Financial Management
Unit I
Reena Talwar
Chapter 1
Concepts of FM
Introduction to FM
Overview of FM
Relationship with closely related fields
Its functions Scope Objectives
Introduction to FM
FM has undergone fundamental changes in its scope
and coverage
In the early years of its evolution, it was treated
synonymously with raising of funds.
In the current scenario, a broader scope is being
universally recognized which includes efficient use of resources in addition to procurement of funds.
Finance and Related Disciplines
FM is not a totally independent area.
Draws heavily on related disciplines and fields of
study such as economics, accounting, marketing, production and quantitative methods.
For e.g. Financial managers should consider impact
of new product development and promotion plans made in marketing as they will require capital outlays. Changes in production process may also necessitate capital expenditures which financial managers must evaluate.
Finance and Economics
Macro
Economics concerned with overall institutional environment in which firm operates.
Since business firms operate in macro economic
environment, it is imp for financial managers to understand broad economic environment. Specifically, they should
Understand how monetary policy affects cost and availability of funds. Be versed with fiscal policy and its effects on economy. Be aware of various financial institutions
Finance and Economics
Micro Economics deals with economic decisions of
individuals and organizations.
Concepts and theories of micro economics which are
relevant to financial management are:
Supply and demand relationships and profit maximization strategies Concept of marginal analysis financial decisions to be made on basis of comparison of marginal revenue and marginal cost.
Finance and Accounting
Closely related as accounting is an imp input in
financial decision making.
It is a necessary input into finance function. Information
contained in financial statements prepared by an organization such as balance sheet, income statement and statement of changes in financial system assists financial managers in assessing past performance and future directions of the firm.
Finance and Accounting
Though they are closely related, there are key differences
between finance and accounting: 1. Treatment of Funds :- Measurement of funds in accounting is based
on accrual principle revenue is recognized at the point of sale and not when collected. Expenses are recognized when they are incurred rather than when actually paid. Finance is based on cash flows i.e. revenues are recognized when actually received in cash (cash inflow) and expenses are recognized on actual payment. Financial manager is concerned with maintaining solvency of the firm by providing cash flows necessary to satisfy its obligations. 2. Decision Making:- Primary Purpose of accounting is collection and presentation of financial data while financial managers major responsibility relates to financial planning, controlling and decision making.
Scope of FM
The approach to the scope and functions of FM is
divided into two brad categories: Traditional Approach Modern Approach
Traditional Approach: Implied a very narrow scope for financial management. Concerned with procurement of funds by corporate enterprise to meet their financing needs. Ignored the important dimension of allocation of capital.
Modern Approach
Provides a conceptual and analytical framework for
decision making.
Covers both acquisition of funds and efficient and
wise allocation of funds to various uses.
Concerned with solution of three major problems
relating to financial operations of a firm.
Modern Approach
Financial Management addresses the following three questions:
What investments should Investment Decision the firm engage in
How can the firm raise the money for the required investments Financing Decision How should the firm deal with profits distribute or retain Dividend Decision
Investment Decision
Selection of assets in which funds will be
invested by a firm
Long term assets which yield a return over a period of time in future Short term or current assets which in the normal course of business are convertible into cash without diminution in value, usually within a year.
The Balance-Sheet Model of the Firm
Total Value of Assets: Current Assets Total Firm Value to Investors: Current Liabilities Long-Term Debt
Fixed Assets 1 Tangible 2 Intangible
Shareholder's Equity
The Balance-Sheet Model of the Firm
The Capital Budgeting Decision
Current Assets
Current Liabilities
Long-Term Debt
Fixed Assets 1 Tangible 2 Intangible
What longterm investments should the firm engage in?
Shareholder's Equity
The Balance-Sheet Model of the Firm
The Net Working Capital Investment Decision
Current Liabilities
Net Working Capital
Current Assets
Long-Term Debt
Fixed Assets 1 Tangible 2 Intangible
How much shortterm cash flow does a company need to pay its bills?
Shareholder's Equity
Financing Decision
Concerned with financing mix or capital
structure or leverage.
Relates to choice of proportion of sources of
funds (debt and equity capital) to finance the investment requirements.
The Balance-Sheet Model of the Firm
The Capital Structure Decision
Current Assets
Current Liabilities
Long-Term Debt
How can the firm raise the money for the required Fixed Assets investments? 1 Tangible
2 Intangible
Shareholders Equity
Dividend Policy Decision
Two alternatives are available in dealing with profits
of the firm: They can be distributed to shareholders in form of dividends They can be retained in business itself.
Decision regarding dividend pay out ratio will depend
on preference of shareholders and investment opportunities available within the firm.
The Financial Manager
To create value, the financial manager should:
Try to make smart investment decisions.
Try to make smart financing decisions.
The Firm and the Financial Markets
Firm
Invests in assets (B) Firm issues securities (A) Retained cash flows (F) Short-term debt
Financial markets
Current assets Cash flow from firm (C) Fixed assets
Dividends and debt payments (E)
Taxes (D)
Long-term debt
Equity shares
Ultimately, the firm must be a cash generating activity.
Government
The cash flows from the firm must exceed the cash flows from the financial markets.
Objectives of FM
There are two widely discussed approaches:
Profit Maximization approach Wealth Maximization approach
Profit Maximization Decision Criterion
Actions that increase profits should be undertaken
and those that decrease profits are to be avoided.
Investment, financing and dividend policy decisions
of a firm should be oriented to maximization of profits.
A firm should select assets, projects and decisions
which are profitable and reject those which are not.
Profit Maximization Decision Criterion
Rationale behind profit maximization as a guide to
financial decision making:
Provides the yardstick by which economic performance can be judged. It leads to efficient allocation of resources as resources tend to be directed to uses which in terms of profitability are the most desirable.
This criterion has been questioned and criticized on
several grounds:
Ambiguity Timing of Benefits Quality of Benefits
Time Pattern of Benefits
Alternative A (profits in lakhs) Period I 50 Alternative B (lakhs)
Period II
Period III Total
100
50 200
100
100 200
If profit maximization is the decision criterion, both the alternatives would be ranked equally. However, alternative A provides higher returns in earlier years whereas returns from alternative B are larger in later years. Thus, they are not identical. Profit max does not consider distinction between returns received in different time periods and treats all benefits as equally valuable irrespective of timing.
Quality of Benefits
State of Economy Recession (Period I) Alternative A (profits in cores) 9 Alternative B 0
Normal (Period II)
Boom (Period III) Total
10
11 30
10
20 30
If profit maximization is the decision criterion, both the alternatives would be ranked equally on total returns.
However, earnings associated with alt B are more uncertain (risky) as they fluctuate widely depending on state of economy. So alt A is considered feasible in terms of risk and uncertainty.
Profit max fails to reveal this.
Wealth Maximization Decision Criterion
Also known as value maximization or net present
worth maximization. It is universally recognized as an appropriate operational decision criterion for FM Its operational features satisfy all three requirements of a suitable operational objective of financial courses of action:
Exactness Quality of benefits Time Value of Money
Wealth Maximization Decision Criterion
Concept is based on cash flows generated by
decision rather than accounting profit. Cash flow is a precise concept with a definite connation as it avoids ambiguity. Value of cash flows is calculated by discounting its element back to present at a capitalization rate that reflects both time and risk. Capitalization rate is the rate that reflects time and risk preferences of owners or suppliers of capital. Large capitalization rate is the result of higher risk and longer time period.
Organization of Finance Function
Responsibilities of FM are spread throughout the organization.
Nevertheless FM is highly specialized in nature and is
handled by specialists.
Organization of Finance Function
Board of Directors Managing Director/Chairman Vice President/Director (Finance)
Treasurer
Controller
Chapter 2
Sources of Finance
Classification
Long term funds
Medium term
Short term funds
Short term sources of funds:
Useful for investment in current assets. Range from a period of one day to max of one year. Sources
are trade credit, factoring, and forfeiting, bill discounting, overdrafts and cash credits from banks and borrowings against receivables.
Classification
Long term sources of funds:
are for acquisition of long term fixed assets or in decisions to
start a new venture or expand its current business. are needed for a period of 5 to 25 years for investments Sources are from internal resources like retained earnings and external sources are from equity capital, debentures, bonds, preference shares, term loans and innovative instruments.
Medium term sources of funds:
are required to make permanent additions to working capital or
to buy fixed assets. are for a period of 1 to 5 years. Sources are leasing and hire purchase and fixed deposits from general public and directors of the company.
Security Financing
is a method of getting external source of financing for
the company.
Important securities which help in raising funds for a
company are: Equity Shares Preference Shares Debentures/Bonds
Equity Shares
Are called ownership shares Are also called high risk securities
Advantages:
Permanent source of funds
Does not have repayment liability
Does not have to pay dividends if company is not making profit.
Disadvantages:
Cost of funds is high
No tax deductible advantages for the company. Floating cost of issuing equity capital is high.
Preference Shares
Have a preferential right to receive dividends before equity
shareholders Do not have voting rights and have fixed dividends. Is a hybrid security Advantages: Do not create a charge on assets of the company Do not have an effect on control pattern of the company Are cheaper in financing compared to equity shares. Disadvantages: Are not tax deductible Have a claim over equity shareholders on assets of company, so their control is diluted.
Types of Preference Shares
Cumulative and Non-Cumulative Preference Shares
Redeemable and Irredeemable Participating and Non-participating Convertible and Non-Convertible Shares
Debentures/Bonds
Are debt securities Have a specific rate of interest and date of maturity
Advantages: Cost of debentures/bonds is low due to tax deduction of interest payments Do not create any dilution of control as holders do not have any voting rights Disadvantages: Creates a financial burden on company Suits only those companies which have a stable return Have a right to charge on property and assets of company in case of liquidation.
Types of Bonds/Debentures
Redeemable and Irredeemable
Secured and Unsecured Bonds/Debentures
Tax free Bonds Zero Coupon Bonds
Deep Discount Bonds
Participating Debentures Convertible Bonds/Debentures Floating rate Bonds Regular Income Bonds Retirement Bonds Inflation Bonds, warrant bonds etc
Loan Financing
Long term loans are taken at time of starting a new business for
expanding their activities. Loans are for period of 5 to 10 years In India, such loans are being disbursed by financial institutions like IDBI, ICICI and IFCI. Features: Security Interest Rate Repayment of loans Restrictive provisions
Loan Financing
Advantages: Are attractive as they have low rate of interest and have low financial burden Interest charges are tax deductible Disadvantages: Have restrictions on working of the company. Some covenants are negative and functioning of company becomes difficult Flexibility is reduced and company has to work acc to rules and regulations framed by lender until loan is returned.
Project Financing
Managing
and financing infrastructural projects.
economic
activities
of
large
High cost with large volume of funds such as power stations,
fertilizer plants, satellites, oil, gas and hotel projects are some of the infrastructural projects in which special techniques are required to manage its finances.
Is a series of techniques for assessing risks and calculation of
cash flows generated by a project.
Loan Syndication
Is a service provided by merchant bankers for financing a
project or for working capital requirements of a company.
Financial institutions like IFCI, IDBI, ICICI, LIC, UTI, GIC and
SFCs are suppliers of finance for loan syndication. Steps Involved: Preparation of detailed project report by merchant bankers Identification of lenders Holding meetings and discussions and negotiate with lenders on loan amount, rate of interest and other terms Prepare a loan application and submit completed app to financial institution Merchant banker obtains letter of intent
Loan Syndication
Steps Involved contd: Negotiations regarding security offered on loans are made with financial institutions. When loan document is complete, merchant banker assists financial institution to disburse the loan to borrower. Advantages: Merchant bankers helps company to identify potential sources of finance for taking loans for a fee. Best Price Disbursal of loan quickly. Disadvantages: Payment of fees
New Financial Institutions & Instruments
In India, several reforms were made to strengthen financial
system after 1991.
Financial reforms were intended to move from controlled
economy to a free economy with following objectives:
Develop financial sector infrastructure Bring about financial supervision for investor protection Financial liberalization for moving from controlled economy to efficient market driven economy. Bring about improvement in quality of services and bring in confidence amongst the savers for encouraging savings Introduce new financial instruments for giving options to investor Emphasize requirement of protection of investors from fraudulent bills.
New Financial Institutions & Instruments
Contributors to Financial System Household sector which are suppliers of funds
Firms that are engaged in commercial activities and require
funds for carrying on business activities
Government which regulates the market through policies and
regulations and gives direction.
Financial institutions which play role of giving funds and
putting savers and investors together.
Financial instruments which facilitate transfer of money within
a country and internationally.
Book Building
New Issue market/Primary market performs functions of
providing an environment for sale and purchase of new issues. Stock market has the function of trading in securities after new securities are allotted and then listed with it. Book Building is used in context of sale of a new security offered for the first time in New Issue market before trading of this share begins in stock market. Process of offering shares to public in new issue market through public demand by bidding for the shares. Based on bids, price is discovered. A price band is given and public is asked to bid for price within that band. Fairly new concept and one of the developments in financial sector to bring about a fair and just system of issuing shares through openness and public demand.
Depository or Paperless trading
Dematerialization of securities for electronic trading of shares is
one of the major steps for improving and modernizing stock market and enhancing level of investor protection. Advantages: Eliminates risk as it does not have physical certificates. Expedite transfer of shares through electronic transfer. De-mat account which provides client identification number and depository identification number. Account statement which is similar as in case of a bank. No Stamp duty on transfer of securities as there is no physical transfer. Allows a nomination facility Automatic credit of bonus amount and other benefits of consolidation or merger
Factoring
Is a financial service for financing credit sales in which
receivables are sold by a company to specialized financial intermediary called factor. Factor provides several services to a company that draws an agreement for managing its receivables.
Parties to factoring: Seller sells goods on credit to buyer. He gives delivery invoice and instructs buyer to pay amount due on credit sales to his agent or factor. Buyer makes an agreement with seller after negotiating terms and signing a memorandum of understanding. Factor is a financial intermediary between buyer and seller. He is an agent of seller. Factor pays 80% of price in advance and receives payment from buyer on due date, then remits balance to seller after deducting his commission.
Types of Factoring
With Recourse Factoring : factor does not take credit risks
which is associated with receivables. Factor has the right to receive commission and his expenses for maintaining sales ledger.
Without Recourse Factoring: Factor has to bear all losses that
arise out of irrecoverable receivables. For this he charges a higher commission which is premium for higher risk. Factor takes a great interest in business matters of client in this type of factoring.
Venture Capital
Is a private equity investment fund through which funds are
borrowed by investors who have technical know how.
Venture capitalists make an agreement whereby they support
the project and fund it, in return for monetary gains, shareholding and acquisition rights in business financed by them.
Fist venture capital in India was established by IFCI in 1975. Other venture capital funds in India are IDBI Venture capital fund ICICI venture funds management company limited
Credit Rating
Is a service provided by a credit rating agency for evaluating a
security and rating it by grading it according to its quality.
In India credit rating had its inception n 1987 with incorporation
of firsts service company named CRISIL Credit Rating Information Services of India Four rating agencies in India which are registered and regulated by SEBI:
CRISIL ICRA Investment Information and Credit Rating Agency of India CARE Credit analysis and Research Ltd. Duff and Phleps.
Objectives of Credit Rating
To analyze the risks of the company Provide information to investor for selecting debt securities Express an opinion of company by grading of debt securities
with technical expertise.
Debenture Rating Symbols
AAA AA A Highest Safety High Safety Adequate safety
Fixed Deposit Rating Symbols
FAAA FAA FA FB Highest Safety High Safety Adequate safety Moderate safety
BBB moderate safety
Commercial Paper (CP)
Is an unsecured short term negotiable instrument with fixed
maturity. Used for raising short term debt.
Is a promise by borrowing company to return loan on specified
date of payment.
Unsecured promissory note which is issued for a period of 7
days and three months.
In India CP are popularly used between 91 to 180 days. Corporate organization can directly issue commercial papers to
investors (direct paper) or can be indirectly issued through a bank or a dealer (dealer paper).
Certificate of Deposit (CDs)
Is a securitized short term deposit issued by banks at high rates
of interest during period of low liquidity. Liquidity gap is met by banks by issuing CDs for short period. In India, CDs are being issued by banks directly or through dealers. Are part of bank deposits and issued for 90 days but maturity period vary acc to corporate organizations Min issue of CDs to single investor is 10 lakh rupees.
Advantages: Reliable Liquidity Flexible Trading
International Depository Receipts
American Depository Receipts Are a method of raising funds in America in US stock markets. First ADR was issued in 1920 to invest in oversees markets and to provide a base to non-USA companies to invest in stock market in USA. ADRs could be traded only in USA. European Depository Receipts EDRs are issued in Europe and denominated in European currency. EDRs have a small market and are not attractive instruments. Are not well developed like ADRs and GDRs.
International Depository Receipts
Global Depository Receipts
Are a method of raising equity capital by organizations which
are in Asian countries. Are placed in USA, Europe and Asia. Have a low cost and help in bringing liquidity. Govt of India allowed Indian cos to mobilize funds from foreign markets through Euro issues of GDRs and foreign currency convertible bonds. Cos with good track record can issue GDRs for developing infrastructure projects in power, telecommunications and petroleum and in construction and development of roads, airports and ports in India.
International Depository Receipts
Indian Depository Receipts
Are like ADRs and GDRs. A new instrument as a source of raising finance. Instrument provides global companies to have an entry in Indian
capital market. Global companies can issue IDRs and raise money from India. Although this instrument has been accepted as an international financial instrument for raising funds, legal formalities are still being worked out by Department of Company Affairs.
Chapter 3
Concepts in Valuation
Time Value of Money
Value of a unit of money is different in different time
periods i.e. Value of a sum of money received today is more than its value received after sometime.
Due to reinvestment opportunities for funds which are
received early.
Since a rupee received today has more value,
rational investors would prefer current receipts to future receipts.
Time Value of Money
Mr. X has option of receiving Rs 1000 now or one
year later. What would be his choice?
He can deposit this amount received now and earn
nominal rate of interest (3%). At the end of the year, amount accumulates to Rs 1030.
As a rational person, he should be expected to prefer
the larger amount (Rs 1030 here).
Same principle applies to a business firm.
Relevance of Time Value of Money
Money received today is higher in value than after a
certain period because of uncertainties, inflation and preference for current consumption and opportunities for reinvestment to get a higher yield.
Importance of money can be analyzed for three
reasons: Compensation for Uncertainty Preference for Current Consumption Reinvestment Opportunity
Techniques of Time Value of Money
Basic techniques are:
Compounding for Future Values Discounting for present Value
Future Value
If you were to invest Rs 10,000 at 5-percent interest for one
year, your investment would grow to Rs 10,500 Rs 500 would be interest (Rs 10,000 .05) Rs 10,000 is the principal repayment (Rs10,000 1) Rs 10,500 is the total due. It can be calculated as: Rs10,500 = Rs10,000(1.05). The total amount due at the end of the investment is call the Future Value (FV).
Compound / Future Value
In the one-period case, the formula for FV can be written as: FV = PV (1 + i)n
Where PV is cash flow today (time zero), present value i is the appropriate interest rate for 1 period n is the number of years
Compound / Future Value
In the multi- period case, the formula for FV can be written as: FV = PV (1 + i/m)nm
Where PV is cash flow today (time zero), present value i is the appropriate interest rate for 1 period n is the number of years m is number of compounding per year
Compound Value of Annuity
Compound Value = Annuity Amount * Compound Value Annuity Factor FV = A * CVAF
Present Value
PV can be calculated through discounting approach. If you were to be promised Rs10,000 due in one year when
interest rates are at 5-percent, your investment be worth Rs9,523.81 in todays rupees. RS 9523.81 = Rs 10000/1.05 The amount that a borrower would need to set aside today to be able to meet the promised payment of Rs10,000 in one year is call the Present Value (PV) of Rs10,000. Note that Rs10,000 = Rs9,523.81(1.05).
Present Value
In the one-period case, the formula for PV can be written as: PV = FV/ (1 + i)n
Where PV is cash flow today (time zero), present value i is the appropriate interest rate for 1 period n is the number of years
Present Value
In the multi- period case, the formula for FV can be written as: PV = FV/ (1 + i/m)nm
Where PV is cash flow today (time zero), present value i is the appropriate interest rate for 1 period n is the number of years m is number of compounding per year
Practical Applications
Valuation of Securities
Valuation of Debentures
Valuation of Preference shares
Valuation of Equity Shares
