
value of money is time dependent. This
principle is based on the following four
reasons:
1. Inflation;
2. Risk;
3. Personal consumption preference; and
4. Investment opportunities.

The Terminology of Time Value
1. Simple Interest: It is the interest calculated on the original
principal only for the time during which the money let is
being used. Simple interest is paid or earned on the principal
amount lent or borrowed. Simple interest can be calculated
from the following formula:
PTR /100 or PTR or Pnr or P (1+nr)
P = Principal amount
T/n = time period/number of year
R/r = rate of interest per annum (should express in decimal)

2. Compound Interest :
– If interest for one period is added to the principal
to get the principal for the next period, it is called
compound interest.
– The time period for compounding the interest
may be annual, semiannual, or any other regular
period of time.
– The period after which interest becomes due is
alled i te est pe iod o o e sio pe iod.
– If the conversion period is not mentioned,
interest is to be compounded annually.
– The compound interest can be calculated as
follows:

1. Compound interest annually:
A = P (1+i)n
2. Half-yearly:
A = P (1+i/2)2n
3. Quarterly:
A = P (1+i/4)4n
4. Monthly:
A = P (1+i/12)12n
5. Weakly:
A = P (1+i/52)52n
6. Daily:
A = P (1+i/365)365n

3. Present Value – It is an amount of money
today, or the current value of a future cash
flow. The formula to compute the PV is as
follows.
PV0 = FVn (PVIFin)
 N
N
i
FV
PV


1

Annuities
• An annuity is a series of nominally equal payments equally
spaced in time
• Annuities are very common:
– Rent
– Mortgage payments
– Car payment
– Pension income
• The timeline shows an example of a 5-year, Rs.100 annuity
0 1 2 3 4 5
100 100 100 100 100

The Principle of Value Additivity
• How do we find the value (PV or FV) of an
annuity?
• First, you must understand the principle of
value additivity:
– The value of any stream of cash flows is equal to
the sum of the values of the components
• In other words, if we can move the cash flows
to the same time period we can simply add
them all together to get the total value

4.Present value annuity:
We can use the principle of value additivity to
find the present value of an annuity, by
simply summing the present values of each of
the components:
Or
PVAn = R/(1+r)1 + R/(1+r)2 + R/(1+r)n
       N
N
N
t
t
t
A
i
Pmt
i
Pmt
i
Pmt
i
Pmt
PV







  1111
2
2
1
1
1

Annuities Due
• Thus far, the annuities that we have looked at begin their
payments at the end of period 1; these are referred to as
regular annuities
• A annuity due is the same as a regular annuity, except that its
cash flows occur at the beginning of the period rather than at
the end
0 1 2 3 4 5
100 100 100 100 100
100 100 100 100 1005-period Annuity Due
5-period Regular Annuity

5. Present Value of an Annuity Due
• We can find the present value of an annuity due in the same
way as we did for a regular annuity, with one exception
• Note from the timeline that, if we ignore the first cash flow,
the annuity due looks just like a four-period regular annuity
• Therefore, we can value an annuity due with:
  
PV Pmt
i
i
PmtAD
N
















1 1
1
1

6. Future Value - An amount of money at some
future time period.

Capital Budgeting Decisions
Module – 2 (Part-I)
PPTs by Dr. Kasamsetty Sailatha

Contents
• Introduction
• Meaning and definition of Capital Budgeting
• Need and Importance of Capital Budgeting
• Capital Budgeting Process
• Evaluation techniques
• NPV Vs IRR
• Multiple IRRs
• Capital Rationing
• Risk Analysis in Capital Budgeting
• Measurement of Risk
• Project variance
• Expected NPV
Dr. Kasamsetty Sailatha

Introduction
• The word Capital refers to be the total
investment of a company in tangible and
intangible assets.
• Whe eas udgeti g defi ed the Rowland
a d Willia it ay be said to be the art of
building budgets.
• Budgets are blue print of a plan and action
expressed in quantities and manners.

• Capital budgeting is a long term planning exercise
in selection of the projects which generates
returns over a number of years in future and the
heavy expenditure is to be incurred in the initial
years of the project to generate returns over the
life of the project. Therefore, this includes the
investment decision.
• Investment decision/ capital budgeting decision is
a decision concerned with allocation of funds to
get proper yield from project. So that it can
recover the cost associated with each source of
fund and earn required amount of profit to
compensate the risk involved in the business.

• The examples of capital expenditure:
1. Purchase of fixed assets such as land and
building, plant and machinery, good will, etc.
2. The expenditure relating to addition,
expansion, improvement and alteration to the
fixed assets.
3. The replacement of fixed assets.
4. Research and development project.

Meaning and Definition
• Capital Budgeting: It is process of planning for
capital expenditure which is to be made to
maximize the long-term profitability of the
organization.

Definition
• According to the Charles T. Hrongreen, apital udgeti g is a
long-term planning for making and financing proposed capital
out lays.
• According to G.C. Philippatos, apital udgeti g is o er ed
with the allo atio of the fi s fi a ial esou es a o g the
available opportunities. The consideration of investment
opportunities involves the comparison of the expected future
streams of earnings from a project with the immediate and
subsequent streams of earning from a project, with the
i ediate a d su se ue t st ea s of e pe ditu e .
• According to the Lyrich, apital udgeti g o sists i pla i g
of available capital for the purpose of maximizing the long-term
p ofita ilit of the o e .

Need and Importance of Capital Budgeting
1. Huge investments: Capital budgeting requires huge
investments of funds, but the available funds are
limited, therefore the firm before investing projects,
plan are control its capital expenditure.
2. Long-term: Capital expenditure is long-term in
nature or permanent in nature. Therefore financial
risks involved in the investment decision are more. If
higher risks are involved, it needs careful planning of
capital budgeting.
3. Irreversible: The capital investment decisions are
irreversible, are not changed back. Once the decision
is taken for purchasing a permanent asset, it is very
difficult to dispose off those assets without involving
huge losses. Dr. Kasamsetty Sailatha

4. Long-term effect: Capital budgeting not only
reduces the cost but also increases the
revenue in long-term and will bring significant
changes in the profit of the company by
avoiding over or more investment or under
investment. Over investments leads to be
unable to utilize assets or over utilization of
fixed assets. Therefore before making the
investment, it is required carefully planning
and analysis of the project thoroughly.

CAPITAL BUDGETING PROCESS
• Capital budgeting is a difficult process to the investment of
available funds. The benefit will attained only in the near future
but, the future is uncertain. However, the following steps followed
for capital budgeting, then the process may be easier are.
1. Identification of various investments proposals: The capital
budgeting may have various investment proposals. The proposal
for the investment opportunities may be defined from the top
management or may be even from the lower rank. The heads of
various department analyse the various investment decisions, and
will select proposals submitted to the planning committee of
competent authority.
2. Screening or matching the proposals: The planning committee
will analyse the various proposals and screenings. The selected
proposals are considered with the available resources of the
concern. Here resources referred as the financial part of the
proposal. This reduces the gap between the resources and the
investment cost. Dr. Kasamsetty Sailatha

3. Evaluation: After screening, the proposals are evaluated
with the help of various methods, such as pay back period
proposal, net discovered present value method, accounting
rate of return and risk analysis. The proposals are evaluated
by.
(a) Independent proposals
(b) Contingent of dependent proposals
(c) Mutually exclusive proposals.
• Independent proposals are not compared with another
proposals and the same may be accepted or rejected.
• Whereas higher proposals acceptance depends upon the
other one or more proposals. For example, the expansion
of plant machinery leads to constructing of new building,
additional manpower etc.
• Mutually exclusive projects are those which competed
with other proposals and to implement the proposals after
considering the risk and return, market demand etc.

4. Fixing property: After the evolution, the planning
committee will predict which proposals will give more
profit or economic consideration. If the projects or
p oposals a e ot suita le fo the o e s fi a ial
condition, the projects are rejected without
considering other nature of the proposals.
5. Final approval: The planning committee approves the
final proposals, with the help of the following:
(a) Profitability
(b) Economic constituents
(c) Financial violability
(d) Market conditions.
• The planning committee prepares the cost estimation
and submits to the management.Dr. Kasamsetty Sailatha

6. Implementing: The competent authority spends
the money and implements the proposals. While
implementing the proposals, assign
responsibilities to the proposals, assign
responsibilities for completing it, within the time
allotted and reduce the cost for this purpose. The
network techniques used such as PERT and CPM.
It helps the management for monitoring and
containing the implementation of the proposal.
7. Performance review of feedback: The final stage
of capital budgeting is actual results compared
with the standard results. The adverse or
unfavourable results identified and removing the
various difficulties of the project. This is helpful
for the future of the proposals.

Evaluation techniques
• By matching the available resources and projects it can
be invested. The funds available are always living
funds. There are many considerations taken for
investment decision process such as environment and
economic conditions. The methods of evaluations are
classified as follows:
(A) Traditional methods (or Non-discount methods)
(i) Pay-back Period Methods
(iii) Accounts Rate of Return
(B) Modern methods (or Discount methods)
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method

Pay-back Period
• It is one of the non-discounted cash flow
methods of capital budgeting. Pay-back
period is the time required to recover the
initial investment in a project.
• Formula to calculate PBP for even cashflows:
Initial investment
Pay-back period =
Annual cash inflows

(c)10 K 22 K 37 K 47K 54 K
Payback Solution for uneven
cashinflows
PBP = a + ( b - c ) / d
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7 K
Cumulative
Inflows
(a)
(-b) (d)

• Thumb Rule for PBP:
– If the calculated PBP is less than the standard PBP
Accept.
– If the calculated PBP is higher than the standard
PBP Reject.
• Thumb Rule for Ranking PBP:
– Shorter the PBP – Higher Ranking
– Longer the PBP – Lower Ranking

• Merits of Pay-back method: The following are
the important merits of the pay-back method:
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement
over the accounting rate return.
3. Pay-back method reduces the possibility of loss
on account of obsolescence.
• Demerits
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back
period.
3. It is one of the misleading evaluations of capital
budgeting.

PBP Strengths and
Weaknesses
Strengths:
– Easy to use and
understand
– Can be used as a
measure of
liquidity
– Easier to forecast ST
than LT flows
Weaknesses:
– Does not account
for TVM
– Does not consider
cash flows beyond
the PBP
– Cutoff period is
subjective

Accounting Rate of Return
• It is also k o as A e age ate of etu , ‘ate of
return, return on investment or return on capital
e plo ed.
• It is based on the accounting information rather
than the cashinflows.
• The ARR may be defined as “the annualized net
income earned on the average funds invested in a
project.” The annual returns of a project are
expressed as a percentage of the net investment in
the project.

• We determine the average profits by adding
up the after-tax profits expected for the each
year of the profits life and dividing the result
by the number of years.

• The average investment is determined by
dividing the net investment by 2.
Or
Or
Or

• The following formula is generally used to determine
the ARR.
or
• The ARR is determined based on the Total Income
method as:

• On the basis of Original Investment Method:
• On the basis of Average Investment Method:

• Thumb Rule For ARR:
– Accept the project if the ARR is more than the
minimum rate of return or the rate of return
predetermined by the financial manger.
– Reject the project if the ARR is less than the
minimum rate of return or the rate of return
predetermined by the financial manager.
• Thumb Rule for Ranking the ARR:
– Higher the ARR – Higher the Rank
– Lower the ARR – Lower the Rank

Particulars Rs.
Sales Xxx
Less: Operating Cost Xxx
Earnings before depreciation, interest and tax Xxx
Less: Depreciation xxx
EBIT xxx
Less: Interest xxx
EBT xxx
Less: Tax xxx
EAT xxx
Add: Depreciation xxx
Net Cashflows (CFAT) xxx
Proforma to Find the Net Cashinflows

• Advantages of ARR:
1. It is easy to calculate because it makes use of
readily available accounting information;
2. It is not concerned with cashflows rather based
upon profits which are reported in annual
accounts and sent to shareholders.
3. Unlike payback period method, this method
does take into consideration all the years
involved in the life of the project.
4. It high profits are required, this is certainly a way
of achieving them.

• Disadvantages of ARR:
1. It does not take into account the time value of
money;
2. It uses straight line method of depreciation, once a
change in method of depreciation takes place, the
method will not be easy to be used wand will not
work properly;
3. This method fails to distinguish the xize of
investment required for individual projects;
4. It is biased against short-term projects;
5. Several concepts of investment are used for working
out accounting rate of return. Thus, different
managers have different meaning when they refere
to ARR; and
6. ARR does not indicate whether an investment
should be accepted or rejected, unless the rate of
return is compared with arbitrary management
targets.

Financial Management- module-1

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