1. CONCEPT OF FINANCIAL MANAGEMENT
What is Finance
1. SUB-SET OF ECONOMICS AND IN ESSENCE IS ALSO TERMED AS
APPLIED MICRO-ECONOMICS.
2. IMPORTANT BUSINESS ACTIVITY.
3. FUND MANAGEMENT SCIENCE.
4. FOCUSES IN WEALTH MAXIMIZATION GOAL/ENHANCING
FIRM’S VALUE.
5. FOCUSES ON FUTURE DECISION BASED ON ACCOUNTING
FINANCIAL STATEMENTS.
6. ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL
FINANCE.
1
2. BASIC CONCEPT OF NATIONAL INCOME AND ECONOMIC
INDICATORS
1. GDP: A measure of the final goods and services, produced by the residents of the
country with resources located in that country. GDP=(C+I+G)+(X-M) {Domestic
Economy}; 5.3% India’s GDP growth during Jan-March 2011-12, slowest in 9 years.
2. GNP: The value measured at market prices, of all final goods and services produced
by an economy in one year. GNP=(C+I+G)+(X-M)+(R+P) {Open Economy}
3. IIP: Index of Industrial production, released monthly, is a measure of capturing
production across factories in India. It records output in factories across three
categories-mining, electricity, manufacturing, IIP was flat at 0.1% in April.
4. WPI: Wholesale price Index; This is India’s most watched cost of living index.
Calculated on a monthly basis, the index gives trends in inflation rate or the rate at
which wholesale prices of goods such as vegetables, fuel, manufactured items and
food grains are changing. It rose to worrisome 7.55% in May.
5. CPI: Consumer Price Index; released monthly, gives retail prices of almost all
everyday products and services from food to footwear and movie tickets to medicine.
It is more realistic cost-of-living index because it captures shop-end prices. It rose
10.36% in May, showing government inability to cool prices.
6. Sensex: The Bombay Stock Exchange’s (BSE) benchmark 30-share index (reflects
the weighted arithmetic average of price relatives of 30 sensitive shares) is a
barometer for equity markets, perhaps the first indicator (base year for calculation of
sensex is 1978-79; value 100) about the health of the economy and investor
sentiments. The Sensex closed up 76 pts. at 17,538.67 on Thursday (5th July), a three-
month high, amid strong expectations about reformist moves in the coming weeks.
2
3. Defines the environment in which the firm
operates i.e. key Macroeconomic factors
such as:-
1. Growth Rate of Economy,
2. Domestic savings.
3. Tax Environment.
4. Inflation rate.
5. Real interest rate.
Finance in essence, is applied Micro-
Economics
key Microeconomic tools
principal of marginal analysis
according to which a decision should
be guided by a comparison of
incremental Benefits and Cost
ECONOMY
INDUSTRY
COMPANY
BUSINESS
FINANCE
1. Economics Focuses on optimization of Valued Goals.
2. Finance Focuses on Wealth Maximization
3. To Sum up, a basic knowledge of macro-economics is necessary for
understanding the environment in which company/firm operates.
4. Good grasp of micro-economic principles is helpful in sharpening the tools of
financial decision making
The fundamental Approach says
SUB-SET OF ECONOMICS
3
5. FUND MANAGEMENT SCIENCE
1. CHOICE OF FINANCIAL MARKET
2. CHOICE OF FINANCIAL INSTRUMENT---
FINANCING DECISION
3. OPTIMUM CAPITAL STRUCTURE DECISION
4. OPTIMIZATION OF COST OF CAPITAL
The Business
Proposal
Investors
• Shareholders
• Lenders
Financial Market
Investors provide the initial cash required to
finance the business proposal
The proposal generates cash to investors
5
6. FUND MANAGEMENT SCIENCE
FINANCE FUNCTION
FINANCING INVESTMENT LIQUIDITY
DECISION DECISION DECISION
1. Investment or Long Term Asset Mix Decision
2. Financing or Capital Mix Decision
3. Dividend or Profit Allocation Decision
4. Liquidity or Short Term Asset Mix Decision
6
8. RISK-RETURN PARADOX
8
Contradictory*
Survive
Avoid financial distress and
bankruptcy
Beat the competition
Maximize sales or market share
Minimize Costs
Maximize profits
Maintain steady earnings growth
PROFITABILITY
Maximize sales
Maximize Market Share
Minimize Cost
MINIMIZING RISK
Bankruptcy avoidance
Stability
Safety
Capital Budgeting
Decision
Capital Structure Decision
Dividend Decision
Working Capital
Management
Risk Management
RISK AND
RETURN TRADE
OFF
WEALTH
MAXIMIZATION/
ENHANCING
VALUE OF THE
FIRM (EVA)
*Pursuit of profit involves risk;
it is not possible to maximize
both safety and profit:- Need of
goal that encompasses both
factors
9. FOCUSES ON FUTURE DECISION BASED ON ACCOUNTING FINANCIAL STATEMENTS
Share Capital
Equity
Preference
Reserve &Surplus
Secured Loans
Debentures
Loans and advances
Unsecured Loans
Current Liabilities and Provisions
Trade Creditors
Provisions
Fixed Assets (net)
Gross block
Less: depreciation
Investments
Current Assets, loans and advances
Cash and bank
Receivables
Inventories
Miscellaneous expenditure and losses
Capital structure and
Cost of Capital
Working Capital
financing policy
Capital Budgeting
Portfolio Management
Cash Management
Credit Management
Inventory Management
9
10. ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE
The Role of The Financial Manager
The Balance-Sheet Model of the Firm-Traditional Approach
The Net Working Capital Investment Decisions
Current Assets
Investment Decisions
“Capital
Budgeting”
Fixed Assets
1 Tangible
2 Intangible
Current
Liabilities
Long-Term Debt
Shareholders’
Equity
Net
Working
Capital
Financing Decisions
“Capital Structure”
10
11. FOCUSES ON FUTURE DECISION BASED ON ACCOUNTING FINANCIAL STATEMENTS
Net Sales
Cost of goods sold
stocks
Wages and salaries
Other manufacturing expenses
Gross Profit
Operating expenses
Selling & Administration expenses
Depreciation
Operating Profit
Non-operating surplus/deficit
Earnings before income and tax
Interest
Profit before tax
Tax
Profit after Tax
Dividends
Retained earnings
Revenue Risk
Depreciation Policy
Business Risk
Tax Planning
Return on Equity
Dividend Policy
Gross Profit Margin
Financial Risk
11
12. Financial
managers
Firm's
operations
Financial
markets
(1) Cash raised from investors
(1)
(2) Cash invested in firm
(2)
(3) Cash generated by operations
(3)
(4a) Cash reinvested
(4a)
(4b) Cash returned to investors
(5) Taxes
(4b)
ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE
The Role of The Financial Manager
Government
(5)
12
13. ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE
The Role of The Financial Manager
Contemporary Approach
Concern on Institutional Imperatives referred as the focus which lead
to divergence between the goals of Managers and Shareholders. Instead
of merely focusing on the efficient allocation of funds among various
assets and the acquisition of funds on favorable terms.
A fundamental change in financial management is the direct result of two
recent trends: the Globalization of Competition and the Integration of
World financial markets facilitated by Improved ability to collect and
analyze information.
A common element, which distinguishes the recent Financial
Management tools from the earlier ones have emerged predominantly
from practice and from consultants. The modern approaches also have
developed concerning the pursuit of shareholder value.
13
14. ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE
The Role of The Financial Manager
Business Knowledge
Effective Costing, Planning & Evaluation
Risk Management
Standards Compliance
Effective Communication
Performance Management
Forecasting, Planning and Budgeting
Accounting/ Financial Knowledge
Valued-added
Advice
Value-
for-
Money
Strategic
Focus
Competencies
14
15. CONCEPT OF ECONOMIC VALUE ADDED
1. Traditional approaches to measuring ‘Shareholders’ Value Creation used
parameters such as earnings capitalisation, market capitalisation and present
value of estimated future cash flows.
2. Extensive equity research has now established that it is not earnings per se, but
value which is important.
3. A new measure called “Economic Value Added” (EVA) is increasingly being
applied to understand and evaluate financial performance.
4. EVA = NOPAT – COCE (Net operating profit after taxes – Cost of Capital
Employed)
NPOAT = Profits after depreciation and taxes but before interest costs. NOPAT thus
represents the total pool of profits available on an ungeared basis to provide a return
to lenders and shareholders;
COCE = Weighted average cost of capital (WACC x Average capital employed)
15
16. CONCEPT OF ECONOMIC VALUE ADDED
What does EVA show ?
EVA is residual income after charging the Company for the cost of capital provided
by lenders and shareholders. It represents the value added to the shareholders by
generating operating profits in excess of the cost of capital employed in the business.
When will EVA increase ?
(a) Operating profits can be made to grow without employing more capital, i.e.
greater efficiency.
(b) Additional capital is invested in projects that return more than the cost of
obtaining new capital, i.e., profitable growth.
(c) Capital is curtailed in activities that do not cover the cost of capital, i.e., liquidate
unproductive capital.
Utility of EVA
(i) EVA represents the value added to the shareholders by generating operating profits
over and above the cost of capital employed in the business. Hence it is a measure of
financial performance.
16
17. CONCEPT OF ECONOMIC VALUE ADDED
Utility of EVA Continued
(ii) EVA is a management tool that discloses the impact of both strategic as well as
operational decision of the management. The examples of strategic decisions are:
what investment to make, which business to exist, which financial structure is
optimal, etc. While operational decision include, whether to make in house or out
source, repair or replace equipment or, make short or long production runs, etc.
(iii) EVA can prove as an effective tool for increasing shareholders’ wealth, through
integrating EVA framework in four key areas, viz., to measuring business
performance, guiding managerial decision-making, aligning managerial incentives
with shareholder interests and improving the financial and business literacy
throughout the organisation.
17
18. 18
The Foreign Exchange Market
The foreign exchange market is the market where the
currency of one country is exchanged for the currency
of another country. Most currency transactions are
channelled through the world-wide interbank market.
Interbank market is the wholesale market in which
major banks trade with each other.
Participants
Speculators
Arbitrageurs
Traders
Hedgers
19. 19
Foreign Exchange Rates
A foreign exchange rate is the price of one currency quoted in terms of
another currency.
When the rate is quoted per unit of the domestic currency, it is referred to
as direct quote. Thus, the US$ and INR exchange rate would be written
as US$ 0.02538/INR.
When the rate is quoted as units of domestic currency per unit of the
foreign currency, it is referred to as indirect quote.
A cross rate is an exchange rate between the currencies of two countries
that are not quoted against each other, but are quoted against one
common currency.
Suppose that German DM is selling for $ 0.62 and the buying rate for the
French franc (FF) is $ 0.17, what is the DM/FF cross-rate? It is:
$ 0.62 3.65
$ 0.17
US FF FF
DM US DM
20. 20
Foreign Exchange Rates
The spot exchange rate is the rate at which a currency can be bought or
sold for immediate delivery which is within two business days after the
day of the trade.
Bid-ask spread is the difference between the bid and ask rates of a
currency.
The forward exchange rate is the rate that is currently paid for the
delivery of a currency at some future date.
The forward rate may be at a premium or at a discount.
For a direct quote, the annualised forward discount or premium can be
calculated as follows:
Spot rate – Forward rate 360
Forward premium (discount)
Spot rate Days
21. 21
International Parity Relationships
There are the following four international parity
relationships:
Interest rate parity (IRP)
Purchasing power parity (PPP)
Forward rates and future spot rates parity
International Fisher effect (IFE).
22. 22
Currency Appreciation and Depreciation
“We frequently hear things like “the dollar strengthened (or weakened) in financial
Markets today” or the dollar is expected to appreciate (or depreciate) relative to the
Rupee.” When we say that the dollar strengthens or appreciates, we mean that the
value of a dollar rises, so that it takes more foreign currency to buy a dollar.
What happens to the exchange rates as currencies fluctuate in value depends on how
exchange rates are quoted. Since we are quoting them as units of foreign currency
per Rupee, the exchange rate move in the same direction as the value of the Rupee: it
rises as the rupee strengthens, and it falls as the rupee weakens.
Relative PPP tells that the exchange rate will rise if the India’s inflation rate is lower
than the foreign country’s. This happens because the foreign currency depreciates in
value and therefore weakens relative to the Rupee.
23. 23
Depreciation of Rupee against US Dollar
1. Rupee has depreciated a record low of Rs. 57.32 on June 22-2012 against US
dollar.
2. Loss of potential European export market. Due to Euro-zone debt crises.
Financial crunch and insolvency. The main countries are Greece, Ireland,
Portugal, Spain and Italy and France.
3. Export leads to foreign exchange inflow.
4. Huge oil bills due to import of crude oil.
5. FII’s turned bearish due to implementation of GAAR* retroactively.
6. The above mentioned reasons lead to scarcity of US dollar and depreciated
partially convertible rupee to a record low.
7. Gradual strengthening of Rupee started form 4th July 2012.
8. Offloading of dollars by banks and exporters.
9. The government increased foreign investment limits in government debt by $ 5
billion to $ 20 billion.
10. FII’s turned bullish due to announcement that application of GAAR will not be
retrospectively.
*General Anti Avoidance Rule aimed at preventing deals or incomes that are
structured to avoid taxes
24. 24
GAAR jarrs
1. What is GAAR? General Anti Avoidance Rule is aimed at preventing deals or
incomes that are structured only to avoid paying taxes.
2. Why is GAAR Required? Isn’t Tax Planning and Tax Savings Legitimate ; In
India the courts have ruled that savings of taxes through permissible instruments
of Tax planning is legitimate. But Tax Avoidance is illegal.
3. Why are Anti-Avoidance measures necessary? According to some expert in an
environment of moderate rates of tax, it is necessary that the correct tax base be
used for calculating taxes in the face of aggressive planning and use of opaque
low tax jurisdictions for residents as well as for sourcing capital.
4. Whom does GAAR Affect ? Almost anybody and everybody. Corporations may
be forced to re-structure salaries of employees if Taxmen conclude that these
were structured only to avoid Taxes. (FII’s) who invest through countries such as
Mauritius to exploit bilateral Tax Treaties will be effected after GARR comes
into force. It’s feared that once GAAR is invoked FII’s will have to pay capital
gain tax for their investment in Indian equities.
5. The committee has proposed to implement GARR on P-Notes. (Participatory
Notes are offshore derivative instruments issued by foreign broking houses to
overseas investors who wish to invest in the Indian stock market without
registering themselves with the market regulator, SEBI.
25. 25
Critical Policies Awaiting Approval
1. India’s is suffering from stagflation of its own version; Morgen and
Stanley
2. P.M. is rated as under-achiever; Times Magazine.
3. Indian economy downgraded from stable to negative; Standard & Poors.
4. Raising FDI Limit in insurance sector from 29% to 49%.
5. Introduce the Direct Tax Code (DTC) to overhaul archaic income tax
laws.
6. Banking laws (Amendment) Bill to empower RBI to supersede banks’
boards; grant license to new private sector banks.
7. Introduce a uniform Goods and Services (GST).
8. Legislate the Pension Fund Regulatory and Development Authority
(PFRDA) Bill to ensure social security for employees.
9. Allow FDI in multi-brand retail.
26. 26
PERPLEXING FACTS
1. PM promises in G20 summit at Los Cabos, Mexico, to provide $ 10
billlion (Appx Rs 56,000 crore) under deficit economy when the people
are subjected to growing economic burdens.
2. The three major rating agencies forced India to allow International
Capital flows by the recent reform witnessed. There is a strong
suspicions that these agencies promote agenda of international finance
capital by manipulating their ratings.
3. These agencies had earlier given AAA rating to mortgage-based debt of
companies like Enron.
4. In 2008, on the eve of the global financial meltdown, they had given a
similar rating to Lehman Brothers and the insurance giant AIG-the main
players in the Wall street collapse.
5. Reforms undertaken; opening Retail trade sector, reducing subsidy,
decontrolling fuel prices, increase foreign investment ceiling in thr
insurance sector, allowing foreign banks to take over Indian private
banks, allowing foreign investment in pension funds to go in for maeket
investment i.e., speculation
27. 27
PERPLEXING FACTS
1. The retail sector in India conservatively contributes 11% of the GDP and
employs over 40 million people. According to the 4th Economic census,
38.2% of rural and 46.4% of urban employment is generated in this
sector.
2. Permitting multinational giants in retail will only displace these millions
into poverty and misery.
3. India to a large extent protected itself from the global financial meltdown
because it did not allowed its financial sector to be open to international
speculation.
4. After the proposed reforms, India may subject itself to international
volatility and thus, become extremely vulnerable.
5. Allowing international speculation in pension funds and the insurance
sector will ruin the lives of millions of working people.
30. Attending to investment decisions
- as to when and
- how to acquire and allocate funds
- for short-term and long-term assets
keeping
- in view the profit generation of the
business
- through which repayment obligation
can be met.
31. Objectives and basic consideration of
Financial management.
Though profit maximisation is the objective of
financial management
The long-term goal of the business entity is to
achieve maximising the shareholder value of the firm
Because the “principle of maximisation of
shareholder wealth provides a rational guide for
running a business and for efficient allocation of
resources in society”.
32. The key objective of Financial
Management is to maximise the
value of the company.
This could be possible by
good investment decisions
prudent financing decisions and
well thought-out financial planning
and control.
33. Maximisation of the value of
the company is also known as
maximisation of the wealth of
the owners.
34. To achieve maximisation of value of
the company, finance manager has
to take careful decisions in respect
of
-Financing
-Investment
-Dividend
-Current asset management.
35. Financing decision-
Has to decide on sources of funds for business.
It is to be decided whether entire capital should be
raised from equity capital or a part is to be raised
from loan.
Hence Debt/Equity ratio or Leverage are important
since each source has in them associated risk
factors involved.
36. • Investment decision
• It relates to acquisition of assets.
• Assets are classified into
• real assets such as
- land
- building
- plant
- equipment etc.
and
- the financial assets are
- shares and
- debentures etc.
• It indicates available mix of financing to fund company’s activities.
• Such decisions on investment in projects come within the field of
capital budgeting which is derived from net present value of assets.
37. Dividend decision-
- It is basically a financing decision.
- This is because profit is a source
of fund.
- By not paying dividend, the
“retained earnings”or ‘reserve’ can be
increased which could be otherwise
available for investment.
This ultimately lead to maximisation of
wealth of the organisation provided
decisions on investments are correct.
38. Current Asset Management-
This is necessary to maintain
balance between current assets
and current liability,
The liquidity of the business is
interrupted because of holding too
much fund in current assets.
39. Wealth maximisation &value maximisation
The goal of financial management is to maximise the
value of companies.
This is generally expressed in terms of maximising the
value of the ownership shares of the company
In short,maximising share price.
Thus,better performing companies can raise additional
funds under more favourable terms.
This basic objective of maximising the price of the
company’s shares is called ‘value maximisation’.
40. Social responsibility is also an important goal of
a company which requires
-Maximising share-price by efficient,well-
managed operations related to consumer
demand parameters.
-Efficiency & innovation leads to value
maximisation which leads to new
products,new technologies and better
employment.
-External factors like pollution,product safety
and
job safety have achieved added dimensions in
relation to value maximisation.
41. Profit maximisation vs.Wealth
maximisation
• Long run vs.Short run Profits.
• Convert total corporate profits to earning per share(EPS).
• EPS is total profits divided by number of shares
outstanding.
• Assume the firm earns Rs.10 mn.and has 1mn.shares
outstanding.The EPS will work out to Rs.10.
• Profit maximisation is a short-term concept,
• while wealth maximisation emphasises the long-term view
point.
