bhu mba 2v financial management notes

FinancialManagement Unit1

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Unit1 FinancialManagement

Structure

1.1 Introduction

1.2 MeaningAndDefinitions

1.3 GoalsOfFinancialManagement

1.3.1 ProfitMaximization

1.3.2 WealthMaximization

1.4FinanceFunctions

1.4.1 InvestmentDecisions:

1.4.2 FinancingDecisions:

1.4.3 DividendDecisions

1.4.4 LiquidityDecision

1.5OrganizationOfFinanceFunction

1.5.1 InterfaceBetweenFinanceAndOtherBusinessFunctions

1.5.2 FinanceAndAccounting

1.5.3 FinanceAndMarketing

1.5.4 FinanceAndProduction(Operations)

1.5.5 FinanceAndHR

1.6 Summary

TerminalQuestions

AnswerstoSAQsandTQs

1.1 Introduction

Toestablishanybusiness,apersonmustfindanswerstothefollowingquestions:

a) Capital investments are required tobemade.Capital investments aremade to acquire the

realassets,requiredforestablishingandrunningthebusinesssmoothly.Realassetsareland

andbuildings,plantandequipmentsetc.

b) Decisiontobetakenonthesourcesfromwhichthefundsrequiredforthecapitalinvestments

mentionedabovecouldbeobtained,tobetaken.

c) Therefore, thereare twosourcesoffundsviz.debtandequity. Inwhatproportionthefunds

aretobeobtainedfromthesesourcesistobedecidedforformulatingthefinancingplan.

suryaStamp


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d) Decisionontheroutineaspectsofdaytodaymanagementofcollectingmoneyduefromthe

firmscustomersandmakingpaymentstothesuppliersofvariousresourcestothefirm.

Thesearethecoreelementsoffinancialmanagementofafirm.

FinancialManagementofafirmisconcernedwithprocurementandeffectiveutilizationoffunds

for thebenefitof its stakeholders. Themostadmired Indian companiesareReliance, Infosys.

Theyhavebeenratedwellbythefinancialanalystonmanycrucialaspectsthatenabledthemto

createvalue for itsshareholders. Theyemploy thebest technology,producequalitygoodsor

renderservicesattheleastcostandcontinuouslycontributetotheshareholderswealth.

Allcorporatedecisionshavefinancialimplications.Therefore,financialmanagementembracesall

thosemanagerialactivitiesthatarerequiredtoprocurefundsattheleastcostandtheireffective

deployment.Financeisthelifebloodofallorganizations.Itoccupiesapivotalroleincorporate

management. Any business which ignores the role of finance in its functioning cannot grow

competitively in todays complex business world. Value maximization is the cardinal rule of

efficientfinancialmanagerstoday.

LearningObjectives:

Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. ThemeaningofBusinessFinance.

2. TheobjectivesofFinancialManagement.

3. Thevarious interfacesbetweenfinanceandothermanagerial functions ofafirm.

1.2MeaningAndDefinitions

The branch of knowledge that deals with the art and science of managing money is called

financialmanagement. With liberalization and globalization of Indian economy, regulatory and

economicenvironmentshaveundergonedrasticchanges.ThishaschangedtheprofileofIndian

financemanagerstoday.Indianfinancialmanagershavetransformedthemselvesfromlicensed

raj managers to well informed dynamic proactive managers capable of taking decisions of

complexnatureinthepresentglobalscenario.

Traditionally, financial management was considered a branch of knowledge with focus on the

procurementoffunds.Instrumentsoffinancing,formation,merger&restructuringoffirms,legal

andinstitutionalframeworkinvolvedthereinoccupiedtheprimeplaceinthistraditionalapproach.

suryaTypewritten Text 2008-2012 GreeneStep Technologies. All rights reserved. All trademarks are property of respective owners.


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Themodernapproachtransformedthefieldofstudyfromthetraditionalnarrowapproachto the

mostanalyticalnature.Thecoreofmodernapproachevolvedaround,procurementoftheleast

costfundsanditseffectiveutilizationformaximizationofshareholderswealth.Globalizationof

business and impact of information technology on financial management have added new

dimensionstothescopeoffinancialmanagement.

SelfAssessmentQuestion1

1. FinancialManagementdealswithprocurementoffundsattheleastcostand______funds.

1.3GoalsOfFinancialManagement

Goalsmean financialobjectiveofafirm. Experts in financialmanagement haveendorsed the

viewthatthegoalofFinancialManagementofafirmismaximizationofeconomicwelfareofits

shareholders. Maximization of economic welfare means maximization of wealth of its

shareholders. Shareholders wealthmaximization is reflected in themarket value of the firms

shares.Afirmscontributiontothesociety ismaximizedwhenitmaximizes itsvalue.Thereare

twoversionsofthegoalsoffinancialmanagementofthefirm:

1.3.1 ProfitMaximization:

Inacompetitiveeconomy,profitmaximizationhasbeenconsideredasthelegitimateobjectiveof

a firm because profit maximization is based on the cardinal rule of efficiency. Under perfect

competition allocationof resourcesshall bebasedon thegoalof profitmaximization. A firms

performance is evaluated in terms of profitability. Investors perception of companys

performancecanbetracedtothegoalofprofitmaximization.But,thegoalofprofitmaximization

hasbeencriticizedonmanyaccounts:

1. Theconceptofprofitlacksclarity.Whatdoestheprofitmean?

a) Isitprofitaftertaxorbeforetax?

b) Isitoperatingprofitornetprofitavailabletoshareholders?

Differences in interpretationon the concept of profit expose theweaknessof the goalof profit

maximization

2. Profitmaximization ignores time value ofmoneybecause it does not differentiate between

profitsofcurrentyearwiththeprofittobeearnedinlateryears.


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3. Theconceptofprofitmaximizationfails toconsiderthefluctuationintheprofitsearnedfrom

yeartoyear.Fluctuationsmaybeattributabletothebusiness riskofthefirmbuttheconcept

failstothrowlightonthisaspect.

4. Profitmaximizationdoesnotmakeclear theconceptofprofitas towhether itisaccounting

profitoreconomicnormalprofitoreconomicsupernormalprofits.

5.Becauseofthesedeficiencies,profitmaximizationfailstomeetthestandardsstipulatedinan

operationallyfeasiblecriterionformaximizingshareholderswealth.

1.3.2 WealthMaximization

WealthMaximization has, beenacceptedby the financemanagers, because it overcomes the

limitationsofprofitmaximisation. Wealthmaximisationmeansmaximizingthenetwealthofthe

Companys share holders. Wealth maximisation is possible only when the company pursues

policiesthatwouldincreasethemarketvalueofsharesofthecompany.

Following arguments are in support of the superiority of wealth maximisation over profit

maximisation:

1. Wealthmaximisationisbasedontheconceptofcashflows.Cashflowsarearealityandnot

based on any subjective interpretation. On the other hand there are many subjective

elementsintheconceptofprofitmaximisation.

2. It considers timevalue ofmoney. Time value ofmoneytranslatescash flowsoccurringat

differentperiodsintoacomparablevalueatzeroperiod.In thisprocess,thequalityofcash

flowsisconsideredcriticallyinalldecisionsasitincorporatestheriskassociatedwiththecash

flowstream.Itfinallycrystallizesintotherateofreturnthatwillmotivateinvestorstopartwith

theirhardearnedsavings.Itiscalledrequiredrateofreturnorhurdleratewhichisemployed

in evaluating all capital projects undertaken by the firm. Maximizing the wealth of

shareholdersmeanspositive net presentvalueof the decisions implemented. Positive net

presentvaluecanbedefinedastheexcessofpresentvalueofcashinflowsofanydecision

implemented over the present value of cash out flows associated with the process of

implementationofthedecisionstaken.Tocomputenetpresentvalueweemploytimevalue

factor. Timevaluefactorisknownastimepreferenceratei.e. thesumofriskfreerateand

riskpremium.Riskfreerateistheratethataninvestorcanearnonanygovernmentsecurity

forthedurationunderconsideration.Riskpremiumistheconsiderationfortheriskperceived

bytheinvestorininvestinginthatassetorsecurity.

XLtd isa listedcompanyengaged in thebusinessofFMCG(FastMovingConsumergoods).

Listedmeansthecompanyssharesareallowedtobetradedofficiallyontheportalsofthestock


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exchange.TheBoardofDirectorsofXLtdtookadecisioninoneofitsBoardmeeting,toenter

into thebusinessof power generation.When the company informs the stockexchangeat the

conclusionof themeetingof the decision taken, thestockmarket reactsunfavourably with the

resultthatthenextdaysclosingofquotationwas30%lessthanthatofthepreviousday.

Thequestionnow is,whythemarket reacted in thismanner. Investors in thisFMCGCompany

mighthavethought that theriskprofileof thenewbusiness(power) that thecompanywantsto

takeupishighercomparedtotheriskprofileoftheexistingFMCGbusinessoftheXLtd.When

theywantahigherreturn,marketvalueofcompanyssharedeclines.Thereforetheriskprofileof

the company gets translated into a timevalue factor. The time value factor so translated

becomestherequiredrateofreturn. Requiredrateofreturnisthereturnthattheinvestorswant

formakinginvestmentinthatsector.

Anyprojectwhichgeneratespositivenetpresentvaluecreateswealthtothecompany.Whena

companycreateswealthfromacourseofactionithasinitiatedtheshareholdersbenefitbecause

suchacourseofactionwillincreasethemarketvalueofthecompanysshares.

SuperiorityofWealthMaximisationoverProfitMaximisation

1. Itisbasedoncashflow,notbasedonaccountingprofit.

2. Through the processof discounting it takes care of the quality of cash flows. Distant cash

flowsareuncertain.Convertingdistantuncertaincashflowsintocomparablevaluesatbase

periodfacilitatesbettercomparisonofprojects. Therearevariouswaysofdealingwith risk

associatedwithcashflows. Theserisksareadequatelyconsideredwhenpresentvaluesof

cashflowsaretakentoarriveatthenetpresentvalueofanyproject.

3. In todays competitive business scenario corporates play a key role. In company form of

organization,shareholdersownthecompanybutthemanagementofthecompanyrestswith

the board of directors. Directors are elected by shareholders and hence agents of the

shareholders. Companymanagementprocuresfundsforexpansionanddiversificationfrom

CapitalMarkets. In the liberalized set up, the society expectscorporatesto tap the capital

markets effectively for their capital requirements. Therefore to keep the investors happy

throughtheperformanceofvalueofsharesinthemarket,managementofthecompanymust

meetthewealthmaximisationcriterion.

4. Whena firm follows wealthmaximisationgoal, itachievesmaximizationofmarket valueof

share.Whenafirmpracticeswealthmaximisationgoal,itispossibleonlywhenitproduces

qualitygoodsatlowcost.Onthisaccountsocietygainsbecauseofthesocietalwelfare.


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5. Maximizationofwealthdemandsonthepartofcorporatestodevelopnewproductsorrender

newservicesinthemosteffectiveandefficientmanner.Thishelpstheconsumersas itwill

bringtothemarkettheproductsandservicesthatconsumersneed.

6. Another notable features of the firms committed to the maximisation of wealth is that to

achievethisgoaltheyareforcedtorenderefficientservicetotheircustomerswithcourtesy.

Thisenhancesconsumerwelfareandhencethebenefittothesociety.

7. Fromthepointofevaluationofperformanceoflistedfirms, themostremarkablemeasureis

that of performance of the company in the sharemarket. Every corporateaction finds its

reflection on themarket valueof shares of the company. Therefore, shareholders wealth

maximizationcouldbeconsideredasuperiorgoalcomparedtoprofitmaximisation.

8. Sincelistingensures liquidity tothesharesheldbythe investors,shareholderscanreapthe

benefits arising from the performance of company only when they sell their shares.

Therefore,itisclearthatmaximizationofmarketvalueofshareswillleadtomaximisationof

thenetwealthofshareholders.

Therefore,wecanconcludethatmaximizationofwealthistheappropriateofgoaloffinancial

managementintodayscontext.

SelfAssessmentQuestions2

1.Underperfectcompetition,allocationofresourcesshallbebasedonthegoalof_______.

2._____________isbasedoncashflows.

3.__________________considertimevalueofmoney.

1.4 FinanceFunctions

Financefunctionsarecloselyrelatedtofinancialdecisions.Thefunctionsperformedbyafinance

manager are known as finance functions. In the course of performing these functions finance

managertakesthefollowingdecisions:

1.Financingdecision 2.InvestmentDecision 3.Dividenddecision 4.Liquiditydecision.


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1.4.1 InvestmentDecisions:

To survive and grow, all organizations must be innovative. Innovation demands managerial

proactiveactions.Proactiveorganization continuouslysearchforinnovativewaysofperforming

the activities of the organization. Innovation iswider in nature. It couldbe expansion through

entering into new markets, adding new products to its product mix, performing value added

activitiestoenhancethecustomersatisfaction,oradoptingnewtechnologythatwoulddrastically

reduce the cost of production or rendering services or mass production at low cost or

restructuring the organization to improve productivity. All these will change the profile of an

organization.Thesedecisionsarestrategicbecause,theyareriskybutifexecutedsuccessfully

withaclearplanofaction,theygeneratesupernormalgrowthtotheorganization.

If themanagementerrsinanyphaseoftakingthesedecisionsandexecutingthem,thefirmmay

becomebankrupt. Therefore,suchdecisionswillhavetobe takenafter taking intoaccountall

factsaffectingthedecisionsandtheirexecution.

Twocriticalissuestobeconsideredinthesedecisionsare:

1. Evaluationofexpectedprofitabilityofthenewinvestments.

2. Rateofreturnrequiredontheproject.

The rate of return required by investor is normally known by hurdle rate or cutoff rate or

opportunitycostofcapital.

Afterafirmtakesadecisiontoenterintoanybusinessorexpanditsexistingbusiness,plansto

investinbuildings,machineriesetc.areconceivedandexecuted.Theprocessinvolvediscalled

CapitalBudgeting.CapitalBudgetingdecisionsdemandconsiderabletime,attentionandenergy

of themanagement.Theyarestrategicinnatureasthesuccessorfailureofanorganization is

directlyattributabletotheexecutionofcapitalbudgetingdecisionstaken.

Investment decisions are also known as Capital Budgeting Decisions. Capital Budgeting

decisionsleadtoinvestmentinrealassets

Dividendsarepayoutstoshareholders.Dividendsarepaidtokeeptheshareholdershappy.

Dividendpolicyformulationrequiresthedecisionofthemanagementastohowmuchofthe

profitsearnedwillbepaidasdividend.Agrowingfirmmayretainalargeportionofprofitsas

retainedearningstomeetitsneedsoffinancingcapitalprojects.Here,thefinancemanagerhas

tostrikeabalancebetweentheexpectationofshareholdersondividendpaymentandtheneedto

provideforfundsoutoftheprofitstomeettheorganizationsgrowth.

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1.4.2 FinancingDecisions:

Financing decisions relate to the acquisition of funds at the least cost. Here cost has two

dimensionsvizexplicitcostandimplicitcost.

Explicitcostreferstothecostintheformofcouponrate,costoffloatingandissuingthesecurities

etc.

Implicitcostisnotavisiblecostbutitmayseriouslyaffect thecompanysoperationsespecially

when itisexposedtobusinessandfinancialrisk.Forexample,implicitcostisthefailureofthe

organizationtopaytoitslendersordebentureholdersloaninstallmentsonduedateonaccount

of fluctuations in cash flow attributable to the firms business risk. In India if the company is

unabletopay itsdebts,creditorsof thecompanymayuse legalmeanstosuethecompanyfor

windingup.Thisriskisnormallyknownasriskofinsolvency.Acompanywhichemploysdebtas

ameansoffinancingnormallyfacesthisriskespeciallywhenitsoperationsareexposedtohigh

degreeofbusinessrisk.

In all financing decisions a firm has to determine the proportion of equity and debt. The

compositionofdebtandequityiscalledthecapitalstructureofthefirm.

Debtischeapbecause interestpayableon loan isallowedasdeductions incomputingtaxable

income on which the company is liable to pay income tax to the Government of India. For

example,if the interestrateon loantaken is12%, taxrateapplicableto thecompanyis50%,

thenwhenthecompanypaysRs.12asinteresttothelender,taxableincomeofthecompanywill

bereducedbyRs.12.

Inotherwordswhenactualcostis12%withthetaxrateof50%theeffectivecostbecomes6%

therefore, debt is cheap. But, every installment of debt brings along with it corresponding

insolvencyrisk.

Anotherthingnotableinthisconnectionisthatthefirmcannotavoiditsobligationtopayinterest

andloaninstallmentstoitslendersanddebentures.

Ontheotherhand,acompanydoesnothaveanyobligationtopaydividendtoitsshareholders.

A company enjoys absolute freedom not to declare dividend even if its profitability and cash

positionsarecomfortable. However,shareholdersareoneofthestakeholdersof thecompany.

Theyareinrealitytheownersofthecompany.Thereforewellmanagedcompaniescannotignore

the claim of shareholders for dividend. Dividend yield is an important determinant for stock

prices.Dividendyieldreferstodividendpaidwithreferencetothemarketpriceofthesharesof

thecompany.Aninvestorincompanysshareshastwoobjectivesforinvesting:

1. IncomefromCapitalappreciation(i.e.Capitalgainsonsaleofsharesatmarketprice)

2. Incomefromdividends.


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Itistheabilityofthecompanytogiveboththeseincomestoitsshareholdersthatdeterminesthe

marketpriceofthecompanysshares.

The most important goal of financial management is maximisation of net wealth of the

shareholders. Therefore,management of everycompany should strive hard to ensure that its

shareholdersenjoybothdividendincomeandcapitalgainsaspertheexpectationofthemarket.

But,dividendisdeclaredoutoftheprofitearnedbythecompanyafterpayingincometaxtothe

GovtofIndia.

Forexample,letusassumethefollowingfacts:

Dividend=12%onpaidupvalue

Taxrateapplicabletothecompany=30%

Dividendtax=10%

When a Company pays Rs.12 on paid up Capital of Rs.100 as dividend, the profit that the

companymustearnbeforetaxis:

Since payment of dividend by an Indian Company attracts dividend tax, the companywhen it

paysRs.12toshareholders,mustpaytotheGovtofIndia

10%ofRs.12=Rs.1.2asdividendtax.Thereforedividendanddividendtaxsumupto12+1.2

=Rs.13.2

Sincethisispaidoutoftheposttaxprofit,inthis question,thecompanymustearn:

Posttaxdividendpaid

1Taxrateapplicabletothecompany=pretaxprofitrequiredtodeclareandpaythedividend

13.2 13.2

10.3 0.7

Therefore, todeclareadividendof12%Companyhastoearnapretaxprofitof19%.Onthe

other hand, to payan interest of 12% Company has to earn only 8.4%. This leads to the

conclusionthatforeveryRs.100procuredthroughdebt,itcosts8.4%whereasthesameamount

procuredintheformofequity(sharecapital)costs

19%. This confirms the established theory that equity is costly but debt is a cheap but risky

sourceoffundstothecorporates.

The challenge before the financemanager is toarriveat acombinationof debt and equity for

financingdecisionswhichwouldattainanoptimalstructureofcapital.Anoptimalstructureisone

thatarrivesattheleastcoststructure,keepinginmindthefinancialriskinvolvedandtheabilityof

thecompanytomanagethebusinessrisk.Besides,financingdecisioninvolvestheconsideration

ofmanagerialcontrol,flexibilityandlegalaspects.Assuchitinvolves quitealotofregulatoryand

managerialelementsinfinancingdecisions.

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1.4.3 DividendDecisions

Dividendyieldisanimportantdeterminantofaninvestorsattitudetowardsthesecurity(stock)in

his portfolio management decisions. But dividend yield is the result of dividend decision.

Dividend decision is a major decision made by a finance manager. It is the decision on

formulationofdividendpolicy.Sincethegoaloffinancialmanagementismaximisationofwealth

ofshareholders,dividendpolicyformulationdemandsthemanagerialattentionontheimpactof

its policy on dividend on the market value of the shares. Optimum dividend policy requires

decisionondividendpaymentratessoastomaximizethemarketvalueofshares. Thepayout

ratiomeanswhatportionofearningspershare isgiventotheshareholdersintheformofcash

dividend. In the formulationof dividendpolicy,management of a companymust consider the

relevanceofitspolicyonbonusshares.

Dividendpolicy influencesthedividendyieldonshares. SincecompanysratingsintheCapital

market have amajor impact on its ability to procure fundsby issuing securities in the capital

markets,dividendpolicy,adeterminantofdividendyieldhastobeformulatedhavingregardtoall

the crucial elements in building up the corporate image. The following need adequate

considerationindecidingondividendpolicy:

1. PreferencesofshareholdersDotheywantcashdividendorCapitalgains?

2. Currentfinancialrequirementsofthecompany

3. Legalconstraintsonpayingdividends.

4. Striking an optimum balance between desires of share holders and the companys funds

requirements.

1.4.4 LiquidityDecision

LiquiditydecisionsareconcernedwithWorkingCapitalManagement. It isconcernedwith the

daytodayfinancialoperationsthatinvolvecurrentassetsandcurrentliabilities.

Theimportantelementofliquiditydecisionsare:

1) Formulationofinventorypolicy

2) Policiesonreceivablemanagement.

3) Formulationofcashmanagementstrategies

4) Policiesonutilizationofspontaneousfinanceeffectively.

1.4.5 OrganizationOfFinanceFunction

Financialdecisionsarestrategicincharacterandtherefore,anefficientorganizationalstructure

isrequiredtoadministerthesame.Financeislikebloodthatflowsthroughouttheorganization.


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InallorganizationsCFOsplayanimportantroleinensuringproperreportingbasedon

substancetothestakeholdersofthecompany.Becauseofthecrucialrolethesefunctionsplay,

financefunctionsareorganizeddirectlyunderthecontrolofBoardofDirectors.Forthesurvival

ofthefirm,thereisaneedtoensurebothlongtermandshorttermfinancialsolvency. Failureto

achievethiswillhaveitsimpactonallotheractivitiesofthefirm.

Weakfunctionalperformancebyfinancialdepartmentwillweakenproduction,marketingandHR

activitiesofthecompany.Theresultwouldbetheorganizationbecominganemic.Once

anemic,unlesscrucialandeffectiveremedialmeasuresaretakenupitwillpavewayfor

corporatebankruptcy.

CFOreportstotheBoardofDirectors. UnderCFO,normallytwoseniorofficersmanagethe

treasurerandcontrollerfunctions.

ATreasurerperformsthefollowingfunction:

1. Obtainingfinance.

2. Liasoningwithtermlendingandotherfinancialinstitutions.

3. Managingworkingcapital.

4. Managinginvestmentinrealassets.

AControllerperforms:

1. AccountingandAuditing

2. Managementcontrolsystems

3. Taxationandinsurance

4. Budgetingandperformanceevaluation

5. Maintaining assets intact to ensurehigher productivity of operating capital employed in the

organization.

In India CFOs have a legal obligation under various regulatory provisions to certify the

correctnessofvariousfinancialstatementsinformationreportedtothestakeholdersintheannual

reports. Listing norms, regulationson corporate governanceand other notificationsofGovtof

IndiahaveadequatelyrecognizedtheroleoffinancefunctioninthecorporatesetupinIndia.


1.____________leadtoinvestmentinrealassets.

2._______________relatetotheacquisitionoffundsattheleastcost.

3.Formulationofinventorypolicyisanimportantelementof___________.

4.Obtainingfinanceisanimportantfunctionof_________.


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1.5 InterfaceBetweenFinanceAndOtherBusinessFunctions

1.5.1 FinanceAndAccounting

Lookingatthehierarchyofthefinancefunctionofanorganization,thecontrollerreportstoCFO.

Accountingisoneofthefunctionsthatacontrollerdischarges.Accountingandfinanceareclosely

related. ForcomputationofReturnon Investment,earningspershareandofvarious ratiosfor

financial analysis the data base will be accounting information. Without a proper accounting

system, an organization cannot administer effectively function of financial management. The

purposeofaccountingistoreportthefinancialperformanceofthebusinessfortheperiodunder

consideration. It is historical in character. But financial management uses the historical

accounting information for decisionmaking. All the financial decisions are futuristic based on

cash flow analysis. All the financial decisions consider quality of cash flows as an important

elementofdecisions.Sincefinancialdecisionsarefuturistic,itistakenandputintoeffectunder

conditionsofuncertainty.

Assumingthedegreeofuncertaintyandincorporatingtheireffectondecisionmakinginvolveuse

ofvariousstatisticalmodels.Intheselectionofthesemodels,elementofsubjectivitycreepsin.

1.5.2 FinanceAndMarketing

Manymarketing decisions have financial implications. Selections of channels of distribution,

decidingonadvertisementpolicy,remuneratingthesalesmenetchavefinancialimplications.In

fact,therecentbehaviourofrupeeagainstus$(appreciationofrupeeagainstUSdollar),affected

thecashflowpositionsofexportorientedtextileunitsandBPOsandothersoftwarecompanies.

Itisgenerallybelievedthatthecurrencyinwhichmarketingmanagerinvoicestheexportsdecides

thecashflowconsequencesoftheorganizationifthecompanyismainlydependentonexports.

Marketing cost analysis, a function of finance managers is thebest example of application of

principlesoffinanceontheperformanceofmarketingfunctionsbyabusinessunit. Formulation

ofpolicyoncreditmanagementcannotbedoneunlesstheintegrationofmarketingwithfinanceis

achieved.Decidingoncredittermstoachieveaparticularlevelofsaleshasfinancialimplication

becausesanctioningliberalcreditmayresultinhugebaddebt,ontheotherhandaconservative

credittermsmaydepressthesales.Credittermsalsoaffecttheinvestmentinreceivable,anarea

of working capital management. There is a close relation between inventory and sales. Co

ordination of stores administration with that of marketing management is required to ensure

customersatisfactionandgoodwill.Butinvestmentininventoryrequiresthefinancialclearance

becausefundsarelockedinandthefundssoblockedhaveopportunitycostofcapital.


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1.5.3FinanceAndProductions(Operations)

Financeandoperationsmanagementarecloselyrelated.Decisionsonplantlayout,technology

selection,productions / operations,processplant size, removing imbalance inthe flowof input

material in the production / operation process and batch size are all operations management

decisionsbuttheirformulationandexecutioncannotbedoneunlessevaluatedfromthefinancial

angle. The capital budgeting decisions are closely related to production and operations

management.Thesedecisionsmakeormarabusinessunit.Wehaveexamplestosubstantiate

this. Failure to understand the implications of the latest technological trend on capacity

expansionshascostevenbluechipcompanies.ManytextileunitsinIndiabecamesickbecause

they did not provide sufficient finance for modernization of plant and machinery. Inventory

management is crucial to successful operation management. But management of inventory

involvesquitealotoffinancialvariables.

1.5.4 FinanceAndHR

Attractingandretainingthebestmanpowerintheindustrycannotbedoneunlesstheyarepaid

salaryatcompetitiverates. Ifanorganizationformulates&implementsapolicyforattractingthe

competent man power it has to pay the most competitive salary packages to them. But it

improvesorganizationalcapitalandproductivity.Infosysdoesnothavephysicalassetssimilarto

thatofIndianRailways.Butifbothweretocometocapitalmarketwithapublicissueofequity,

InfosyswouldcommandbetterinvestorsacceptancethantheIndianRailways.Thisisbecause

thevalueofhumanresourcesplaysanimportantroleinvaluingafirm.Thebetterthequalityof

manpower inanorganization, thehigher thevalueof thehumancapitalandconsequently the

highertheproductivityoftheorganization.

IndianSoftwareandITenabledserviceshavebeengloballyacclaimedonlybecauseoftheman

powertheypossess.Butithasacostfactori.e.thebestremunerationtothestaff.

1.6Summary

Financial Management is concerned with the procurement of the least cost funds and its

effectiveutilizationformaximizationof thenetwealthof thefirm.Thereexistsacloserelation

betweenthemaximizationofnetwealthofshareholdersandthemaximizationofthenetwealth

of the company. The broad areas of decision are capital budgeting, financing, dividend and

working capital. Dividend decision demands the managerial attention to strike a balance

betweentheinvestorsexpectationandtheorganizationsgrowth.


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TerminalQuestions

1. Whataretheobjectivesoffinancialmanagement?

2. Howdoesafinancemanagerarriveatanoptimalcapitalstructure?

3. Examinetherelationshipoffinancialmanagementwithotherfunctionalareasofafirm.

AnswersToSelfAssessmentQuestionss

SelfAssessmentQuestions1:

1. Effectiveutilization


1. Profitmaximisation.

2. Wealth maximisation

3. Wealthmaximisation


1. Investmentdecisions.

2. Financingdecisions

3. Liquidity

4. Treasures

AnswerforTerminalQuestions

1. Refer1.3

2. Refer1.4.1

3. Refer1.5


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Unit2FinancialPlanning

Structure

2.1. Introduction

2.2. Stepsinfinancialplanning

2.3. Factorsaffectingfinancialplan

2.4. Estimationoffinancialrequirementsofafirm.

2.5. Capitalizations

2.1.1 CostTheory

2.1.2 Earningstheory:

2.1.3 Overcapitalization

2.1.4 Undercapitalization

2.6 Summary

TerminalQuestions

AnswertoSAQsandTQs

2.1 Introduction

LiberalizationandglobalizationpoliciesinitiatedbytheGovernmenthavechangedthedimension

of businessenvironment. It has changed thedimension of competitionthat a firm faces today.

Thereforeforsurvivalandgrowthafirmhastoexecuteplannedstrategysystematically.

Toexecuteanystrategicplan,resourcesarerequired.Resourcesmaybemanpower,plantand

machinery,building,technologyoranyintangibleasset.

To acquire all these assets financial resources are essentially required. Therefore, finance

managerofacompanymusthavebothlongrangeandshortrangefinancialplans.Integrationof

boththeseplansisrequiredfortheeffectiveutilizationofalltheresourcesofthefirm.

Thelongrangeplanmustconsider(1)Fundsrequiredtoexecutetheplannedcourseofaction.

(2)Fundsavailableat thedisposalof thecompany. (3)Determinationof funds tobeprocured

fromoutsidesources.


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LearningObjectives:

Afterstudyingthisunityoushould

1. Explainthestepsinvolvedinfinancialplanning.

2. Explainthefactorsaffectingthefinancialplanning.

3. Listoutthecausesofovercapitation

4. Explaintheeffectsofundercapitation.

ObjectivesofFinancialPlanning

FinancialPlanningisaprocessbywhichfundsrequiredforeachcourseofactionisdecided.It

must consider expected business Scenario and develop appropriate courses of action. A

financial plan has to consider Capital Structure, Capital expenditure and cash flow. In this

connectiondecisionsonthecompositionofdebtandequitymustbetaken.

Financialplanninggeneratesfinancialplan.Financialplanindicates:

1. Thequantumoffundsrequiredtoexecutebusinessplans.

2. Compositionofdebtandequity,keepinginviewtheriskprofileoftheexistingbusiness,new

businesstobetakenupandthedynamicsofcapitalmarketconditions.

3. Formulationofpoliciesforgivingeffecttothefinancialplansunderconsideration.

Afinancialplanisatthecoreofvaluecreationprocess. Asuccessfulvaluecreationprocesscan

effectivelymeetthebenchmarksofinvestorsexpectations.

Benefitsthataccruetoafirmoutofthefinancialplanning

1. Effectiveutilizationoffunds:Shortageismanagedbyaplanthatensuresflowofcashatthe

leastcost. Surplus isdeployed throughwellplannedtreasurymanagement. Ultimately the

productivityofassetsisenhanced.

2. Flexibilityincapitalstructureisgivenadequateconsideration.Hereflexibilitymeansthefirms

ability tochange the compositionof funds thatconstitute itscapitalstructure in accordance

withthechangingconditionsofcapitalmarket.Flexibilityreferstotheabilityofafirmtoobtain

funds at the right time, in the right quantity and at the least cost as per requirements to

financeemergingopportunities.

3. Formulationof policiesand institutingprocedures foreliminationof all typesofwastages in

theprocessofexecutionofstrategicplans.

4. Maintainingtheoperatingcapabilityofthefirmthroughtheevolutionofscientificreplacement

schemesforplantandmachineryandotherfixedassets.Thiswillhelpthefirminreducingits


17

operatingcapital.Operatingcapitalreferstotheratioofcapitalemployedtosalesgenerated.

A perusal of annual reports of Dell computers will throw light on how Dell strategically

minimized theoperatingcapital required tosupportsales. Suchcompaniesareadmiredby

investingcommunity.

5. Integrationoflongrangeplanswiththeshortageplans.

Guidelinesforfinancialplanning

1. Neverignorethecoordinalprinciplethatfixedassetrequirementsbemetfromthelongterm

sources.

2. Make maximum use of spontaneous source of finance to achieve highest productivity of

resources.

3. Maintain the operating capital intact by providing adequately out of the current periods

earnings.Dueattentiontobegiventophysicalcapitalmaintenanceoroperatingcapability.

4. Neverignoretheneedforfinancialcapitalmaintenanceinunitsofconstantpurchasingpower.

5. Employcurrentcostprinciplewhereverrequired.

6. Givedueweightagetocostandriskinusingdebtandequity.

7. Keeping the need for finance for expansion of business, formulate plough back policy of

earnings.

8. Exercisethoroughcontroloveroverheads.

9. Seasonalpeakrequirementstobemetfromshorttermborrowingsfrombanks.

2.2 StepsInFinancialPlanning

1. EstablishCorporateObjectives: Corporateobjectivescouldbegroupedintoqualitativeand

quantitative. Forexample,acompanysmissionstatementmayspecify createeconomic

valueadded.Butthisqualitativestatementhastobestatedinquantitativetermssuchasa

25%ROEora12%earningsgrowthrates.Sincebusinessenterprisesoperateinadynamic

environment,thereisaneedtoformulatebothshortrunandlongrunobjectives.

2. Next stage is formulation of strategies for attaining the objectives set. In this connection

corporatesdevelopoperatingplans.Operatingplansareframedwithatimehorizon.Itcould

beafiveyearplanoratenyearplan.

3. Once the plans are formulated, responsibility for achieving sales target, operating targets,

costmanagementbenchmarks,profittargetsetcisfixedonrespectiveexecutives.

4. Forecastthevariousfinancialvariablessuchassales,assetsrequired,flowoffunds,costto

be incurredand then translate thesame into financialstatements. Suchforecastshelpthe


18

finance manager to monitor the deviations of actual from the forecasts and take effective

remedialmeasurestoensurethattargetssetareachievedwithoutanytimeoverrunandcost

overrun.

5. Develop a detailed plan for funds required for the plan period under various heads of

expenditure.

6. Fromthefundsrequiredplan,developaforecastoffundsthatcanbeobtainedfrominternal

aswellas external sourcesduring the timehorizon forwhichplansaredeveloped. In this

connectionlegalconstrainsinobtainingfundsonthebasisofcovenantsofborrowingsshould

begivendueweightage.Thereisalsoaneedtocollaboratethefirmsbusinessriskwithrisk

implicationsofaparticularsourceoffunds.

7. Developacontrolmechanismforallocationoffundsandtheireffectiveuse.

8. Atthetimeofformulatingtheplanscertainassumptionsneedtobemadeabouttheeconomic

environment. But when plans are implemented economic environment may change. To

manage such situations, there is a need to incorporate an inbuiltmechanismwhichwould

scaleuporscaledowntheoperationsaccordingly.

ForecastofIncomeStatementandBalanceSheet

Therearethreemethodsofpreparingincomestatement:

1. Percentofsalesmethodorconstantratiomethod

2. Expensemethod

3. Combinationofboththesetwo

PercentofSalesmethod:Thisapproachisbasedontheassumptionsthateachelementofcost

bearssomeconstantrelationshipwiththesalesrevenue.

Forexample,Rawmaterialcostis40%ofsalesrevenueoftheyearended31.03.2007.Butthis

methodassumesthattheratioofrawmaterialcosttosaleswillcontinuetobethesamein2008

also. Such an assumption may not hold good in most of the situations. For example, Raw

materialcostincreasesby10%in2008butsellingpriceoffinishedgoodsincreasesonlyby5%.

Inthiscaserawmaterialcostwillbe44/105ofthesalesrevenuein2008.Thiscanbesolvedto

someextentbytakingaverageforsamerepresentativeyears.However,inflation,changeinGovt

policies,wageagreements,technologicalinnovationtotallyinvalidatethisapproachonalongrun

basis.


19

2. BudgetedExpenseMethod:Expensesfor theplanningperiodarebudgetedonthebasisof

anticipated behaviour of various items of cost and revenue. This demands effective data

baseforreasonablebudgetingofexpenses.

3. Combinationofboththesemethodsisusedbecausesomeexpensescanbebudgetedbythe

management taking into account the expected business environment and some other

expensescouldbebasedontheirrelationshipwiththesalesrevenueexpectedtobeearned.

ForecastofBalanceSheet

1. Itemsofcertainassetsandliabilitieswhichhaveacloserelationshipwith thesalesrevenue

could be computed based on the forecast of sales and the historical data base of their

relationshipwiththesales.

2. Determine the equityand debtmix on the basis of funds requirements and the companys

policyonCapitalstructure.

Example:ThefollowingdetailshavebeenextractedfromthebooksofXLtd

IncomeStatement(Rs.Inmillions)

2006 2007

Saleslessreturns 1000 1300

GrossProfit 300 520

SellingExpenses 100 120

Administration 40 45

Deprecation 60 75

OperatingProfit 100 280

Nonoperatingincome 20 40

EBIT(Earningsbeforeinterest&Tax 120 320

Interest 15 18

Profitbeforetax 105 302

Tax 30 100

Profitaftertax 75 202

Dividend 38 100

Retainedearnings 37 102

BalanceSheet (Rs.Inmillion)


20

Liabilities 2006 2007 Assets 2006 2007

Shareholdersfund FixedAssets 400 510

ShareCapital Less:Depreciation 100 120

Equity 120 120 300 390

Preference 50 50 Investments 50 50

Reserves&Surplus 122 224

SecuredLoans 100 120CurrentAssets,loans

&Advances

Unsecuredloans 50 60 CashatBank 10 12

Receivables 80 128

CurrentLiabilities Inventories 200 300

TradeCrs 210 250 Loans&Advances 50 80

ProvisionsMiscellaneous

expenditure10 24

Tax 10 60

ProposedDividend 38 100

760 984 700 984

Forecast the income statement and balance sheet for the year 2008 based on the following

assumptions.

1. Salesfortheyear2008willincreaseby30%overthesalesvaluefor2007.

2. Usepercent of salesmethod to forecast the values for various itemsof income statement

usingthepercentagefortheyear2007.

3. Depreciationistochargedat25%offixedassets.

4. FixedassetswillincreasebyRs.100million.

5. InvestmentswillincreasebyRs.100million.

6. CurrentassetsandCurrentliabilitiesaretobedecidedbasedontheirrelationshiptosalesin

theyear2007.

7. MiscellaneousexpenditurewillincreasebyRs.19million.

8. Securedloansin2008willbebasedonitsrelationshiptosalesintheyear2007.

9. Additionalfundsrequired,ifany,willbemetbybankborrowings.

10. Taxrateswillbe30%.


21

11. Dividendswillbe50%ofprofitaftertax.

12. Nonoperatingincomewillincreaseby10%.

13. Therewillbenochangeinthetotalamountofadministrationexpensestobespentintheyear

2008

14. Thereisnochangeinequityandpreferencecapitalin2008.

15. Interestfor2008willmaintainthesameratioasithasin2007withthesalesof2007.

IncomeStatementfortheYear2008 (Rs.Inmillion)

(Forecast)

Particulars Basis Working Amount(Rs.)

a.Sales Increaseby30% 1300x1.3 1690

b.CostofSales Increaseby30% 780x1.3 1014

c.Grossprofit SalesCostofsales 16901014 676

d.Sellingexpenses 30%increase 120x1.3 156

e.Administration Nochange 45

f.Depreciation %given 390+100

4

123(Roundedoff)

g.OperatingProfit C(D+E+F) 352

h.NonoperatingIncome Increaseby10% 1.1x40 44

i.EarningsBefore

Interest&Taxes(EBIT)

396

j.Interest 18ofsales

1300

18x1690

1300

23(Decimalignored)

k.Profitbeforetax 373

l.Tax 112

m.Profitaftertax 261

n.Dividends 130

o.Retainedearnings 131

BalanceSheetfortheyear2008(Rs.Inmillion)

(Forecast)


22

Particulars Basis Working Amount(Rs.)

Assets

FixedAssets Given 510

Add:Addition 100

610

Depreciation 120+123 243

1.Netfixedassets 367

2.Investments 150

3.CurrentAssets&Loans

&advances

Cashatbank 12

1300

12x1690

130016(Roundedoff)

Receivables 128

1300

128x1690

1300166

Inventories 300

1300

300x1690

1300390

Loans&Advances 80

1300

80x1690

1300104

4.Miscellaneous

ExpenditureGiven 24+19 43

Total 1236

Liabilities

1. ShareCapital

Equity 120

Preference 50

2.Reserves&Surplus Increasebycurrent

yearsretained

earnings

355

3.SecuredLoan 60

1300

60x1690

130078

Bankborrowings 40(Difference

Balancingfigure)


23

4. UnsecuredLoan 60 60

5. CurrentLiabilities&

Provision

Tradecreditors 250

1300

250x1690

1300325

Provisionfortax 60

1300

60x1690

130078

ProposedDividend Currentyeargiven 130

TotalLiabilities 1236

ComputerisedFinancialPlanningSystems

AllcorporateforecastsuseComputerisedforecastingmodels.

Additional funds required to finance the increase in sales could be ascertained using a

mathematicalrelationshipbasedonthefollowing:

Additionalfunds =Requiredincrease Spontaneous Increasein

Required inassets increasein retained

liabilities earnings

(This formulahas been recommended by Engene.F.BrighaomandMichael CEhrharte in their

bookfinancialmanagementTheoryandPractice,10thedition.

Prof.PrasannaChandra,inhisbookFinancialManagement,hasgivenacomprehensiveformula

forascertainingtheexternalfinancingrequirements:

EFR=A(Ds)L(Ds)ms(1d)(D1m+SR)

S S

Here

A =Expectedincreaseinassets,bothfixedandcurrentrequiredforthe

Sexpectedincreaseinsalesinthenextyear.

L=ExpectedSpontaneousfinancingavailablefortheexpectedincreasein

Ssales

MS1 (1d)=Itistheproductof

ProfitmarginxExpectedsalesforthenextyearxRetentionRatio

X Ds

X Ds


24

Here, retention ratio is 1 payout ratio. Payout ratio refers to the ratio of dividendpaid to

earningspershare

D1m=Expectedchangeinthelevelofinvestmentsandmiscellaneousexpenditure

SR=Itisthefirmsrepaymentliabilityontermloansanddebentureforthenextyear.

Thisformulahascertainfeatures:

1. Ratiosofassetsandspontaneousliabilitiestosalesremainconstantovertheplanningperiod.

2. Dividendpayoutandprofitmarginforthenextyearcanbereasonablyplannedinadvance.

3. Sinceexternal funds requirements involve borrowings from financial institution, the formula

rightlyincorporatesthemanagementsliabilityonrepayments.

Example

ALtdhasgiventhefollowingforecasts:

Salesin2008willincreasetoRs.2000fromRs.1000in2007

ThebalancesheetofthecompanyasonDecember31,2007givesthefollowingdetails:

Liabilities Rs Assets Rs

ShareCapital NetFixedAssets 500

Equity(SharesofRs.10each) 100 Inventories 200

Reserves&Surplus 250 Cash 100

Longtermloan 400 BillsReceivable 200

Crsforexpensesoutstanding 50

Tradecreditors 50

BillsPayable 150

1000 1000

Ascertain theexternal funds requirements for the year 2008, taking into account the following

information:

1. TheCompanysutilizationoffixedassetsin2007was50%ofcapacitybutitscurrentassets

wereattheirproperlevels.

2. Currentassetsincreaseatthesamerateassales.

3. Companysaftertaxprofitmarginisexpectedtobe5%,anditspayoutratiowillbe60%.

4. Creditorsforexpensesarecloselyrelatedtosales(AdaptedfromIGNOUMBA)

Answers

Preliminaryworkings

A=Currentassets=Cash+BillsReceivables+Inventories


25

=100+200+200=500

A=500=Rs.500

S1000

L=Tradecreditors+Billspayable+Expensesoutstanding

=50+150+50=Rs.250

L =250=Rs.250

S 1000

M(ProfitMargin)=5/100=0.05

S1=Rs.200

1d=10.6=0.4or40%

D1m=NIL

SR=NIL

Therefore:

)1()1()(

1 SRmdmSSxSL

SsA

EFR + D - - - D - D

=

=500250(0.05x200x0.4)(0+0)

=50025040(0+0)

=Rs.210

Therefore, external funds requirements (additional funds required) for 2008 will be Rs.210.

This additional funds requirementswill be procured by the firm based on its policy on capital

structure.


1. Corporateobjectivescouldbegroupinto________and________.

2. Controlmechanismisdevelopedfor_____________andtheireffectiveuse.

3. Seasonalpeakrequirementstobemetfrom___________________frombanks.

4. Exercisethrough_________overoverheads.

2.3FactorsAffectingFinancialPlan

1. Natureof the industry: Here,wemustconsiderwhether it isacapital intensiveor labour

intensiveindustry.Thiswillhaveamajorimpactonthetotalassetsthatthefirmowns.

2. Sizeof theCompany: Thesizeof thecompanygreatly influences theavailabilityof funds

fromdifferent sources. A smallcompanynormally finds it difficult to raise funds from long

X Ds X1000

X Ds X1000


26

termsourcesatcompetitiveterms. Ontheotherhand,largecompanies likeRelianceenjoy

theprivilegeofobtainingfundsbothshorttermandlongtermatattractiverates.

3. Status of the company in the industry: A well established company enjoying a good

market share, for its productsnormally commandsinvestors confidence. Sucha company

cantapthecapitalmarketforraisingfundsincompetitivetermsforimplementingnewprojects

toexploitthenewopportunitiesemergingfromchangingbusinessenvironment.

4. Sourcesof financeavailable: Sourcesof finance couldbe grouped into debtandequity.

Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital

structure thatwould achieve the least cost capital structure. A large firmwith adiversified

product mix may manage higher quantum of debt because the firm may manage higher

financialriskwithalowerbusinessrisk.Selectionofsourcesoffinanceiscloselylinkedtothe

firmscapacitytomanagetheriskexposure.

5. TheCapitalstructureofacompany is influencedby thedesireof theexistingmanagement

(promoters)ofthecompanytoretaincontrolovertheaffairsofthecompany.Thepromoters

whodonotliketolosetheirgripovertheaffairsofthecompanynormallyobtainextrafunds

forgrowthbyissuingpreferencesharesanddebenturestooutsiders.

6. Matching thesourceswithutilization:Theprudentpolicyofanygoodfinancialplan is to

match the term of the source with the term of investment. To finance fluctuating working

capitalneedsthefirmresortstoshorttermsfinance.Allfixedassetsfinancedinvestmentsare

tobefinancialbylongtermsources.Itisacardinalprincipleoffinancialplanning.

7. Flexibility:Thefinancialplanofacompanyshouldpossessflexibilitysoastoeffectchanges

in the compositionof capital structurewhen ever needarises. If the capital structure of a

companyisflexible,itwillnotfaceanydifficultyinchangingthesourcesoffunds.Thisfactor

hasbecomeasignificantonetodaybecauseoftheglobalizationofcapitalmarket.

8. GovernmentPolicy:SEBIguidelines,financeministrycirculars,variousclausesofStandard

Listing Agreement and regulatory mechanism imposed by FEMA and Department of

corporate affairs (Govt of India) influence the financial plans of corporates today.

ManagementofpublicissuesofsharesdemandsthecomplianceswithmanystatuesinIndia.

Theyaretobecompliedwithatimeconstraint.

SelfAssessmentQuestions2:

1. ___________hasamajorimpactonthetotalassetsthatthefirmowns.

2. Sourcesoffinancecouldbegroupedinto__and_______________.


27

3. ___________ofanygoodfinancialplanis tomatchthetermofthesourcewiththetermof

thesourcewiththetermoftheinvestment.

4. ________________referstheabilityto______________________wheneverneedarises.

2.4 EstimationOfFinancialRequirementsOfaFirm.

Theestimationofcapitalrequirementsofafirminvolvesacomplexprocess.Evenwithexpertise,

managementsofsuccessfulfirmscouldnotarriveattheoptimumcapitalcompositionintermsof

thequantumandthesources.Capitalrequirementsofafirmcouldbegroupedintofixedcapital

andworkingcapital.Thelongtermrequirementssuchasinvestmentinfixedassetswillhaveto

bemetoutof fundsobtainedon long termbasis. Variableworkingcapital requirementswhich

fluctuate from season to season will have to be financed only by short term sources. Any

departurefromthiswellacceptednormcausesnegativeimpactsonfirmsfinances.

SelfAssessmentQuestion3:

1.Capitalrequirementofafirmcouldbegroupedinto________and__________.

2.Variableworkingcapitalwillhavetobefinancedonlyby_______________.

2.5Capitalizations

Meaning: Capitalizationofafirmrefersthecompositionofits longtermfunds. It referstothe

capitalstructureofthefirm.Ithastwocomponentsvizdebtandequity.

Afterestimatingthefinancialrequirementsofafirm,thenthenextdecisionthatthemanagement

hastotakeistoarriveatthevalueatwhichthecompanyhastobecapitalized.

TherearetwotheoriesofCapitalizationfornewcompanies:

1.Costtheoryand 2.Earningstheory

2.5.1CostTheory:

Under this approach, the total amount of capitalization for a new company is the sum of the

following:

1. Costoffixedassets.

2. Costofestablishingthebusiness.

3. Amountofworkingcapitalrequired


28

Meritsofcostapproach:

1. It helps promoters to estimate theamount of capital required for incorporationof company

conducting market surveys, preparing detailed project report, procuring funds, procuring

assetsbothfixedandcurrent,trialproductionrunandsuccessfullyproducing,positioningand

marketingofitsproductsorrenderingofservices.

2. Ifdonesystematicallyitwilllayfoundationforsuccessfulinitiationoftheworkingofthefirm.

Demerits

1. Ifthefirmestablishesitsproductionfacilitiesatinflatedprices,productivityofthefirmwillbe

lessthanthatoftheindustry.

2. Networthofacompanyisdecidedbytheinvestorsbytheearningsofacompany.Earnings

capacitybasednetworthhelpsafirmtoarriveatthetotalcapitalintermsofindustryspecified

yardstick ( i,e,operatingcapitalbasedonbenchmarks in that industry) cost theoryfails in

thisrespect.

2.5.2 EarningsTheory:

Earningsareforecastandcapitalizedatarateofreturnwhichisrepresentativeoftheindustry.It

involvestwosteps.

1. Estimationoftheaverageannualfutureearnings.

2. Normalearningrateoftheindustrytowhichthecompanybelongs.

Merits

1. It is superior to cost theorybecause thereare, the least chancesof neitherundernotover

capitalization.

2. Comparisonofearningsapproachwiththatofcostapproachwillmakethemanagementtobe

cautious in negotiating the technology and cost of procuring and establishing the new

business.

Demerits

1. The major challenge that a new firm faces is in deciding on capitalization and its division

thereofintovariousprocurementsources.

2. Arrivingatcapitalizationrateisequallyaformidabletaskbecausetheinvestorsperceptionof

established companies cannot be really representative of what investors perceive of the

earningpowerofnewcompany.


29

Because of the problem, most of the new companies are forced to adopt the cost theory of

capitalization.

Ideallyeverycompanyshouldhavenormalcapitalization.Butitisanutopianwayofthinking.

Changing business environment, role of international forces and dynamics of capital market

conditionsforceustothinkintermsofwhatisoptimaltodayneednotbesotomorrow.Evenwith

these constraints, management of every firm should continuously monitor the firms capital

structuretoensuretoavoidthebadconsequencesofoverandundercapitalization.

2.5.3 Overcapitalization

Acompanyissaidtobeovercapitalized,whenitstotalcapital(bothequityanddebt)exceedsthe

truevalueofitsassets. Itiswrongtoidentifyovercapitalizationwithexcessofcapitalbecause

most of theovercapitalized firms suffer from theproblemsof liquidity. Thecorrect indicatorof

overcapitalizationistheearningscapacityofthefirm.Iftheearningsofthefirmarelessthenthat

of themarketexpectation,itwillnotbe inapositiontopaydividendstoitsshareholdersasper

theirexpectations.Itisasignofovercapitalization.Itisalsopossiblethatacompanyhasmore

fundsthanitsrequirementsbasedoncurrentoperationlevels,andyethavelowearnings.

Overcapitalizationmaybeonaccountofanyofthefollowing:

1. Acquiringassetsatinflatedrates

2. Acquiringunproductiveassets.

3. Highinitialcostofestablishingthefirm

4. Companieswhichestablishtheirnewbusinessduringboomconditionareforcedtopaymore

for acquiring assets, causing a situation of overcapitalization once the boom conditions

subside.

5. Totalfundsrequirementshavebeenoverestimated.

6. Unpredictablecircumstances(likechangeinimportexportpolicy,changeinmarketratesof

interest,changesininternationaleconomicandpoliticalenvironment)reducesubstantiallythe

earningcapacityofthefirm.Forexample,rupeeappreciationagainstU.S.dollarhasaffected

earningcapacityoffirmsengagedmainlyinexportbusinessbecausetheyinvoicetheirsales

inUSdollar.

7. Inadequateprovisionfordepreciationadverselyaffects theearningcapacityofacompany ,

leadingtoovercapitalizationofthefirm.

8. Existenceofidlefunds.


30

Effectsofovercapitalization

1. Declineintheearningsofthecompany.

2. Fallindividendrates.

3. Marketvalueofcompanyssharefalls,andcompanylosesinvestorsconfidence.

4. Companymaycollapseatanytimebecauseofanemicfinancialconditions itwillaffectits

employees, society, consumers and its shareholders. Employees will lose jobs. If the

companyisengagedintheproductionandmarketingofcertainessentialgoodsandservices

tothesociety,thecollapseofthecompanywillcausesocialdamage.

RemediesforOvercapitalization:

Restructuringthefirmistobeexecutedtoavoidthesituationofcompanybecomingsick.

Itinvolves

1. Reductionofdebtburden.

2. Negotiationwithtermlendinginstitutionsforreductionininterestobligation.

3. Redemptionofpreferencesharesthroughaschemeofcapitalreduction.

4. Reducingthefacevalueandpaidupvalueofequityshares.

5. Initiatingmergerwithwellmanagedprofitmakingcompanies interested in takingoverailing

company.

2.5.4 Undercapitalization

Undercapitalization is just the reverse of overcapitalization. A company is considered to be

undercapitalizedwhenitsactualcapitalizationislowerthanitspropercapitalizationaswarranted

byitsearningcapacity.

Symptomsofundercapitalization

1. Actualcapitalizationislessthanthatwarrantedbyitsearningcapacity.

2. Its rateofearnings isexceptionallyhigh in relation to the returnenjoyedbysimilarsituated

companiesinthesameindustry.

Causesofundercapitalization

1. Underestimationoffutureearningsatthetimeofpromotionofthecompany.

2. Abnormalincreaseinearningsfromneweconomicandbusinessenvironment.

3. Underestimationoftotalfundsrequirements.


31

4. Maintainingveryhighefficiencythroughimprovedmeansofproductionofgoodsorrendering

ofservices.

5. Companieswhicharesetupduringrecessionstartmakinghigherearningcapacityassoon

astherecessionisover.

6. Useoflowcapitalizationrate.

7. Companieswhichfollowconservativedividendpolicywillachieveaprocessofgraduallyrising

profits.

8. Purchaseofassetsatexceptionallylow pricesduringrecession.

Effectsofundercapitalization

1. Encouragement to competition: undercapitalization encourages competition by creating a

feelingthatthelineofbusinessislucrative.

2. Itencouragesthemanagementofthecompanytomanipulatethecompanysshareprices.

3. Highprofitswillattracthigheramountoftaxes.

4. High profits will make the workers demand higher wages. Such a feeling on the part of

employeesleadstolabourunrest.

5. High margin of profit may create among consumers an impression that the company is

charginghighpricesforitsproducts.

6. High margin of profits and the consequent dissatisfaction among its employees and

consumer,mayinvitegovernmentalenquiryintothepricingmechanismofthecompany.

Remedies

1. SplittingupofthesharesThiswillreducethedividendpershare.

2. Issueofbonusshares:Thiswillreduceboththedividendpershareandearningspershare.

Bothovercapitalizationandundercapitalizationaredetrimentaltotheinterestsofthesociety.


1.______________ofafirmreferstothecompositionofitslongtermfunds.

2.Twotheoriesofcapitalizationfornewcompaniesare________andearningstheory.

3.Acompanyissaidtobe___________,whenitstotalcapitalexceedsthetruevalueofits

assets.

4.Acompanyisconsideredtobe________________whenitsactualcapitalizationislowerthan

itspropercapitalizationaswarrantedbyitsearningcapacity.


32

2.6 Summary

Financial planning deals with the planning, execution and monitoring of theprocurement and

utilizationoffunds.Financialplanningprocessgivesbirthtofinancialplan.Itcouldbethoughtof

ablueprintexplainingtheproposedstrategyanditsexecution.Therearemanyfinancialplanning

models. All these models forecast the future operations and then translate them into income

statementsandbalancesheets.Itwillalsohelpthefinancemanagerstoascertainthefundsto

be procured fromoutside sources. Theessenceofall these is toachievea least cost capital

structurewhichwouldmatchwiththeriskexposureofthecompany. Failuretofollowtheprinciple

of financial planning may lead a new firm to over or undercapitalization when the economic

environmentundergoesachange. Ideallyeveryfirmshouldaimatoptimumcapitalization.Other

wiseitmayfaceasituationofoverorundercapitalization.Botharedetrimentaltotheinterestsof

thesociety.Therearetwotheoriesofcapitalizationvizcosttheoryandearningstheory.

TerminalQuestions

1. ExplainthestepsinvolvedinFinancialPlanning.

2. ExplainthefactorsaffectingFinancialPlan

3. ListoutthecausesofOverCapitalization.

4. ExplaintheeffectsofUnderCapitalization.

AnswersToSelfAssessmentQuestions


1. Qualitative,Quantitative.

2. Allocationoffunds

3. Shorttermborrowings


1. Natureoftheindustry

2. Debt,Equity

3. Theproductpolicy

4. Flexibilityincapitalstructure,effectchangesinthecompositesofcapitalstructure



33

1. Fixedcapital,workingcapital.

2. Shorttermsources


1. Capitalization

2. Costtheory

3. OverCapitalized

4. Undercapitalized

AnswertoTerminalQuestions

1. Refertounit2.2

2. Refertounit 2.3

3. Refertounit 2.5.3

4. Refer tounit 2.5.4


34

Unit3 TimeValueofMoney

Structure

3.1 Introduction

3.2 TimePreferenceRateandRequiredRateofReturn

3.2.1 CompoundingTechnique

3.2.2 DiscountingTechnique

3.2.3 FutureValueofaSingleFlow(Lumpsum):

3.2.4 FutureValueofSeriesofCashFlows

3.2.5 FutureValueofanAnnuity

3.2.5.1SinkingFund

3.3 PresentValue

3.3.1 DiscountingorPresentValueofaSingleFlow

3.3.2 PresentValueofaSeriesofCashFlows

3.3.2.1 PresentValueofPerpetuity

3.3.2.2 CapitalRecoveryFactor

3.4 Summary

SolvedProblems

TerminalQuestions

AnswertoSAQsandTQs

3.1 Introduction

Themainobjectiveofthisunitistoenableyoutolearnthetimevalueofmoney.Inthepreviousunit,

wehavelearntthatwealthmaximizationistheprimaryobjectiveoffinancialmanagementandthatis

more important thanprofitmaximization for its superiority in the sense that it is futureoriented.A

decisiontakentodaywillhavefarfetchingimplications.Forexample,afirminvestinginfixedassets

willreapthebenefitsofsuchinvestmentforanumberofyears.Ifsuchassetsareprocuredthrough

bankborrowingsortermloansfromfinancial institutions, theseinvolveanobligationtopayinterest

and return of principal. Decisions aremade by comparing the cash inflows (benefits/returns) and

cashoutflows(outlays).Sincethesetwocomponentsoccuratdifferenttimeperiods,thereshouldbe


35

acomparison.Inordertohavealogicalandmeaningfulcomparisonbetweencashflowsthataccrue

overdifferentintervalsoftime,itisnecessarytoconverttheamountstoacommonpointoftime.This

unitisdevotedforadiscussionofthetechniquesofdoingso.

LearningObjectives:


1. Explainthetimevalueofmoney.

2. Understandthevaluationconcepts.

3. Calculatethepresentandfuturevaluesoflumpsumandannuityflows.

Rationale: TimeValue ofMoney is the valueof a unit ofmoneyat different time intervals. The

valueofmoney received today ismore than itsvalue receivedata laterdate. Inotherwords, the

valueofmoneychangesoveraperiodoftime.Sincearupeereceivedtodayhasmorevalue,rational

investors would prefer current receipts to future receipts. That is why this phenomenon is also

referredtoasTimePreferenceofMoney.Someimportantfactorscontributingtothisare:

Investmentopportunities:

Preferenceforconsumption

Risk

ThesefactorsremindusofthefamousEnglishsayingAbirdinhandisworthtwointhebush.

Whyshouldmoneyhavetimevalue?

Someofthereasonsare:

Moneycanbeemployedproductivelytogeneraterealreturns.Forexample,ifwespendRs.500on

materialsandRs.300onlabourandRs.200onotherexpensesandthefinishedproductissoldfor

Rs.1100,wecansaythattheinvestmentofRs.1000hasfetchedusareturnof10%.

Secondly,duringperiodsofinflation,arupeehasahigherpurchasingpowerthanarupeeinfuture.

Thirdly, we all live under conditions of risk and uncertainty. As future is characterized by

uncertainty, individuals prefer current consumption to future consumption. Most people have


36

subjective preference for present consumption either because of their current preferences or

becauseofinflationarypressures.

3.2 FutureValue:

TimePreferenceRateandRequiredRateofReturn

Thetimepreferenceformoneyisgenerallyexpressedbyaninterestrate.Thisratewillbepositive

even in theabsenceof any risk. It is called the riskfree rate. Forexample, if an individuals time

preferenceis8%,itimpliesthatheiswillingtoforegoRs.100todaytoreceiveRs.108afteraperiod

ofoneyear.ThusheconsidersRs.100andRs.108areequivalentinvalue.Butinrealitythisisnot

theonlyfactorheconsiders.There isanamountof risk involved insuch investment.He therefore

requiresanotherrateforcompensatinghimwiththiswhichiscalledtheriskpremium.

Requiredrateofreturn=Riskfreerate+RiskPremium

There are two methods by which time value of money can be calculated compounding and

discounting.

3.2.1CompoundingTechnique:Underthismethodofcompounding,thefuturevaluesofallcash

inflowsattheendofthetimehorizonataparticularrateofinterestarefound.Interestiscompounded

when theamountearnedonan initial depositbecomespartof theprincipalat theendof the first

compoundingperiod.IfMr.AinvestsRs.1000inabankwhichoffershim5%interestcompounded

annually,hehasRs.1050 inhisaccountat theendof thefirstyear.The totalof the interestand

principal Rs. 1050 constitutes the principal for the next year. He thus earns Rs. 1102.50 for the

secondyear.Thisbecomestheprincipalforthethirdyear.Thiscompoundingprocedurewillcontinue

for an indefinitenumberof years.Thecompoundingof interest canbe calculatedby the following

equation:

A=P(1+i)n

WhereA=Amountattheendoftheperiod

P=Principalattheendoftheperiod

i=rateofinterest

n=numberofyears

Theamountofmoney in theaccountat theendofvariousyears iscalculatedasunder,using the

equation:


37

Amountattheendofyear1=Rs.1000(1+0.05)==Rs.1050

Amountattheendofyear2=Rs.1050(1+0.05)==Rs.1102.50

Amountattheendofyear3=Rs.1102.50(1+0.05)==Rs.1157.63

Year 1 2 3

Beginningamount Rs.1000 Rs.1050 Rs.1102.50

Interestrate 5% 5% 5%

Amountofinterest 50 52.50 55.13

Beginningprincipal

1000 Rs.1050 Rs.1102.50

Endingprincipal Rs.1050 Rs.1102.50 Rs.1157.63

Theamountattheendofyear2canbeascertainedbysubstitutingRs.1000(1+0.05)forR.

1050,thatis,Rs.1000(1+0.05)(1+0.05)=Rs.1102.50.

Similarly, theamountat theendofyear3canbeascertainedbysubstitutingRs.Rs.1000(1+0.05)

(1+0.05)(1+0.05)=Rs.1157.63.

ThusbysubstitutingtheactualfiguresfortheinvestmentorRs.1000intheformulaA=P(1+i)n,we

arriveattheresultshownaboveinTable.

3.2.2DiscountingTechnique:Underthemethodofdiscounting,wefindthetimevalueofmoney

now,thatis,attime0onthetimeline.Itisconcernedwithdeterminingthepresentvalueofafuture

amount.This is in contrast to the compoundingapproachwhereweconvert presentamounts into

futureamountsindiscountingapproachweconvertthefuturevaluetopresentsums.Forexample,if

Mr.ArequirestohaveRs.1050attheendofyear1,giventherateofinterestas5%,hewouldlike

toknowhowmuchheshouldinvesttodaytoearnthisamount.IfPistheunknownamountandusing

theequationwegetP(1+0.5)=1050.Solvingtheequation,wegetP=Rs.1050/1.05=Rs.1000.

ThusRs.1000wouldbetherequiredprincipalinvestmenttohaveRs.1050attheendofyear1at

5%interestrate.Inotherwords,thepresentvalueofRs.1050receivedoneyearfromnow,rateof

interest5%, isRs.1000.Thepresentvalueofmoney is the reciprocalof thecompoundingvalue.

Mathematically, we have P=A {1/(1+i)n} in which P is the present value for the future sum to be

received,Aisthesumtobereceivedinfuture,iistheinterestrateandnisthenumberofyears.


38

3.2.3FutureValueofaSingleFlow (lump sum): Theprocessof calculating futurevaluewill

becomeverycumbersomeiftheyhavetobecalculatedoverlongmaturityperiodsof10or20years.

Ageneralizedprocedureforcalculatingthefuturevalueofasinglecashflowcompoundedannually

isasfollows:

FVn=PV(1+i)n

WhereFVn=Futurevalueoftheinitialflowinnyearshence

PV=Initialcashflow

I=Annualrateofinterest

N=Lifeofinvestment

Theexpression (1+i)n represents thefuturevalueof the initial investmentofRe.1at theendofn

numberofyearsattheinterestratei,referredtoastheFutureValueInterestFactor(FVIF).Tohelp

ease in calculations, the various combinations of I and n can be referred to in the table. To

calculate the future value of any investment, the corresponding value of (1+i)n from the table is

multipliedwiththeinitialinvestment.

Example:Thefixeddepositschemeofabankoffersthefollowinginterestrates:

Periodofdeposit Rateperannum


39

A much accurate way of calculating doubling period is the rule of 69, which is expressed as

0.35+69/interestrate.Goingbythesameexamplegivenabove,wegetthenumberofyearsas7.25

years{0.35+69/10(0.35+6.9)}.

Increasedfrequencyofcompounding

It has been assumed that the compounding is done annually. If a scheme is offered where

compounding isdonemore frequently, let us see its effecton interestearned.Forexample, ifwe

have deposited Rs. 10000 in a bank which offers 10% interest per annum compounded semi

annually,theinterestearnedwillbeasfollows:

Amountinvested Rs. 10000

Interestearnedforfirst6months

10000*10%*1/2(for6months) Rs. 500

Amountattheendof6months Rs. 10500

Interestearnedforsecond6months

10500*10%*1/2 Rs. 525

Amountattheendoftheyear Rs. 11025

If in theabovecasecompoundingisdoneonlyonceayearthe interestearnedwillbe10000*10%

whichisequaltoRs.1000andwewillhaveRs.11000attheendoffirstyear.Wefindthatweget

moreinterestifcompoundingisdoneonamorefrequentbasis.Thegeneralizedformulaforshorter

compoundingperiodsis:

FVn=PV(1+i/m)m*n

Where,FVn=Futurevalueafternyears

PV=Cashflowtoday

i=Nominalinterestrateperannum

m=No.oftimescompoundingisdoneduringayear

n=No.ofyearsforwhichcompoundingisdone.

Example: Under the Andhra Banks Cash Multiplier Scheme, deposits can be made for periods

rangingfrom3months to5years.Everyquarter, interest isadded to theprincipal.Theapplicable

rateof interest is9%fordeposits lessthan23monthsand10%forperiodsmorethan24months.

WhatwilltheamountofRs.1000todaybeafter2years?


40

Solution:

FVn=PV(1+i/m)m*n

1000(1+0.10/4)4*2

1000(1+0.10/4)8

Rs.1218

Effectivevs.nominal rateof interest:Wehave just learnt that interestaccumulationbyfrequent

compoundingismuchmorethantheannualcompounding.Thismeansthattherateofinterestgiven

to us, that is, 10% is the nominal rate of interest per annum. If the compounding is done more

frequently,saysemiannually,theprincipalamountgrowsat10.25%perannum.0.25%isknownas

theEffectiveRateofInterest.Thegeneralrelationshipbetweentheeffectiveandnominalratesof

interestisasfollows:

r={(1+i/m)m}1

Where,

r=Effectiverateofinterest

i=Nominalrateofinterest

m=Frequencyofcompoundingperyear.

Example:Calculatetheeffectiverateofinterestifthenominalrateofinterestis12%andinterestis

compoundedquarterly.

Solution:

r={(1+i/m)m}1

r={(1+0.12/4)4}1

r=0.126or12.6%p.a.

3.2.4 FutureValueOfSeriesOfCashFlows

Wehaveconsideredonlysinglepaymentmadeonceanditsaccumulationeffect.Aninvestormaybe

interestedininvestingmoneyininstallmentsandwishtoknowthevalueofhissavingsafternyears.

Forexample,Mr.MadaninvestsRs.500,Rs.1000,Rs.1500,Rs.2000andRs.2500attheendof

eachyearfor5years.Calculatethevalueattheendof5yearscompoundedannuallyiftherateof

interestis5%p.a.


41

Solution:

Endofyear

Amountinvested

Numberofyears

compounded

Compoundedinterestfactorfromtables

FVinRs.

1 Rs.500 4 1.216 608

2 Rs.1000

3 1.158 1158

3 Rs.1500

2 1.103 1654

4 Rs.2000 1 1.050 2100

5 Rs.2500

0 1.000 2500

Amountattheendof5thYear Rs.8020

3.2.5 FutureValueOfAnAnnuity

Annuityreferstotheperiodicflowsofequalamounts.Theseflowscanbeeithertermedasreceipts

or payments. For example, if you have subscribed to the Recurring Deposit Scheme of a bank

requiring you to pay Rs. 5000 annually for 10 years, this stream of payouts can be called

Annuities.Annuities require calculationsbasedon regular periodic contributionofa fixed sumof

money.

Thefuturevalueofaregularannuityforaperiodofnyearsatirateofinterestcanbesummedupas

under:

FVAn=A{(1+i)n1}/i

WhereFVAn=Accumulationattheendofnyears

i=Rateofinterest

n=Timehorizonorno.ofyears

A=Amountdeposit/investedattheendofeveryyearfornyears.

Theexpression {(1+i)n1}/ i iscalled theFutureValue InterestFactor forAnnuity (FVIFA).This

representstheaccumulationofRe.1investedattheendofeveryyearfornnumberofyearsatirate

ofinterest.Thetablesattheendofthisbookgiveusthecalculationsfordifferentcombinationsofi

andn.We justhave tomultiply the relevantvaluewithAandget theaccumulation in theformula

givenabove.


42

Example:M.RamKumardepositsRs.3000attheendofeveryyearfor5yearsintohisaccountfor

5years,interestbeing5%compoundedannually.Determinetheamountofmoneyhewillhaveatthe

endofthe5thyear.

Endofyear

Amountinvested

Numberofyears

compounded

Compoundedinterest

factorfromtables

FVinRs.

1 Rs.2000

4 1.216 2432

2 Rs.2000

3 1.158 2316

3 Rs.2000

2 1.103 2206

4 Rs.2000 1 1.050 2100

5 Rs.2000

0 1.000 2000

Amountattheendof5thYear Rs.11054

ORUsingformulaandthetableswecanfindthat:

=2000FVIFA(5%,5y)

=2000*5.526

=Rs.11052

Wenoticethatwecangettheaccumulationsattheendofnperiodusingthetables.Calculationsfor

alongtimehorizonareeasilydonewiththehelpofreferencetables.Annuitytablesarewidelyused

inthefieldofinvestmentbankingasreadyreckoners.

Example:Calculate the valueof anannuity flowofRs.5000doneona yearlybasis for 5 years,

yieldinganinterestof8%p.a.

Solution:

=5000FVIFA(8%,5y)

=5000*5.867

=Rs.29335


43

3.2.5.1SinkingFund

Sinkingfundisafundwhichiscreatedoutoffixedpaymentseachperiodtoaccumulatetoafuture

sumafteraspecifiedperiod.Thesinkingfundfactorisusefulindeterminingtheannualamounttobe

putinafundtorepaybondsordebenturesortopurchaseafixedassetorapropertyattheendofa

specifiedperiod.

A=FVA*i/{(1+i)n1}

i/{(1+i)n1}iscalledtheSinkingFundFactor.


1. Theimportantfactorscontributingtotimevalueofmoneyare__________,________________

and_______.

2. Duringperiodsofinflation,arupeehasa___________thanarupeeinfuture.

3. As future is characterized by uncertainty, individuals prefer _________consumption to

__________consumption.

4. There are twomethods by which time value of money can be calculated by _________ and

_________techniques.

3.3 PresentValue

Wehavesofarseenhowthecompoundingtechniquecanbeused.Theycanbeusedtocompare

thecashflowsseparatedbymorethanonetimeperiod,giventheinterestrate.Withthistechnique,

theamountofpresentcashcanbeconvertedintoanamountofcashofequivalentvalueinfuture.

Likewise, wemaybe interested in converting the future cash flows into their present values. The

PresentValuePVofafuturecashflow is theamountof thecurrentcash that isequivalent to the

investor. The process of determining present value of a future payment or a series of future

paymentsisknownasdiscounting.


44

3.3.1DiscountingorPresentValueofaSingleFlow:

WecandeterminethePVofafuturecashfloworastreamoffuturecashflowsusingtheformula:

PV=FVn/(1+i)n

WherePV=PresentValue

FVn=Amount

i=Interestrate

n=Numberofyears

Example: IfMs.SapnaexpectstohaveanamountofRs.1000afteroneyearwhatshouldbethe

amountshehastoinvesttodayifthebankisoffering10%interestrate?

Solution:

PV=FVn/(1+i)n

=1000/(1+0.10)1

=Rs.909.09

Thesamecanbecalculatedwiththehelpoftables.

=1000*PVIF(10%,1y)

=1000*0.909

=Rs.909

Example:AninvestorwantstofindoutthevalueofanamountofRs.100000tobereceivedafter15

years.Theinterestofferedbybankis9%.CalculatethePVofthisamount.

Solution:

PV=FVn/(1+i)nor100000PVIF(9%,15y)

=100000*0.275

=Rs.27500

3.3.2PresentValueofaSeriesofCashFlows

Inabusinessscenario,thebusinessmanwillreceiveperiodicamounts(annuity)foracertainnumber

ofyears.Aninvestmentdonetodaywillfetchhimreturnsspreadoveraperiodoftime.Hewouldlike

toknow if it isworthwhile to investacertainsumnow inanticipationof returnsheexpectsovera

certainnumberofyears.Heshouldthereforeequatetheanticipatedfuturereturnstothepresentsum

heiswillingtoforego.ThePVofaseriesofcashflowscanberepresentedbythefollowingformula:


45

PV=Ct/(1=i)1+Ct/(1=i)2+Ct/(1=i)3 Ct/(1=i)4+..+Ct/(1=i)n

Whichreducesto:

PVAn=A{1+i)n1/i(1+i)n}

The expression {1+i)n1 / i(1+i)n} is known as Present Value Interest Factor Annuity (PVIFA). It

representsthePVIFAofRe.1forthegivenvaluesofiandn.ThevaluesofPVIFA(I,n)canbefound

outusingthetablesattheendofthebook.Itshouldbenotedthatthesevaluesaretrueonlyifthe

cashflowsareequalandtheflowsoccurattheendofeveryyear.

Example:

Calculate thePVofanannuityofRs.500 receivedannuallyfor4year,whendiscountingfactor is

10%.

Endofyear Cashinflows

PVfactor PVinRs.

1 Rs.500 0.909 454

2 Rs.500 0.827 413

3 Rs.500 0.751 375

4 Rs.500 0.683 341

PresentValueofanannuityRs.1585.

ORbydirectlylookingatthetablewecancalculate:

=500*PVIFA(10%,4y)

=500*3.170

=Rs.1585

Example:Findout thepresentvalueofanannuityofRs.10000over3yearswhendiscountedat

5%.

Solution:

=10000*PVIFA(5%,3y)

=10000*2.773

=Rs.27730


46

3.3.2.1PresentValueofPerpetuity

Anannuityforaninfinitetimeperiodisperpetuity.Itoccursindefinitely.Apersonmayliketofindout

thepresentvalueofhis investmentassuminghewill receiveaconstantreturnyearafteryear.The

PVofperpetuityiscalculatedasP=A/i

Example: If theprincipalofacollegewants to instituteascholarshipofRs.5000 toameritorious

studentinfinanceeveryyear,findoutthePVofinvestmentwhichwouldyieldRs.5000inperpetuity,

discountedat10%.

Solution:

P=A/i

=5000/0.10

=Rs.50000

ThismeansheshouldinvestRs.50000togetanannualreturnofRs.5000.

Presentvalueofanunevenperiodicsum:Insomeinvestmentdecisionsofafirm,thereturnsmay

notbeconstant.Insuchcases,thePViscalculatedasfollows:

P=A1/(1+i)+A2/(1+i)2+A3/(1+i)3+A4/(1+i)4++An/(1+i)n

OR

PV=A1PVIF(i,1)+A2PVIF(i,2)+A3PVIF(i,3)+A4PVIF(i,4)+.+AnPVIF(i,n)

Example: An investor will receive Rs. 10000, Rs. 15000, Rs. 8000, Rs. 11000 and R. 4000

respectivelyattheendofeachof5years.Findoutthepresentvalueofthisstreamofunevencash

flows,iftheinvestorsinterestrateis8%.

PV=10000/(1+0.08)+15000/(1+0.08)2+8000/(1+0.08)3+11000/(1+0.08)4+4000/(1+0.08)5

=Rs.39276

Or

PV=10000PVIF(8,1)+15000PVIF(8,2)+8000PVIF(8,3)+11000PVIF(8,4)+

4000PVIF(8,5)

=10000*0.926+15000*0.857+8000*0.794+11000*0.735+4000*0.681

=Rs.39276


47

3.3.2.2CapitalRecoveryFactor

Capitalrecovery istheannuityofan investmentforaspecifiedtimeatagivenrateof interest.The

reciprocalofthepresentvalueannuityfactoriscalledCapitalRecoveryFactor.

A=PVAn{i(1+i)n}/(1+i)n1}

{i(1+i)n}/(1+i)n1}isknownastheCapitalRecoveryFactor.

Example:A loanofRs.100000istoberepaid in5equalannual installments. Ifthe loancarriesa

rateof14%p.a,whatistheamountofeachinstallment?

Solution:

Installment*PVIFA(14%,5)=100000

Installment=100000/3.433=Rs.29129


1. _________________iscreatedoutoffixedpaymentseachperiodtoaccumulatetoafuturesum

afteraspecifiedperiod.

2. The________________ofafuturecashflowistheamountofthecurrentcashthatisequivalent

totheinvestor.

3. Anannuityforaninfinitetimeperiodiscalled______________.

4. Thereciprocalofthepresentvalueannuityfactoriscalled_____________.

3.4 Summary

Money has time preference. A rupee in hand today is more valuable than a rupee a year later.

Individualspreferpossessionofcashnowratherthanatafuturepointoftime.Thereforecashflows

occurring at different points in time cannot be compared. Interest rategivesmoney its value and

facilitates comparison of cash flows occurring at different periods of time. Compounding and

discountingaretwomethodsusedtocalculatethetimevalueofmoney.

SolvedProblemsTimeValueofMoney

1. WhatisthefuturevalueofaregularannuityofRe.1.00earningarateof12%interestp.a.for5

years?

Solution:1*FVIFA(12%,5y)=1*6.353=Rs.6.353


48

2. IfaborrowerpromisestopayRs.20000eightyearsfromnowinreturnforaloanofRs.12550

today,whatistheannualinterestbeingoffered?

Solution:20000*PVIF(k%,8y)=Rs.12550Kisapproximately6%.

3. AloanofRs.500000istoberepaidin10equalinstallments.Iftheloancarries12%interestp.a.

whatisthevalueofoneinstallment?

Solution:A*PVIFA(12%,10y)=500000SoA=500000/5.650=Rs.88492

4. ApersondepositsRs.25000inabankthatpays6%interesthalfyearly.Calculatetheamountat

theendof3years.

Solution:25000*(1+0.06)3*2=25000*1.194=Rs.29850

5. FindthepresentvalueofRs.100000receivableafter10yearsif10%isthetimepreferencefor

money.

Solution:100000*(0.386)=Rs.38600

TerminalQuestions

1. If you deposit Rs. 10000 today in a bank that offers 8% interest, in howmany yearswill this

amountdouble?

2. AnemployeeofabankdepositsRs.30000intohisPFA/cattheendofeachyearfor20years.

What is theamounthewillaccumulate inhisPFat theendof20 years, if the rateof interest

givenbyPFauthoritiesis9%?

3. Apersoncansave_____________annuallytoaccumulateRs.400000bytheendof10years,

ifthesavingearns12%.

4. Mr. Vinod has to receive Rs. 20000 per year for 5 years. Calculate the present value of the

annuityassuminghecanearninterestonhisinvestmentat10%p.a.

5. AparnainvestsRs.5000attheendofeachyearat10%interestp.a.Whatistheamountshe

willreceiveafter4years?

AnswerstoSelfAssessmentQuestions


1. Investmentopportunities,preferenceforconsumption,risk.

2. Higherpurchasingpower

3. Currentandfuture


49

4. Compoundinganddiscounting


1. Sinkingfund

2. PresentValuePV

3. Perpetuity

4. CapitalRecoveryFactor.

AnswerstoTerminalQuestions

1. (Hint:Useruleof72and69)

2. 30000*FVIFA(9%,20Y)=30000*51.160=Rs.1534800

3. A*FVIFA(12%,10y)=400000whichis400000/17.549=Rs.22795

4. 20000*PVIFA(105,5y)=20000*3.791=Rs.75820

5. 5000*FVIFA(10%,5y)=5000*6.105=Rs.23205


50

Unit4 ValuationOfBondsAndShares

4.1 Introduction

4.2 ValuationofBonds

TypesofBonds

4.2.1 IrredeemableorPerpetualBonds

4.2.2 RedeemableorBondswithMaturityPeriod

4.2.3 ZeroCouponBond

BondyieldMeasures

4.2.1 HoldingPeriodRateofReturn

4.2.2 CurrentYield

4.2.3 YieldtoMaturity(YTM)

4.2.4 BondValueTheorems

4.3 ValuationofShares

4.3.1 ValuationofPreferenceShares

4.3.2 ValuationofOrdinaryShares

4.4 Summary

SolvedProblems

TerminalQuestions

AnswerstoSAQsandTQs

4.1 Introduction

Valuationistheprocessoflinkingriskwithreturnstodeterminetheworthofanasset.Assetscanbe

realorfinancialsecuritiesarecalledfinancialassets,physicalassetsarerealassets.Theultimate

goalof any individual investor ismaximizationof profits. Investmentmanagement isa continuous

processrequiringconstantmonitoring.Thevalueofanassetdependsonthecashflowitisexpected

toprovideover theholdingperiod.Thefact thatasondate there isnomethodbywhichpricesof

shares and bonds can be accurately predicted should be kept in mind by an investor before he

decides to take an investment decision. The present chapter will help us to know why some


51

securitiesarepricedhigher thanothers.Wecandesignour investment structurebyexploiting the

variablestomaximizeourreturns.

Ordinarysharesareriskierthanbondsordebenturesandsomesharesaremoreriskythanothers.

Theinvestorwouldthereforecommitfundsonashareonlyifheisconvincedabouttherateofreturn

beingcommensuratewithrisk.

LearningObjectives:


1. KnowthemeaningofvalueasusedinFinanceTheory.

2. UnderstandthemechanicsofBondvaluation,and

3. Understandthemechanicsofvaluationofequityshares.

Concept of Intrinsic value: A security can be evaluated by the series of dividends or interest

paymentsreceivableoveraperiodoftime.Inotherwords,asecuritycanbedefinedasthepresent

valueofthefuturecashstreamstheintrinsicvalueofanassetisequaltothepresentvalueofthe

benefitsassociatedwith it. Theexpected returns (cash inflows)arediscountedusing the required

returncommensuratewiththerisk.Mathematically,itcanberepresentedby:

V0=C1/(1+i)1+C2/(1+i)2+C3/(1+i)3+Cn/(1+i)n

=Cn/(1+i)n

WhereV0=Valueoftheassetattimezero(t=0)

P0=Presentvalueoftheasset

Cn=Expectedcashflowattheendofperiodn

i=Discountrateorrequiredrateofreturnonthecashflows

n=Expectedlifeofanasset.

Example:

Assumingadiscount rateof10%and thecashflowsassociatedwith2projectsAandBovera3

yearperiod,determinethevalueoftheassets.


52

Year CashflowsofA(Rs.)

CashflowsofB(Rs)

1 20000 10000

2 20000 20000

3 20000 30000

Solution:

ValueofassetA=20000PVIFA(10%,3y)

=20000*2.487

=Rs.49470

ValueofassetB=10000PVIF(10%,1)+20000PVIF(10%,2)+30000PVIF(10%,3)

=10000*0.909+20000*0.826+30000*0.751

=9090+16520+22530

=Rs.48140

Example:

CalculatethevalueofanassetiftheannualcashinflowisRs.5000peryearforthenext6yearsand

thediscountrateis16%.

Solution:

Valueoftheasset=Cn/(1+i)n

=5000/(1+0.16)6

Or =5000PVIFA(16%,6y)

=5000*3.685

=Rs.18425

4.1.1ConceptsofValue

Bookvalue:Bookvalueisanaccountingconcept.Valueiswhatanassetisworthtodayintermsof

theirpotentialbenefits.Assetsarerecordedathistoricalcostandthesearedepreciatedoveryears.

Bookvaluemayincludeintangibleassetsatacquisitioncostminusamortizedvalue.Thebookvalue

ofadebtisstatedattheoutstandingamount.Thedifferencebetweenthebookvalueofassetsand

liabilities isequal to theshareholdersnetworth. (Networth is thesumtotalofpaidupcapitaland

reservesandsurplus).Bookvalueo

bhu mba 2v financial management notes

Documents

capital investments

thishaschange managers

todays complex business

thereare twosourcesoffundsviz

financial management