FM-BBA.pptx

Course Teacher:
Dr. Ikram Ullah Khan
PhD in Banking & Finance
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Defining Financial Management
Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.
According to Van Horne “FM is concerned with the acquisition, financing, and management
of assets with some overall goal in mind”. Thus the decision function of financial
management can be broken down into three major areas: the investment, financing, and
asset management decisions.
1. Investment Decision
The investment decision is the most important of the firm’s three major decisions when it
comes to value creation. It begins with a determination of the total amount of assets needed
to be held by the firm. Picture the firm’s balance sheet in your mind for a moment. Imagine
liabilities and owners’ equity being listed on the right
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side of the balance sheet and its assets on the left. The financial manager needs to determine
the dollar amount that appears above the double lines on the left-hand side of the balance sheet
– that is, the size of the firm. Even when this number is known, the composition of the assets
must still be decided.
2. Financing Decision
The second major decision of the firm is the financing decision. Here the financial manager is
concerned with the makeup of the right-hand side of the balance sheet. If you look at the mix of
financing for firms across industries, you will see marked differences. Some firms have relatively
large amounts of debt, whereas others are almost debt free.
In addition, dividend policy must be viewed as an integral part of the firm’s financing decision.
The dividend-payout ratio determines the amount of earnings that can be retained in the firm.
Retaining a greater amount of current earnings in the firm means that fewer dollars will be
available for current dividend payments. The value of the dividends paid to stockholders must
therefore be balanced against the opportunity cost of retained earnings lost as a means of equity
financing.
3. Asset Management Decision
The third important decision of the firm is the asset management decision. Once assets have
been acquired and appropriate financing provided, these assets must still be
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managed efficiently. The financial manager is charged with varying degrees of operating
responsibility over existing assets. These responsibilities require that the financial manager be
more concerned with the management of current assets than with that of fixed assets.
Some other Definitions
“Financial management is the activity concerned with planning, raising, controlling and
administering of funds used in the business.” – Guthman and Dougal
“Financial management is that area of business management devoted to a judicious use of
capital and a careful selection of the source of capital in order to enable a spending unit to
move in the direction of reaching the goals.” – J.F. Brandley
“Financial management is the operational activity of a business that is responsible for obtaining
and effectively utilizing the funds necessary for efficient operations.”- Massie
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Evolving Role of Financial Management
• Until around the first half of the 1900s financial managers primarily raised funds and managed their
firms’ cash positions – and that was pretty much it.
• In the 1950s, the increasing acceptance of present value concepts encouraged financial managers
to expand their responsibilities and to become concerned with the selection of capital investment
projects.
• Today, external factors have an increasing impact on the financial manager. Heightened corporate
competition, technological change, volatility in inflation and interest rates, world-wide economic
uncertainty, fluctuating exchange rates, tax law changes, environmental issues, and ethical
concerns over certain financial dealings must be dealt with almost daily.
• As a result, finance is required to play an ever more vital strategic role within the corporation. The
financial manager has emerged as a team player in the overall effort of a company to create value.
The “old ways of doing things” simply are not good enough in a world where old ways quickly
become obsolete. Thus, today’s financial manager must have the flexibility to adapt to the changing
external environment if his or her firm is to survive.
• If you become a financial manager, your ability to adapt to change, raise funds, invest in assets,
and manage wisely will affect the success of your firm and, ultimately, the overall economy as well.
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IMPORTANCE OF FINANCIAL MANAGEMENT
Finance is the lifeblood of business organization. It needs to meet the requirement of the
business concern. Each and every business concern must maintain adequate amount of finance
for their smooth running of the business concern and also maintain the business carefully to
achieve the goal of the business concern. The business goal can be achieved only with the help
of effective management of finance. We can’t neglect the importance of finance at any time at
and at any situation. Some of the importance of the financial management is as follows:
1. Financial Planning
Financial management helps to determine the financial requirement of the business concern and
leads to take financial planning of the concern. Financial planning is an important part of the
business concern, which helps to promotion of an enterprise.
2. Acquisition of Funds
Financial management involves the acquisition of required finance to the business concern.
Acquiring needed funds play a major part of the financial management, which involve possible
source of finance at minimum cost.
3. Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of the business
concern. When the finance manager uses the funds properly, they can reduce the cost of capital
and increase the value of the firm.
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4. Financial Decision
Financial management helps to take sound financial decision in the business concern.
Financial decision will affect the entire business operation of the concern. Because there is a
direct relationship with various department functions such as marketing, production
personnel, etc.
5. Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper utilization of funds
by the business concern. Financial management helps to improve the profitability position of
the concern with the help of strong financial control devices such as budgetary control, ratio
analysis and cost volume profit analysis.
6. Increase the Value of the Firm
Financial management is very important in the field of increasing the wealth of the investors
and the business concern. Ultimate aim of any business concern will achieve the maximum
profit and higher profitability leads to maximize the wealth of the investors as well as the
nation.
7. Promoting Savings
Savings are possible only when the business concern earns higher profitability and
maximizing wealth. Effective financial management helps to promoting and mobilizing
individual and corporate savings.
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The Goal of the Firm
Efficient financial management requires the existence of some objective or goal, because
judgment as to whether or not a financial decision is efficient must be made in light of some
standard.
1. Value Creation
Frequently, profit maximization is offered as the proper objective of the firm. However, under
this goal a manager could continue to show profit increases by merely issuing stock and
using the proceeds to invest in Treasury bills. For most firms, this would result in a decrease
in each owner’s share of profits – that is, earnings per share (EPS) would fall. Maximizing
EPS, therefore, is often advocated as an improved version of profit maximization.
However there are certain flaws in the concept of maximizing EPS. For Example
a) It’s a vague concept.
b) It ignores the time value of money, i.e., the exact duration of expected returns.
c) Risk is not considered. Some projects are more risky than others.
d) The effect of dividend policy on the stock market price is ignored. If the only objective
were to maximize earnings per share, the firm would never pay a dividend. It could always
improve earnings per share by retaining earnings and investing them at any positive rate
of return, however small.
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Maximizing Market Price Per Share/ Wealth maximization
Wealth maximization is also known as Value or Net present worth maximization. The market
price of a firm’s stock represents the focal judgment of all market participants as to the value
of the particular firm. It takes into account present and expected future earnings per share; the
timing, duration, and risk of these earnings; the dividend policy of the firm; and other factors
that bear on the market price of the stock. The market price serves as a barometer for
business performance; it indicates how well management is doing on behalf of its
shareholders.
Management is under continuous review. Shareholders who are dissatisfied with management
performance may sell their shares and invest in another company. This action, if taken by
other dissatisfied shareholders, will put downward pressure on market price per share.
Thus management must focus on creating value for shareholders. This requires management
to judge alternative investment, financing, and asset management strategies in terms of their
effect on shareholder value (share price).
How to check the performance of agents is the share prices and reputation.
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Corporate Social Responsibility (CSR)
Maximizing shareholder wealth does not mean that management should ignore corporate
social responsibility (CSR), such as protecting the consumer, paying fair wages to employees,
maintaining fair hiring practices and safe working conditions, supporting education, and
becoming involved in such environmental issues as clean air and water. It is appropriate for
management to consider the interests of stakeholders other than shareholders.
These stakeholders include creditors, employees, customers, suppliers, communities in which
a company operates, and others. Only through attention to the legitimate concerns of the ﬁrm’s
various stakeholders can the ﬁrm attain its ultimate goal of maximizing shareholder wealth.
Over the last few decades ‘sustainability’ has become a growing focus of many corporate
social responsibility efforts. the concept of sustainability has evolved to such an extent that it is
now viewed by many businesses to mean meeting the needs of the present without
compromising the ability of future generations to meet their own needs. Therefore, more and
more companies are being proactive and taking steps to address issues such as climate
change, oil depletion, and energy usage.
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Agency Problems
It has long been recognized that the separation of ownership and control in the modern
corporation results in potential conflicts between owners and managers. In particular, the
objectives of management may differ from those of the firm’s shareholders.
We may think of management as the agents of the owners. Shareholders, hoping that the
agents will act in the shareholders’ best interests, delegate decision-making authority to them.
Jensen and Meckling were the first to develop a comprehensive theory of the firm under
agency arrangements. They showed that the principals, in our case the shareholders, can
assure themselves that the agents (management) will make optimal decisions only if
appropriate incentives are given and only if the agents are monitored. Incentives include stock
options, bonuses, and perquisites (“perks,” such as company automobiles and expensive
offices), and these must be directly related to how close management decisions come to the
interests of the shareholders.
Monitoring is done by bonding the agent, systematically reviewing management perquisites,
auditing financial statements, and limiting management decisions. These monitoring activities
necessarily involve costs, an inevitable result of the separation of ownership and control of a
corporation.
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Functions of Financial Management
Some of the major Functions of a financial manager are as follows: 1. Estimating the Amount of
Capital Required 2. Determining Capital Structure 3. Choice of Sources of Funds 4.
Procurement of Funds 5. Utilization of Funds 6. Disposal of Profits or Surplus 7. Management
of Cash 8. Financial Control.
1. Estimating the Amount of Investment:
This is the foremost function of the financial manager. Business firms require capital for:
(i) purchase of fixed assets,
(ii) meeting working capital requirements, and
(iii) modernization and expansion of business.
The financial manager makes estimates of funds required for both short-term and long-term.
2. Determining Capital Structure:
Once the requirement of capital funds has been determined, a decision regarding the kind and
proportion of various sources of funds has to be taken. For this, financial manager has to
determine the proper mix of equity and debt and short-term and long-term debt ratio. This is
done to achieve minimum cost of capital and maximize shareholders wealth.
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3. Choice of Sources of Funds:
Before the actual procurement of funds, the finance manager has to decide the sources
from which the funds are to be raised. The management can raise finance from various
sources like equity shareholders, preference shareholders, debenture- holders, banks and
other financial institutions, public deposits, etc.
4. Procurement of Funds:
The financial manager takes steps to procure the funds required for the business. It might
require negotiation with creditors and financial institutions, issue of prospectus, etc. The
procurement of funds is dependent not only upon cost of raising funds but also on other
factors like general market conditions, choice of investors, government policy, etc.
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5. Utilization of Funds:
The funds procured by the financial manager are to be prudently invested in various assets
so as to maximize the return on investment: While taking investment decisions,
management should be guided by three important principles, viz., safety, profitability, and
liquidity.
6. Profit Planning
Profit earning is one of the prime functions of any business organization. Profit earning is
important for survival and sustenance of any organization. Profit planning refers to proper
usage of the profit generated by the firm.
Profit arises due to many factors such as pricing, industry competition, state of the
economy, mechanism of demand and supply, cost and output.
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A healthy mix of variable and fixed factors of production can lead to an increase in the
profitability of the firm.
Fixed costs are incurred by the use of fixed factors of production such as land and
machinery. In order to maintain a tandem it is important to continuously value the
depreciation cost of fixed cost of production. An opportunity cost must be calculated in
order to replace those factors of production which has gone thrown wear and tear. If this is
not noted then these fixed cost can cause huge fluctuations in profit.
7. The Dividend Decision
One of the main roles of financial management is the dividend decision. The dividend
should be analyzed in relation to the financing decision of the firm. Two alternatives are
available in dealing with the profits of a firm:
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 They can be distributed to the shareholders in the form of the dividends
 They can be retained in the business itself. The decision as to which course should be
followed depends largely on the significant dividend decision, the dividend –pay –out
ratio, i.e. what proportion of net profits should be paid out to the shareholders.
8. Management of Cash:
Management of cash and other current assets is an important task of financial manager. It
involves forecasting the cash inflows and outflows to ensure that there is neither shortage
nor surplus of cash with the firm. Sufficient funds must be available for purchase of
materials, payment of wages and meeting day-to-day expenses.
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9. Financial Control:
Evaluation of financial performance is also an important function of financial manager. The
overall measure of evaluation is Return on Investment (ROI). The other techniques of
financial control and evaluation include budgetary control, cost control, internal audit,
break-even analysis and ratio analysis. The financial manager must lay emphasis on
financial planning as well.
10.Understanding Capital Markets
Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important
function of a financial manager.
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When securities are traded on stock market there involves a huge amount of risk involved.
Therefore a financial manger understands and calculates the risk involved in this trading of
shares and debentures.
Its on the discretion of a financial manager as to how to distribute the profits. Many investors
do not like the firm to distribute the profits amongst share holders as dividend instead invest
in the business itself to enhance growth. The practices of a financial manager directly impact
the operation in capital market.
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Chapter 2: Management of Working Capital
Working Capital Concepts
There are two major concepts of working capital –
 net working capital
 gross working capital.
When accountants use the term working capital, they are generally referring to net working
capital, which is the dollar difference between current assets and current liabilities. This is one
measure of the extent to which the firm is protected from liquidity problems.
Financial analysts, on the other hand, mean current assets when they speak of working capital.
Therefore, their focus is on gross working capital.
Net working capital = Current assets - current liabilities
Gross working capital = The firm’s investment in current assets (like cash and marketable
securities, receivables, and inventory).
Working capital Management = The administration of the firm’s current assets
and the financing needed (especially current liabilities) to support current assets.
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Significance of Working Capital
• The current assets of a typical manufacturing firm account for over half of its total assets.
• Avoiding low returns: Excessive levels of current assets can easily result in a firm realizing a
substandard return on investment. However, firms with too few current assets may incur
shortages and difficulties in maintaining smooth operations.
• Well–utilization of short term financing: For small companies, current liabilities are the
principal source of external financing. These firms do not have access to the longer-term
capital markets, other than to acquire a mortgage on a building. The fast-growing but larger
company also makes use of current liability financing.
• For these reasons, the financial manager and staff devote a considerable portion of their time
to working capital matters. The management of cash, marketable securities, accounts
receivable, accounts payable, accruals, and other means of short-term financing is the direct
responsibility of the financial manager; only the management of inventories is not.
• working capital management is important, if for no other reason than the proportion of the
financial manager’s time that must be devoted to it. More fundamental, however, is the effect
that working capital decisions have on the company’s risk, return, and share price.
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Profitability and Risk
Sound working capital management lie two fundamental decision issues for the
firm. They are the determination of
1. the optimal level of investment in current assets
2. the appropriate mix of short-term and long-term financing used to support this investment in
current assets.
In turn, these decisions are influenced by the trade-off that must be made between profitability
and risk. Lowering the level of investment in current assets, while still being able to support
sales, would lead to an increase in the firm’s return on total assets. To the extent that the
explicit costs of short-term financing are less than those of intermediate- and long-term
financing, the greater the proportion of short-term debt to total debt, the higher is the
profitability of the firm.
Although short-term interest rates sometimes exceed long-term rates, generally they are less.
Even when short-term rates are higher, the situation is likely to be only temporary.
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Over an extended period of time, we would expect to pay more in interest cost with long-term
debt than we would with short-term borrowings, which are continually rolled over (refinanced)
at maturity.
Moreover, the use of short-term debt as opposed to longer-term debt is likely to result in higher
profits because debt will be paid off during periods when it is not needed.
These profitability assumptions suggest maintaining a low level of current assets and a
high proportion of current liabilities to total liabilities.
This strategy will result in a low, or conceivably negative, level of net working capital.
Offsetting the profitability of this strategy, however, is the increased risk to the firm. Here, risk
means jeopardy to the firm for not maintaining sufficient current assets to
• meet its cash obligations as they occur
• support the proper level of sales (e.g., running out of inventory).
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Optimal Amount/Level of Current Assets
In determining the appropriate amount, or level, of current assets, management must con-
sider the trade-off between proﬁtability and risk.
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If we equate liquidity with “conservativeness,” Policy A is the most conservative of the three
alternatives. At all levels of output, Policy A provides for more current assets than any other
policy. The greater the level of current assets, the greater the liquidity of the firm, all other
things equal. Policy A is seen as preparing the firm for almost any conceivable current asset
need; it is the financial equivalent to wearing a belt and suspenders.
Policy C is least liquid and can be labeled “aggressive.” This “lean and mean” [only
necessary] policy calls for low levels of cash and marketable securities, receivables, and
inventories. We should keep in mind that for every output level there is a minimum level of
current assets that the firm needs just to get by. There is a limit to how “lean and mean” a
firm can get.
We can now summarize the rankings of the alternative working capital policies in respect to
liquidity as follows:
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Though policy A clearly provides the highest liquidity, how do the three alternative policies
rank when we shift our attention to expected profitability? To answer this question, we need
to recast the familiar return on investment (ROI) equation as follows:
From the equation above we can see that decreasing the amounts of current assets held
(for example, a movement from Policy A toward Policy C) will increase our potential
profitability. If we can reduce the firm’s investment in current assets while still being able to
properly support output and sales, ROI will increase. Lower levels of cash, receivables,
and inventory would reduce the denominator in the equation; and net profits, our
numerator, would remain roughly the same or perhaps even increase. Policy C, then,
provides the highest profitability potential as measured by ROI.
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A movement from Policy A toward Policy C results in other effects besides increased
profitability. Decreasing cash reduces the firm’s ability to meet financial obligations as they
come due. Decreasing receivables, by adopting stricter credit terms and a tougher
enforcement policy, may result in some lost customers and sales. Decreasing inventory
may also result in lost sales due to products being out of stock. Therefore more aggressive
working capital policies lead to increased risk. Clearly, Policy C is the most risky working
capital policy. It is also a policy that emphasizes profitability over liquidity.
In short, we can now make the following generalizations:
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Interestingly, our discussion of working capital policies has just illustrated the two most
basic principles in finance:
1. Profitability varies inversely with liquidity. Notice that for our three alternative
working capital policies, the liquidity rankings are the exact opposite of those for
profitability. Increased liquidity generally comes at the expense of reduced profitability.
2. Profitability moves together with risk (i.e., there is a trade-off between risk and
return). In search of higher profitability, we must expect to take greater risks. Notice how
the profitability and risk rankings for our alternative working capital policies are identical.
You might say that risk and return walk hand in hand.
Ultimately, the optimal level of each current asset (cash, marketable securities, receivables,
and inventory) will be determined by management’s attitude to the trade-off between
profitability and risk.
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Classification of Working Capital
Having defined working capital as current assets, it can now be classified according to
• Components, such as cash, marketable securities, receivables, and inventory
• Time, as either permanent or temporary.
A firm’s permanent working capital is the amount of current assets required to meet long-
term minimum needs. You might call this “bare bones” working capital. Temporary working
capital, on the other hand, is the investment in current assets that varies with seasonal
requirements.
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Permanent working capital is similar to the firm’s fixed assets in two important respects.
First, the dollar investment is long term, despite the seeming contradiction that the assets
being financed are called “current.”
Second, for a growing firm, the level of permanent working capital needed will increase
over time in the same way that a firm’s fixed assets will need to increase over time.
However, permanent working capital is different from fixed assets in
one very important respect – it is constantly changing.
Thus permanent working capital does not consist of particular current assets staying
permanently in place, but is a permanent level of investment in current assets, whose
individual items are constantly turning over.
Like permanent working capital, temporary working capital also consists of current assets in
a constantly changing form. However, because the need for this portion of the firm’s total
current assets is seasonal, we may want to consider financing this level of current assets
from a source which can itself be seasonal or temporary in nature.
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Financing Current Assets: Short-Term and Long-Term Mix
The way in which the assets of a company are financed involves a trade-off between risk and
profitability.
The amounts of accounts payable and of accruals included in current liabilities are not active
decision variables. These current liabilities are regarded as spontaneous financing (Trade
credit, and other payables and accruals, that arise spontaneously in the firm’s day-to-day
operations). We are concerned with the assets that are not supported through spontaneous
financing.
Hedging (Maturity Matching) Approach
If the firm adopts a hedging (maturity matching) approach to financing, each asset would be
offset with a financing instrument of the same approximate maturity. Short-term or seasonal
variations in current assets would be financed with short-term debt; the permanent component
of current assets and all fixed assets would be financed with long-term debt or with equity.
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Maturity matching approach has various advantages and disadvantages. The biggest
advantages are that it maintains an optimum level of funds, saves interest cost, no
refinancing risk, and interest rate fluctuation risk. The main disadvantage is its
difficulty in implementation.
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Aggressive Working Capital Approach
An aggressive working capital policy is one in which firms uses a minimal investment in
current assets coupled with an extensive use of short-term credit. Your goal is to put as much
money to work as possible to decrease the time needed to produce products, turn over
inventory or deliver services. In this policy there is high risk and high return.
Conservative Working Capital Approach
If firms employ a conservative working capital policy, there’s plenty of cash in the bank, your
warehouses are full of inventory and your payables are all up to date. It shows a high level of
current assets as compared to short term liabilities. Firms are at safe side here but the profit
level is comparatively low. Companies in volatile or seasonal industries such as tourism,
farming or construction might adopt conservative working capital policies to buffer against
risk.
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Chapter 3: Managing Cash and Marketable securities
Meaning of cash and cash Management
• For accounting purposes, cash includes money in hand, petty cash, bank account balance,
customer checks, and marketable securities. It may also include the unutilized portion of an
overdraft facility or line of credit.
• Cash management involves the efficient collection, disbursement, and temporary
investment of cash. The treasurer’s department of a company is usually responsible for the
firm’s cash management system. A cash budget, instrumental in the process (see Chapter
7), tells us how much cash we are likely to have, when we are likely to have it, and for how
long. Thus it serves as a foundation for cash forecasting and control. In addition to the
cash budget, the firm needs systematic information on cash as well as some kind of control
system.
• For a large firm, the information is usually computer based. It is necessary to obtain
frequent reports, generally daily, on cash balances in each of the company’s bank
accounts, on cash disbursements, on average daily balances, and on the marketable
security position of the firm as well as a detailed report on changes in this position. It is
also useful to have information on major anticipated cash receipts and cash
disbursements.
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Reasons/Motives for Holding Cash
John Maynard Keynes suggested three reasons for individuals to hold cash. Keynes
labeled these motives as follows: transactions, speculative, and precautionary. Shifting
the emphasis away from individuals, we can use these three categories to describe the
motives for corporations to hold cash.
1. Transactions motive: to meet payments, such as purchases, wages, taxes, and
dividends, arising in the ordinary course of business.
2. Speculative motive: to take advantage of temporary opportunities, such as a
sudden decline in the price of a raw material.
3. Precautionary motive: to maintain a safety cushion or buffer to meet unexpected
cash needs. The more predictable the inflows and outflows of cash for a firm, the
less cash that needs to be held for precautionary needs. Ready borrowing power to
meet emergency cash drains also reduces the need for this type of cash balance.
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The various collection and disbursement methods that a firm employs to improve its cash
management efficiency constitute two sides of the same coin. They exercise a joint impact on the
overall efficiency of cash management. The general idea is that the firm will benefit by “speeding
up” cash receipts and “s-l-o-w-i-n-g d-o-w-n” cash payouts.
Speeding up cash collections
The firm wants to speed up the collection of accounts receivable so that it can have the use of
money sooner. Conversely, it wants to pay accounts payable as late as is consistent with
maintaining the firm’s credit standing with suppliers so that it can make the most use of the money
it already has.
Collections
We consider first the acceleration of collections, which includes the steps taken by the firm from
the time a product or service is sold until the customers’ checks are collected and become usable
funds for the firm. A number of methods are designed to speed up this collection process by doing
one or more of the following:
(1) expedite preparing and mailing the invoice;
(2) accelerate the mailing of payments from customers to the firm; and
(3) reduce the time during which payments received by the firm remain uncollected funds.
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Collection Float. Collection float refers to the total time between the mailing of a check
by a customer and the availability of cash to the receiving firm. The second item, by
itself, refers to mail float, or the time for which the check is in the mail.
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The third item, representing deposit float, has two aspects. The first, processing float, is
the time it takes a company to process checks internally. This interval extends from the
moment a check is received until the moment it is deposited with a bank for credit to the
company’s account. The second aspect of deposit float is availability float; it involves the
time consumed in clearing the check through the banking system. A check becomes
collected funds when it is presented to the payor’s bank and is actually paid by that bank.
Collection float is important to the financial manager because a company usually must wait
until a check mailed by a customer finally clears the banking system before the cash
becomes available to the firm. Because the name of the game is to turn mailed checks into
cash more quickly, the financial manager wants to reduce collection float as much as
possible.
Various ways to speed up the collection process
1. Earlier Billing
An obvious but easily overlooked way to speed up the collection of receivables is to get
invoices to customers earlier. Customers have different payment habits.
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Some pay their bills on the discount date or the final due date (or later), and others pay
immediately on receipt of an invoice. In any event, accelerated preparation and mailing of
invoices will result in faster payment because of the earlier invoice receipt and resulting
earlier discount and due dates.
Billing can be eliminated entirely through the use of a preauthorized debit. A customer
signs an agreement with a firm allowing the firm to automatically debit the customer’s bank
account on a specified date and transfer funds from the customer’s bank to the firm’s bank.
2. Lockbox System
The single most important tool for accelerating the collection of remittances in the United
States is the lockbox. A company rents a local post office box and authorizes its bank to
pick up remittances in the box. Customers are billed with instructions to mail their
remittances to the lockbox. The bank picks up the mail several times a day and deposits the
checks directly into the company’s account. The checks are recorded and cleared for
collection. The company receives a deposit slip and a list of payments, together with any
material in the envelopes.
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In addition to a traditional lockbox arrangement, banks also offer to provide a firm with an
electronic lockbox to receive electronic payments. Electronic lockbox is a collection
service provided by a firm’s bank that receives electronic payments and accompanying
remittance data and communicates this information to the company in a specified format.
3. Concentration Banking
The firm that uses a lockbox network as well as the one having numerous sales outlets that
receive funds over the counter have something in common. Both firms will find themselves
with deposit balances at a number of regional banks. Each firm may find it advantageous to
move part or all of these deposits to one central location, which is known as a concentration
bank. This process of cash concentration has several effects:
1. It improves control over inflows and outflows of corporate cash. The idea is to put
all of your eggs (or in this case, cash) into one basket and then to watch the basket
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2. It reduces idle balances – that is, keeps deposit balances at regional
banks no higher than necessary to meet transactions needs (or
alternatively, minimum compensating balance requirements). Any excess
funds would be moved to the concentration bank.
3. It allows for more effective investments. Pooling excess balances
provides the larger cash amounts needed for some of the higher yielding,
short-term investment opportunities that require a larger minimum
purchase. For example, some marketable securities are sold in blocks of
$100,000 or more.
S-l-o-w-i-n-g D-o-w-n Cash Payouts
Whereas one of the underlying objectives of cash management is to
accelerate collections, still another objective is to slow down cash
disbursements as much as possible. The combination of fast collections
and slow disbursements will result in increased availability of cash.
42

Playing the Float
The cash figure shown on a firm’s books seldom represents the available
amount of cash that the firm has in the bank. In fact, the funds available in
the bank are generally greater than the balance shown on the company’s
books. The dollar difference between the company’s bank balance and its
book balance of cash is called net float (or sometimes, just plain float).
Net float is the result of delays between the time checks are written and
their eventual clearing by the bank. It is very possible for a company to
have a negative cash balance on its books and a positive bank balance,
because checks just written by the company may still be outstanding.
Control of Disbursements
Essential to good cash management is a company’s control of
disbursements that will slow down cash outflows and minimize the time
that cash deposits are idle. A company with multiple banks should be able
to shift funds quickly to banks from which disbursements are made to
prevent excess balances from temporarily building up in a particular bank.
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The idea is to have adequate cash at the various banks, but not to let excess balances build up.
This requires daily information on collected balances. Excess funds may then be transferred to
disbursement banks, either to pay bills or to invest in marketable securities.
One procedure for tightly controlling disbursements is to centralize payables into a
single account (or a small number of accounts), presumably at the company’s headquarters.
In this way, disbursements can be made at the precise time they are desired. Operating
procedures for disbursements should be well established. If cash discounts are taken on
accounts payable, the firm should send payment at the end of the cash discount period. But, if
a discount is not taken, the firm should not pay until the final due date in order to have
maximum use of cash.
Payable Through Draft (PTD)
A means for delaying disbursements is through the use of payable through drafts (PTDs).
Unlike an ordinary check, the payable through draft is not payable on demand. When it is
presented to the issuer’s bank for collection, the bank must present it to the issuer for
acceptance. The funds are then deposited by the issuing firm to cover payment of the draft.
The advantage of the draft arrangement is that it delays the time the firm actually has to have
funds on deposit to cover the draft. Consequently, it allows the firm to maintain smaller
balances at its banks. A disadvantage of a draft system is that certain suppliers may prefer
checks.
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Payroll and Dividend Disbursements
Many companies maintain a separate account for payroll disbursements. To minimize the
balance in this account, the ﬁrm must predict when the payroll checks issued will be
presented for payment. If payday falls on a Friday, not all of
the checks will be cashed on that day. Consequently, the ﬁrm does not need to have funds
on deposit to cover its entire payroll. Even on Monday, some checks will not be presented
because of delays in their deposit.
Zero Balance Account (ZBA)
ZBA is a corporate checking account in which a zero balance is maintained. The
account requires a master (parent) account from which funds are drawn to cover negative
balances or to which excess balances are sent. he use of a zero balance account (ZBA)
system, which is offered by many major banks, eliminates the need to accurately estimate
and fund each individual disbursement account. Under such a system, one master
disbursing account services all other subsidiary accounts. When checks are cleared at the
end of each day, the bank automatically transfers just enough funds from the master
account to each disbursement account
(e.g., one for payroll, one for payables, etc.) to just cover checks presented.
45

Marketable securities ?
Marketable securities (MS) are securities or debts that are to be sold or redeemed within a
year. These are financial instruments that can be easily converted to cash such as government
bonds, common stock or certificates of deposit.
MS are any unrestricted financial instrument(s) that can be bought or sold on a public stock
exchange. Therefore, MS are classified as either a marketable equity security or a marketable
debt security. Other requirements of marketable securities include having a strong secondary
market that can facilitate quick buy and sell transactions.
Firms try to maintain some target level of cash to meet their needs for transactions and/or
compensating balances requirements. But beyond that we often find firms investing in short-term
marketable securities. In this section we explore the firm’s use of marketable securities as near-
cash investments. Before we begin, we should mention that, for accounting purposes, short-term
marketable securities are often shown on the balance sheet as “short-term investments.”
• Marketable securities act as a reserve for the company’s cash account.
• These securities are intended to provide the first line of defense against unforeseen operating
needs of the firm, these securities may have to be liquidated on very short notice.
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Variables in Marketable Securities Selection
1. Safety: The most basic test that marketable securities must pass concerns safety of principal.
This refers to the likelihood of getting back the same number of dollars originally invested.
Safety is judged relative to US Treasury securities, which are considered certain if held to
maturity. For securities other than Treasury issues, the safety of these securities will vary
depending on the issuer and the type of security issued.
2. Marketability: The marketability (or liquidity) of a security relates to the owner’s ability to
convert it into cash on short notice. Although it is possible that a security could be quite “safe” if
held to maturity, this does not necessarily mean that it is always possible to easily sell the
security before maturity without incurring a loss.
3. Yield: The yield, or return, on a security is related to the interest and/or appreciation of
principal provided by the security. Some securities, notably Treasury bills, do not pay interest.
Instead, they are sold at a discount and redeemed at face value.
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It’s worth noting that price of a debt security varies inversely with the interest rate or yield.
The firm’s marketable securities portfolio manager, therefore, needs to be alert to interest-
rate (or yield) risk. The fact is that a loss can be incurred if a marketable security is sold
prior to maturity and the level of interest rates has increased.
4. Maturity:
Maturity simply refers to the life of the security. Some marketable securities have a specific
life. Treasury bills, for example, have original lives of 4, 13, or 26 weeks. Other securities,
such as commercial paper and negotiable certificates of deposit, can have lives tailored to
meet specific needs. Usually, the longer the maturity, the greater the yield, but also the
more exposure to yield risk.
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Chapter 4: Management of Accounts Receivable
• Meaning of A/R
Accounts receivable refers to the Amounts of money owed to a firm by customers who have
bought goods or services on credit. A current asset, the accounts receivable account is also
called receivables.
• Credit policy and its elements
Clear, written guidelines that set (1) the terms and conditions for supplying goods on credit,
(2) customer qualification criteria, (3) procedure for making collections, and (3) steps to be
taken in case of customer delinquency.
• Credit Standards
Credit policy can have a significant influence on sales. If our competitors extend credit
liberally and we do not, our policy may have a dampening effect on our firm’s marketing effort.
Credit is one of the many factors that influence the demand for a firm’s product.
The firm should lower its quality standard for accounts accepted as long as the profitability of
sales generated exceeds the added costs of the receivables.
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Costs of relaxing credit standards
I. enlarged credit department
II. clerical work involved in checking additional accounts
III. servicing the added volume of receivable
IV. bad-debt losses
V. opportunity cost of committing funds to the investment in additional receivables instead of to
some other investment.
An Example of the Trade-off
• Assume that Sale price per unit $10 (Variable cost $8 per unit)
• Contribution margin= $10 - $8= $2
• Current sales $2.4 million ($2400,000/10=240000 units)
• 25% increase is expected in sales due to the relaxation in credit standards
• Total expected sales 2.4 * 1.25 = $3 million ($3,000,000)
• Increase in sales 3000000-2400000= $600,000
• Increase in units sold (additional units sold) 600000/10= 60000 units
• Assume opportunity cost before taxes is 20%
• Existing customers pay in 30 days
• relaxation in credit standards results in doubling the days i.e., 60 days
• Average collection period 60 days i.e., 2 months
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• Receivable turnover= 12 months/average collection period = 6 times
Summary
• Increased profitability= $120000
• Increased Cost = $16000
The ﬁrm would be well advised to relax its credit standards. An optimal policy would involve
extending credit more liberally until the marginal proﬁtability on additional sales equals the
required return on the additional investment in
receivables necessary to generate those sales.
Home Work: Solve the self-correction problem No. 1 on page No 274 and Problem No. 1 on
page No 275 in the recommended book.
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• Credit period
Credit terms specify the length of time over which credit is extended to a customer and the
discount, if any, given for early payment. For example, one firm’s credit terms might be
expressed as “2/10, net 30.” The term “2/10” means that a 2 percent discount is given if the bill
is paid within 10 days of the invoice date. The term “net 30” implies that if a discount is not
taken, the full payment is due by the 30th day from invoice date. Thus the credit period is 30
days.
Although the customs of the industry frequently dictate the credit terms given, the credit period
is another means by which a firm may be able to increase product demand. As before, the
trade-off is between the profitability of additional sales and the required return on the
additional investment in receivables.
Home Work:
Carefully study the example on page No 252 and 253 for understanding the credit period.
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• Cash Discount
The cash discount period represents the period of time during which a cash discount can be
taken for early payment. Though technically a credit policy variable, like the credit period, it
usually stays at some standard length. For many firms, 10 days is about the minimum time
they could expect between when an invoice is mailed to the customer and when the customer
could put a check in the mail.
Varying the cash discount involves an attempt to speed up the payment of receivables. Here
we must determine whether a speedup in collections would more than offset the cost of an
increase in the discount. If it would, the present discount policy should be changed. Suppose
that the firm has annual credit sales of $3 million and an average collection period of two
months. Also, assume that sales terms are “net 45,” with no cash discount given.
Consequently, the average receivables balance is $3,000,000/6 = $500,000. By initiating
terms of “2/10, net 45,” the average collection period can be reduced to one month, as 60
percent of the customers (in dollar volume) take advantage of the 2 percent discount. The
opportunity cost of the discount to the firm is 0.02 × 0.6 × $3 million, or $36,000 annually. The
turnover of receivables has improved to 12 times a year, so that average receivables are
reduced from $500,000 to $250,000 (i.e., $3,000,000/12 = $250,000).
53

Thus the ﬁrm realizes $250,000 from accelerated collections. The value of the funds released
is their opportunity cost. If we assume a 20 percent before-tax rate of return, the opportunity
saving is $50,000.
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55
Decision:
In this case the opportunity saving arising from a speedup in collections is greater than the
cost of the discount. The ﬁrm should adopt a 2 percent discount. If the speedup in collections
had not resulted in sufﬁcient opportunity savings to offset the cost of the cash discount, the
discount policy would not be changed. It is possible, of course, that discounts other than 2
percent may result in an even greater difference between the opportunity saving and the cost
of the discount.

• Collection Policy and Procedures
The ﬁrm determines its overall collection policy by the combination of collection procedures it
undertakes. These procedures include such things as letters, faxes, phone calls, personal
visits, and legal action. One of the principal policy variables is the amount of money spent on
collection procedures. Within a range, the greater the relative amount expended, the lower the
proportion of bad-debt losses, and the shorter the average collection period, all other things
being the same.
If sales are independent of the collection effort, the appropriate level of collection expenditures
again involves a trade-off – this time between the level of expenditure on the one hand and the
reduction in the cost of bad-debt losses and savings due to the reduction in investment in
receivables on the other.
Initially, a telephone call is usually made to ask why payment has not been made. Next, a
letter is often sent and followed, perhaps, by additional letters that become more serious in
tone. A phone call or letter from the company’s attorney may then prove necessary. Some
companies have collection personnel who make visits to a customer about an overdue
account.
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Analyzing the credit applicant
Having established the terms of sale to be offered, the firm must evaluate individual credit
applicants and consider the possibilities of a bad debt or slow payment. The credit
evaluation procedure involves three related steps: (1) obtaining information on the
applicant, (2) analyzing this information to determine the applicant’s creditworthiness, and
(3) making the credit decision. The credit decision, in turn, establishes whether credit
should be extended
and what the maximum amount of credit should be.
A. Credit Information
A number of services supply credit information on businesses, but for some accounts,
especially small ones, the cost of collecting this information may outweigh the potential
profitability of the account. The firm extending credit may have to be satisfied with a limited
amount of information on which to base a decision. In addition to cost, the firm must
consider the time it takes to investigate a credit applicant.
Depending on these considerations, the credit analyst may use one or more of the
following sources of information;
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I. Financial Statements
At the time of the prospective sale, the seller may request financial statements, one of the
most desirable sources of information for credit analysis. Frequently,
there is a correlation between a company’s refusal to provide statements and a weak financial
position. Audited statements are preferable.
II. Credit Ratings and Reports
In addition to financial statements, credit ratings are available from various credit reporting
agencies. Dun & Bradstreet (D&B) is perhaps the best known and most comprehensive of
these agencies. D&B ratings give the credit analyst an indication of the estimated size of net
worth (a rough guide to financial capacity) and a credit appraisal for companies of a particular
size, ranging from “high = 1” to “limited = 4.”2 D&B also indicates when the information
available is insufficient to provide a rating for a given business.
III. Bank Checking
Another source of credit information for the credit analyst checking on a particular firm is the
firm’s bank. Most banks have credit departments that will provide information on their
commercial customers as a service to those customers seeking to acquire trade credit (credit
granted from one business to another)
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By calling or writing to a bank in which the credit applicant has an account, the analyst can
obtain information, such as aver-age cash balance carried, loan accommodations, experience,
and sometimes more extensive ﬁnancial information.
IV. Trade Checking
Credit information is frequently exchanged among companies selling to the same customer.
Through various credit organizations, credit people in a particular area become a closely knit
group. A company can ask other suppliers about their experiences with an account.
V. The Company’s Own Experience
A study of the promptness of past payments, including any seasonal patterns, is very useful.
Frequently, the credit department will make written assessments of the quality of the
management of a company to whom credit may be extended.
These assessments are very important, for they pertain to the original “three Cs” of credit
analysis:
a. Character: creditor’s willingness to honor obligations.
b. Capacity: creditor’s ability to generate cash to meet obligations.
c. Capital: creditor’s net worth and the relationship of net worth to debt.
d. Collateral: Collateral can help a borrower secure loans.
e. Conditions: The conditions of the loan, such as its interest rate and amount of principal,
influence the lender's desire to finance the borrower.
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B. Credit Analysis
Having collected credit information, the firm must make a credit analysis of the applicant. In
practice, the collection of information and its analysis are closely related. If, on the basis of
initial credit information, a large account appears to be relatively risky, the credit analyst will
want to obtain further information. Presumably, the expected value of the additional
information will exceed the cost of acquiring it. Given the financial statements of a credit
applicant, the credit analyst should undertake a ratio analysis.
The analyst will be particularly interested in the applicant’s liquidity and ability to pay bills on
time. Such ratios as the quick ratio, receivable and inventory turnovers, the average payable
period, and debt-to-equity ratio are particularly relevant. In addition to analyzing financial
statements, the credit analyst will consider the character of the company and its
management, the financial strength of the firm, and various other matters.
C. Credit scoring
Quantitative approaches have been developed to estimate the ability of businesses to service
credit granted to them; however, the final decision for most companies extending trade credit
(credit granted from one business to another) rests on the credit analyst’s judgment in
evaluating available information.
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Credit scoring system is a system used to decide whether to grant credit by
assigning numerical scores to various characteristics related to creditworthiness.
Strictly numerical evaluations have been successful in determining the granting of
credit to retail customers (consumer credit), where various characteristics of an
individual are quantitatively rated, and a credit decision is made on the basis of the
total score. The plastic credit cards many of us hold are often given out on the
basis of a credit-scoring system in which such things as occupation, duration of
employment, home ownership, years of residence, and annual income are taken
into account. Numerical rating systems are also being used by some companies
extending trade credit.
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Chapter#5: Risk and Return
What is Risk?
The variability of returns from those that are expected. OR The probability that an
actual return on an investment will be lower than the expected return.
Assume that you buy a US Treasury note (T-note), with exactly one year remaining until
ﬁnal maturity, to yield 8 percent. If you hold it for the full year, you will realize a
government-guaranteed 8 percent return on your investment – not more, not less. Now,
buy a share of common stock in any company and hold it for one year. The cash
dividend that you anticipate receiving may or may not materialize as expected. And,
what is more, the year-end price of the stock might be much lower than expected –
maybe even less than you started with. Thus your actual return on this investment may
differ substantially from your expected return.
If we deﬁne risk as the variability of returns from those that are expected, the T-note
would be a risk-free security whereas the common stock would be a risky security. The
greater the variability, the riskier the security is said to be.
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64
Return:
The total rate of return is the total gain or loss experienced on an investment over a given
period. Mathematically, an investment’s total return is the sum of any cash distributions
(for example, dividends or interest payments) plus the change in the investment’s value,
divided by the beginning-of-period value. The expression for calculating the total rate of
return earned on any asset over period t, rt, is commonly defined as

65 Example of Calculating Return

In simple words, Return is the Income received on an investment plus any change in market
price, usually expressed as a percentage of the beginning market price of the investment.
The return from holding an investment over some period – say, a year – is simply any cash
payments received due to ownership, plus the change in market price, divided by the beginning
price.
You might, for example, buy for $100 a security that would pay $7 in cash to you
and be worth $106 one year later. The return would be ($7 + $6)/$100 = 13%. Thus return
comes to you from two sources: income plus any price appreciation (or loss in price).
Using probability distributions to measure risk
Probability distribution: A set of possible values that a random variable can assume and their
associated probabilities of occurrence. Probability distributions provide a more quantitative
insight into an asset’s risk. The probability of a given outcome is its chance of occurring.
As we have just noted, for all except risk-free securities the return we expect may be different
from the return we receive. For risky securities, the actual rate of return can be viewed as a
random variable subject to a probability distribution.
This probability distribution can be summarized in terms of two parameters of the distribution: (1)
the expected return and (2) the standard deviation.
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The standard deviation, r , measures the dispersion of an investment’s return around the expected
return. The expected return, , is the average return that an investment is expected to produce over
time.
(1) Expected Return
Expected return (R) is the weighted average of possible returns, with the weights being the
probabilities of occurrence.
where Ri is the return for the ith possibility, Pi is the probability of that return occurring, and n is
the total number of possibilities. Thus the expected return is simply a weighted average of the
possible returns, with the weights being the probabilities of occurrence.
To complete the two-parameter description of our return distribution, we need a measure of the
dispersion, or variability, around our expected return. The conventional measure of dispersion is
the standard deviation. The greater the standard deviation of returns, the greater the variability of
returns, and the greater the risk of the investment.
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The standard deviation, σ, can be expressed mathematically as;
where √ represents the square root. The square of the standard deviation, σ
2
, is known as the variance of the distribution.
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Operationally, we generally first calculate a distribution’s variance, or the weighted
average of squared deviations of possible occurrences from the mean value of the
distribution, with the weights being the probabilities of occurrence. Then the square
root of this figure provides us with the standard deviation.
Table 5.1 reveals our example distribution’s variance to be 0.00703. Taking the
square root of this value, we find that the distribution’s standard deviation is 8.38
percent.
Class Work: Solve Self Correction problem 1 on page No 122 from the
recommended book.
Home Work: Solve problem 1 on page No 122 from the recommended book.
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• Coefficient of Variation
The standard deviation can sometimes be misleading in comparing the risk, or
uncertainty, surrounding alternatives if they differ in size. Consider two investment
opportunities, A and B, whose normal probability distributions of one-year returns
have the following characteristics:
Can we conclude that because the standard deviation of B is larger than that of A, it is
the riskier investment? With standard deviation as our risk measure, we would have to.
However, relative to the size of expected return, investment A has greater variation.
This is similar to recognizing that a $10,000 standard deviation of annual income to a
multimillionaire is really less significant than an $8,000 standard deviation in annual
income would be to you. To adjust for the size, or scale, problem, the standard
deviation can be divided by the expected return to compute the coefficient of variation
(CV):
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Thus the coefﬁcient of variation is a measure of relative dispersion (risk) – a
measure of risk “per unit of expected return.” The larger the CV, the larger the
relative risk of the investment. Using the CV as our risk measure, investment A
with a return distribution CV of 0.75 is viewed as being more risky than
investment B, whose CV equals only 0.33.
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Attitudes Toward Risk
Just when you thought that you were safely immersed in the middle of a finance chapter,
you find yourself caught up in a time warp, and you are a contestant on the television
game show Let’s Make a Deal. The host, Monty Hall, explains that you get to keep
whatever you find behind either door #1 or door #2. He tells you that behind one door is
$10,000 in cash, but behind the other door is a “zonk,” a used tire with a current market
value of zero. You choose to open door #1 and claim your prize. But before you can make
a move, Monty says that he will offer you a sum of money to call off the whole deal.
Let’s assume that you decide that if Monty offers you $2,999 or less, you will keep the
door. At $3,000 you can’t quite make up your mind. But at $3,001, or more, you would take
the cash offered and give up the door. Monty offers you $3,500, so you take the cash and
give up the door. (By the way, the $10,000 was behind door #1, so you blew it.)
In our example, you found your-self indifferent between a risky (uncertain) $5,000
expected return and a certain return of $3,000. In other words, this certain or riskless
amount, your certainty equivalent (CE) [a guaranteed return] to the risky gamble,
provided you with the same utility or satisfaction as the risky expected value of $5,000.
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Certainty equivalent (CE): The amount of cash someone would require with certainty at a
point in time to make the individual indifferent between that certain amount and an amount
expected to be received with risk at the same point in time. OR the certainty equivalent is a
guaranteed return that someone would accept rather than taking a chance on a higher, but
uncertain, return.
Studies have shown that the vast majority of individuals, if placed in a similar situation,
would have a certainty equivalent less than the expected value (i.e., less than $5,000). We
can, in fact, use the relationship of an individual’s certainty equivalent to the expected
monetary value of a risky investment (or opportunity) to deﬁne their attitude toward risk.
Certainty equivalent < expected value, risk aversion is present.
Certainty equivalent = expected value, risk indifference is present.
Certainty equivalent > expected value, risk preference is present.
Three type of investors attitudes towards Risk:
1. Risk aversion
2. Risk indifference/Neutrality
3. Risk preference Or Risk Seeking (Risk Lovers)
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74
1. Risk Aversion:
The first category, and the one that describes the behavior of most people most of the time, is called
risk aversion. A person who is a risk-averse investor prefers less risky over more risky investments,
holding the rate of return fixed. A risk-averse investor who believes that two different investments have
the same expected return will choose the investment whose returns are more certain. Stated another
way, when choosing between two investments, a risk-averse investor will not make the riskier
investment unless it offers a higher expected return to compensate the investor for bearing the
additional risk.
2. Risk Indifference/Neutral
A second attitude toward risk is called risk neutrality. An investor who is risk neutral chooses
investments based solely on their expected returns, disregarding the risks. When choosing between
two investments, a risk-neutral investor will always choose the investment with the higher expected
return regardless of its risk.
3. Risk Preference Or Risk Seeking
Risk-seeking investor is one who prefers investments with higher risk and may even sacrifice some
expected return when choosing a riskier investment. By design, the average person who buys a lottery
ticket or gambles in a casino loses money. After all, state governments and casinos make money off of
these endeavors, so individuals lose on average. This implies that the expected return on these
activities is negative. Yet people do buy lottery tickets and visit casinos, and in doing so they exhibit
risk-seeking behavior.

Risk and Return in portfolio context
Investors rarely place their entire wealth into a single asset or investment. Rather, they
construct a portfolio or group of investments. Therefore we need to extend our
analysis of risk and return to include portfolios.
Portfolio Return
The expected return of a portfolio is simply a weighted average of the expected returns
of the securities constituting that portfolio. The weights are equal to the proportion of
total funds invested in each security (the weights must sum to 100 percent). The
general formula for the expected return of a portfolio, bp, is as follows:
where Wj is the proportion, or weight, of total funds invested in security j ; bj is the
expected return for security j ; and m is the total number of different securities in the
portfolio.
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The expected return and standard deviation of the probability distribution of possible returns for
two securities are shown below.
If equal amounts of money are invested in the two securities, the expected return of the port-
folio is (0.5)14.0% + (0.5)11.5% = 12.75%.
Homework: Solve self-correction Problem No 3 [Page No 122] and Problem No 7 on Page No
124 from the recommended book.
Diversification
The concept of diversification makes such common sense that our language even contains
everyday expressions that exhort us to diversify (“Don’t put all your eggs in one basket”). The
idea is to spread your risk across a number of assets or investments. While pointing us in the
right direction, this is a rather naive approach to diversification.
It would seem to imply that investing $10,000 evenly across 10 different securities makes you
more diversified than the same amount of money invested evenly across 5
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securities. The catch is that naive diversification ignores the covariance (or correlation)
between security returns. The portfolio containing 10 securities could represent stocks
from only one industry and have returns that are highly correlated. The 5-stock portfolio
might represent various industries whose security returns might show low correlation
and, hence, low portfolio return variability.
Systematic and unsystematic risk
The first part, systematic risk, is due to risk factors that affect the overall market – such
as changes in the nation’s economy, tax reform by Congress, or a change in the world
energy situation. These are risks that affect securities overall and, consequently, cannot
be diversified away. In other words, even an investor who holds a well-diversified portfolio
will be exposed to this type of risk.
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The second risk component, unsystematic risk, is risk unique to a particular company or
industry; it is independent of economic, political, and other factors that affect all securities in
a systematic manner. A wildcat strike may affect only one company; a new competitor may
begin to produce essentially the same product; or a technological breakthrough may make
an existing product obsolete.
Capital-asset pricing model (CAPM)
Based on the behavior of risk-averse investors, there is an implied equilibrium relationship
between risk and expected return for each security. In market equilibrium, a security is
supposed to provide an expected return commensurate with its systematic risk – the risk
that cannot be avoided by diversiﬁcation. The greater the systematic risk of a security, the
greater the return that investors will expect from the security.
The relationship between expected return and systematic risk, and the valuation of
securities that follows, is the essence of Nobel laureate William Sharpe’s capital-asset
pricing model (CAPM). This model was developed in the 1960s, and it has had important
implications for ﬁnance ever since. Though other models also attempt to capture market
behavior, the CAPM is simple in concept and has real-world applicability.
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Capital-asset pricing model (CAPM): A model that describes the relationship
between risk and expected (required) return; in this model, a security’s expected
(required) return is the risk-free rate plus a premium based on the systematic risk of the
security.
As with any model, there are assumptions to be made. First, we assume that capital
markets are efﬁcient in that investors are well informed, transactions costs are low, there
are negligible restrictions on investment, and no investor is large enough to affect the
market price of a stock. We also assume that investors are in general agreement about
the likely performance of individual securities and that their expectations are based on a
common holding period, say one year.
The CAPM formula is:
ra = rrf + Ba (rm- rrf)
Where:
Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return on market
Note: “Risk Premium” = (Rm – Rrf)
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Home Work:
Solve self-correction No 2 (a) and C on page No 122 and Problem No 4 on page 123
from the recommended Book.

Ch#6: The Management of Capital Budgeting
The word Capital refers to be the total investment of a company of firm in money, tangible and
intangible assets. Whereas budgeting defined by the “Rowland and William” it may be said to
be the art of building budgets. Budgets are a blue print of a plan and action expressed in
quantities and manners. 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.
When a business makes a capital investment, it incurs a current cash outlay in the expectation
of future benefits. Usually, these benefits extend beyond one year in the future. Examples
include investment in assets, such as equipment, buildings, and land, as well as the introduction
of a new product, a new distribution system, or a new program for research and development. In
short, the firm’s future success and profitability depend on long-term decisions currently made.
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Capital budgeting is the process of identifying, analyzing, and selecting investment
projects whose returns (cash ﬂows) are expected to extend beyond one year.
Importance of Capital Budgeting
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.
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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.
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The process of Capital Budgeting
a) Project proposals and classification
b) Estimating the project cash flows
c) Methods used to evaluate proposed projects
• Payback Period
• NPV
• IRR
• Profitability Index
d) The post audit
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A. Project proposals and classification
Investment project proposals can stem from a variety of sources. For purposes of
analysis, projects may be classified into one of five categories:
1. New products or expansion of existing products
2. Replacement of equipment or buildings
3. Research and development
4. Exploration
5. Other (for example, safety-related or pollution-control devices)
Most firms screen proposals at multiple levels of authority. For a proposal originating in
the production area, the hierarchy of authority might run (1) from section chiefs, (2) to
plant managers, (3) to the vice president for operations, (4) to a capital expenditures
committee under the financial manager, (5) to the president, and (6) to the board of
directors.
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B) Estimating Project “After-Tax Incremental Operating Cash Flows”
• One of the most important tasks in capital budgeting is estimating future cash flows for a
project. The final results we obtain from our analysis are no better than the accuracy of our
cash-flow estimates. Because cash, not accounting income, is central to all decisions of
the firm, we express whatever benefits we expect from a project in terms of cash flows
rather than income flows. The firm invests cash now in the hope of receiving even greater
cash returns in the future.
• Cash flows should be determined on an after-tax basis. The initial investment outlay or
initial cash outflow (ICO), as well as the appropriate discount rate, will be expressed in
after-tax terms. Take into account the depreciation methods (especially, MACRS) while
calculating the after tax basis.
• For each investment proposal we need to provide information on operating, as opposed to
financing, cash flows. Financing flows, such as interest payments, principal payments, and
cash dividends, are excluded from our cash-flow analysis. However, the need for an
investment’s return to cover capital costs is not ignored.
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• The information must be presented on an incremental basis, so that we analyze only the
difference between the cash flows of the firm with and without the project.
• Sunk costs must be ignored. Our concern lies with incremental costs and benefits.
Unrecoverable past costs are irrelevant and should not enter into the decision process.
• Opportunity cost (What is lost by not taking the next-best investment alternative) must be
included in the project’s evaluation.
• When a capital investment contains a current asset component, this component (net of any
spontaneous changes in current liabilities) is treated as part of the capital investment and
not as a separate working capital decision. For example, with the acceptance of a new
project it is sometimes necessary to carry additional cash, receivables, or inventories. This
investment in working capital should be treated as a cash outflow at the time it occurs.
• In estimating cash flows, anticipated inflation must be taken into account.
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Project Evaluation and Selection: Alternative Methods
Traditional/Non-discounted Cash flow method
1. Payback period
Discounted cash flow methods/Techniques
2. Internal rate of return
3. Net present value
4. Profitability index
1. Payback Period
The payback period (PBP) of an investment project tells us the number of years
required to recover our initial cash investment based on the project’s expected cash
flows.
Pay-back period = Initial investment /Annual cash inflows [for even cash flow]
Example
An initial cash outflow of $100,000, the Faversham Fish Farm expected to generate net
cash flows of $34,432, $39,530, $39,359, and $32,219 over the next 4 years. Recording
the cash flows in a column, and following a few simple steps, will help you calculate the
payback period.
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2 years complete
($100,000 − $73,962)/$39,359 = 0.66.]
2+.66= 2.66 Years
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.
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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.
Accept /Reject criteria
If the actual pay-back period is less than the predetermined pay-back period, the
project would be accepted. If not, it would be rejected.
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2. Internal Rate of Return (IRR)
Because of the various shortcomings in the payback method, it is
generally felt that discounted cash flow methods provide a more objective
basis for evaluating and selecting investment projects.
The internal rate of return (IRR) for an investment proposal is the
discount rate that equates the present value of the expected net cash
flows (CFs) with the initial cash outflow (ICO).
Thus IRR is the interest rate that discounts the stream of future net cash
flows – CF1 through CFn – to equal in present value the initial cash
outflow (ICO) at time 0.
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Acceptance Criterion
The acceptance criterion generally employed with the internal rate of return method is to
compare the internal rate of return to a required rate of return, known as the cutoff or hurdle
rate. We assume for now that the required rate of return is given. If the internal rate of return
exceeds the required rate, the project is accepted; if not, the project is rejected.
Note: Study Interpolation in case of IRR on page 326.
3. Net Present Value (NPV)
NPV refers to the present value of an investment project’s net cash ﬂows minus the project’s
initial cash outﬂow.
where k is the required rate of return
If we assume a required rate of return of 12 percent after taxes, the net present value of our
previous example is
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Acceptance Criterion
If an investment project’s net present value is zero or more, the project is accepted; if
not, it is rejected. Another way to express the acceptance criterion is to say that the
project will be accepted if the present value of cash inﬂows exceeds the present value
of cash outﬂows.
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4. Profitability Index
The profitability index (PI), or benefit-cost ratio, of a project is the ratio of the present
value of future net cash flows to the initial cash outflow.
Putting in our previous example
Acceptance Criterion. As long as the profitability index is 1.00 or greater, the
investment proposal is acceptable. For any given project, the net present value and
the profitability index methods give the same accept-reject signals. (A profitability
index greater than 1.00 implies that a project’s present value is greater than its initial
cash outflow which, in turn, implies that net present value is greater than zero.) The
net present value method, however, is often preferred over the profitability index
method.
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Home work
Solve all the numerical questions at the end of this chapter from your
recommended book (Page 346-350).
Project Monitoring: Progress Reviews and Post-Completion
Audits
The capital budgeting process should not end with the decision to
accept a project. Continual monitoring of the project is the necessary
next step to help ensure project success. Therefore, companies should
perform progress reviews followed by post-completion audits for all
large projects; strategically important projects, regardless of size; and a
sample of smaller projects. Progress reviews, or status reports, can
provide, especially during the implementation phase of a project, early
warnings of potential cost overruns, revenue shortfalls, invalid
assumptions, and outright project failure. Information revealed through
progress reviews may lead to revised forecasts, remedial actions to
improve performance, or project abandonment.
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Post-completion audits allow management to determine how close the actual results of an
implemented project have come to its original estimates. When they are used properly,
progress reviews and post-completion audits can help identify forecasting weaknesses and
any important factors that were omitted. With a good feedback system, any lessons learned
can be used to improve the quality of future capital budgeting decision making.
Monitoring of a project can also have important psychological effects on managers. For
example, if managers know in advance that their capital investment decisions will be
monitored, they will be more likely to make realistic forecasts and to see that original
estimates are met. In addition, managers may ﬁnd it easier to abandon a failing project within
the context of a formal review process. Finally, it is useful for managers to set milestones for a
project and to agree in advance to abandon it if these milestones are not met
Homework:
1. Solve self-correction Q No 1 and 2 on page 346.
2. Solve Problems 1 to 4 on page No 347 in the recommended book.
-The End-
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