financial management - · pdf file5 cost of capital 12 ... economic order quantity etc....

Financial Management(Introduction to Financial Management - I)

(As Per the Revised Syllabus of F.Y. B.A.F, 2016-17, Semester I, University of Mumbai)

Rajiv MishraM.Com., MBA, M.Phil., UGC NET,

Assistant Professor at N.E.S. Ratnam College of Arts, Science & Commerce for BBI &Coordinator for M.Com., Bhandup (W), Mumbai-400078.

Visiting Faculty at Nitin Godiwala, Chandrabhan Sharma, S.M. Shetty College,N.G. Acharya, V.K. Menon College, Sikkim Manipal University & Vikas College for

M.Com., MBA, BBI, BMS, BFM & BAF.

Sunita SherifaniM.Com., M.Phil., MBA, SET

Head, Dept of Accountancy andAssociate Professor,

V.E.S. College of Arts, Science and Commerce,Chembur.

Asif BaigM.Com., B.Ed., M.Phil., MBA, NET

HOD, Accounts at Gurukul College, Ghatkopar &Visiting Faculty at NES Ratnam College for M.Com.

Dr. Shraddha Mayuresh BhomePh.D. in Commerce, Professional MBA, M.Phil. (Gold

Medalist), M.Com. (University of Mumbai),Research Guide (Supervisor), Shri JJT University,

Rajasthan,Assistant Professor and Coordinator of BAF,

Satish Pradhan Dnyansadhana College, Thane

Mukesh C. KanojiaM.Com., M.Phil., B.Ed. & NET

Co-ordinator,R.D. & S.H. National College,

Bandra (W)..

Manoj WaghM.Com., B.Ed.

Assistant Professor,Satish Pradhan Dnyansadhana College,

Thane.

Neha BhatiaM.Com., M.Phil., SETAssistant Professor,

S.M. Shetty College, Powai

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First Edition : 2016

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Preface

It is a matter of great pleasure to present the first edition of this book on FinancialManagement to the students and teachers of First Year Bachelor of Commerce –Accounting and Finance (F.Y. BAF), Semester I course started by University of Mumbai.

We have tried to make and present the book in simple language and precise. We arehoping that the diagrams and step-by-step answers put up will be helpful to understand thesubject clearly.

We are thankful to our all family members for constant support and motivation. We arealso grateful to our Principal, Vice-Principal, Co-ordinator, Colleagues, Library Staff andmy dear students and friends for encouraging us to write the book. Special thanks toHimalaya Publishing House Pvt. Ltd. for publishing our book.

Any constructive suggestions from the students and teachers for improving the text infuture are welcome.

Authors

SyllabusFinancial Management

(Introduction to Financial Management - I)Sr. No. Modules No. of Lectures

1 Introduction to Financial Management 122 Concepts in Valuation 123 Leverage 124 Types of Financing 125 Cost of Capital 12

Total 60

Sr. No. Modules/Units

1 Introduction to Financial Management● Introduction● Meaning● Importance● Scope and Objectives● Profit vs. Value Maximization

2 Concepts in Valuation● The Time Value of Money● Present Value● Internal Rate of Return● Bonds Returns● The Returns from Stocks● Annuity● Techniques of Discounting● Techniques of Compounding

3 Leverage● Introduction● EBIT and EPS Analysis● Types of Leverages: Operating Leverage, Financial Leverage and Composite Leverage● Relationship between Operating Leverage and Financial Leverage (Including Practical Problems)

4 Types of Financing● Introduction● Needs of Finance and Sources: Long Term, Medium Term and Short Term● Long Term Sources of Finance● Short Term Sources of Finance

5 Cost of Capital● Introduction● Definition and Importance of Cost of Capital● Measurement of Cost of Capital● WACC (Including Practical Problems)

Question Paper Pattern

Scheme of ExaminationCredit Based Grading System Scheme of Examination Internal Assessment – 25% 25 Marks Semester End Examinations – 75% 75 Marks

Question Paper PatternDuration: 21/2 HoursMaximum Marks: 75Questions to be Set: 05

All questions are compulsory carrying 15 marks each.

Particulars Marks

Q.1 Objective Questions(a) Sub-questions to be asked (10) and to be answered (any 08)(b) Sub-questions to be asked (10) and to be answered (any 07)(*Multiple Choice/True or False/Match the Column, Fill in the Blanks)

15 Marks

Q.2

Q.2

Full Length Practical QuestionORFull Length Practical Question

15 Marks

15 Marks

Q.3

Q.3


15 Marks

15 Marks

Q.4

Q.4


15 Marks

15 Marks

Q.5

Q.5

(a) Theory Questions(b) Theory QuestionsORShort NotesTo be asked (05)To be answered (03)

08 Marks07 Marks

15 Marks

Note: Full length question of 15 Marks may be divided into two sub-questions of 08 and 07Marks.

Contents

1. Introduction to Financial Management 1 – 8

2. Concepts in Valuation 9 – 22

3. Leverage 23 – 58

4. Types of Financing 59 – 86

5. Cost of Capital 87 – 127

Chapter 1

MEANING OF FINANCIAL MANAGEMENT

Financial Management is broadly concerned with the mobilization and deployment of funds by abusiness organization. For efficient operation of business, it is necessary to obtain and utilize the fundseffectively. This job is done by Financial Management.

According to ‘Warren Buffet’, “Finance is simply the art and science of managing money.”Basically, therefore, financial management centers around fund raising for business in the mosteconomical way and investing these funds in optimum way so that maximum returns can be obtainedfor the shareholders. Practically, all business decisions have financial implication. Hence, financialmanagement is interlinked with all other functions of business.

SCOPE OF FINANCIAL MANAGEMENT

Scope of Financial Management

Forecasting Financing Coordinationand Control

Costing DecisionMaking

Others

Analysis ofEconomicTrends

Acquiring Funds FinancialAdjustment

Measuring Costof Capital

FinancialDecision

TaxManagement

Analysis ofIndustry Trends

Allocation ofFunds

AccountingBudgeting

Preparing CostSheet

InvestmentDecision

Fixed AssetsManagement

ForecastingFinancialRequirement

Investment ofFunds

MarginalCosting

Management ofIncome

Inventory/ReceivableManagement

Profit Planning EnsuringAvailability ofFunds

Reporting DividendDecision

CorporateGovernance

EstimatingROI

MeetingContingentLiability

EmploymentBenefits

Introduction to FinancialManagement

2 Financial Management

Financial management is one of the important part of overall management, which is directlyrelated with various functional departments like personnel, marketing and production. Financialmanagement covers wide area with multidimensional approaches. The following includes importantscope of financial management.

1. Financial Management and Economics

Economic concepts like micro economics and macroeconomics are directly applied with thefinancial management approaches. Investment decisions, micro and macro environmental factors areclosely associated with the functions of financial manager. Financial management also uses theeconomic equations like money value, discount factor, economic order quantity etc. Financialeconomics is one of the emerging area, which provides immense opportunities to financial andeconomical areas.

2. Financial Management and Accounting

Accounting records includes the financial information of the business concern. Hence, we caneasily understand the relationship between financial management and accounting. In the olden periods,both financial management and accounting were treated as a same discipline and then were mergedwith Management Accounting because this part is very much helpful for finance manager to takedecisions.

3. Financial Management and Mathematics

Modern approaches of financial management applied large number of mathematical andstatistical tools and techniques. They are also called as econometrics. Economic order quantity,discount factor, time value of money, present value of money, cost of capital, capital structure theories,dividend theories, ratio analysis and working capital analysis are used as mathematical and statisticaltools and techniques in the field of financial management.

4. Financial Management and Production Management

Production management is the operational part of the business concern, which helps to multiplythe money into profit. Profit of the concern depends upon the production performance. Productionperformance needs finance, because production department requires raw material, machinery, wages,operating expenses, etc.

5. Financial Management and Marketing

Produced goods are sold in the market with innovative and modern approaches. For this, themarketing department needs finance to meet their requirements. The finance manager or financedepartment is responsible to allocate adequate finance to the marketing department.

6. Financial Management and Human Resource

Financial management is also related with human resource department, which providesmanpower to all the functional areas of the management.

Introduction to Financial Management 3

7. Financial Management and Ethics

With growing number of SCAMS, ethics is playing increasingly very important role in variousfinancial management decisions (Corporate Governance).

FUNCTIONS OF FINANCIAL MANAGEMENT

Functions/Role of Financial Management/Finance Manager and how have they changed inrecent years?

Ans:

Role of Financial Management/Manager

Sources/Mobilization of Funds(Financial Decisions)

Application/Deployment of funds(Investment Decisions)

1. Proprietor’s FundsShare CapitalReserves & Surplus

1. Fixed Assets(Capital Budgeting)

2. Borrowed Funds(Capital Structure) (Leverage)(Cost of Capital) (Sources of Finance)(Dividend Policy)

2. Investments(Treasury Management)

3. Net Current Assets(Working Capital Management)

Business Restructuring

The twin aspects of procurement and effective utilization of funds are the crucial tasks, which thefinancial manager faces. The finance manager is required to look into financial implication of anydecision in a firm. The finance manager has to manage funds in such a way as to make their optimumutilization and to ensure that their procurement is in a manner so that the risk, cost and controlconsiderations are properly balanced under a given situation.

“ Rule No. 1: Never Loose Money

Rule No. 2: Never Forget Rule No. 1”

… Warren Buffet

Functions of Financial Manager

1. Estimating the requirement of fund.

2. Decision regarding capital structure.

3. Investment decision.

4. Dividend decision.

5. Working capital management/liquidity function.

6. Maintaining financial procedures and systems etc.


1. Estimating the Requirement of Funds: In a business, the requirements of funds have to becarefully estimated. Certain funds are required for long-term purposes, i.e., investments in fixed assetsetc. Certain funds are required for short-term purposes, i.e., Working Capital. A careful estimation ofsuch funds and the timing of requirement must be made. Forecasting the requirements of fundsinvolves the use of technique of budgetary control. Estimates of requirements of fund can be madeonly if all physical activities of the organization have been forecasted.

2. Decisions Regarding Capital Structure: Once the requirements of funds have been estimated,decisions regarding various sources from where these funds would be raised have to be taken. Financemanager has to carefully look into existing capital structure and see how the various proposals ofraising funds will affect it. He has to maintain a proper balance between long-term funds and short-term funds. Long-term funds raised from outsiders have to be in a certain proportion with the fundsprocured from the owner. He has to see that the capitalization of company is such that the company isable to procure funds in future also. All such decisions are ‘financing decisions’.

3. Investment Decision: Funds procured from different sources have to be invested in variouskinds of assets. Investments of funds in a project have to be made after careful assessment of thevarious projects through capital budgeting. A part of long-term funds is also to be kept for financingworking capital requirement. The production manager and finance manager keeping in view therequirement of production, future price estimates of raw material and availability of funds woulddetermine inventory policy.

4. Dividend Decision: Finance manager is concerned with the decision to pay or declaredividend. He has to assist management in deciding as to what amount of profit should be retained inbusiness and this depends on whether the company can make a more profitable use of funds. But inpractice, trend of earning, share market prices, requirement of funds for future growth, cash flowsituation, expectation of shareholders has to be kept in mind while deciding dividend.

5. Working Capital Management/Liquidity Function: The finance manager has to properlymanage current assets such as cash, inventory and accounts receivable. He has to ensure a trade-offbetween liquidity and profitability. He has to ensure efficient utilization of every current assets andalso overall working capital involved in current assets. Adequate level of current assets is necessary tomaintain required level of liquidity of funds. On the other hand, if the funds are idle, the profitabilitymay be low. Therefore, the finance manager has to maintain a proper balance between liquidity andprofitability. It includes cash management and receivable management.

6. Maintaining Financial Procedures and Systems: This includes procedures established forthe effective execution of the other functions. Budgetary accounting, record keeping, ManagementInformation System (MIS) and corporate governance are integral part of any organization.

In the last few years, the complexion of the economic and financial environment has altered inmany ways.

Therefore, the role of finance manager has changed from mobilization and deployment of fundsto profit planning, maximizing shareholder wealth, understanding capital markets and good corporategovernance.


These changes have made the job of the finance manager more important, complex anddemanding.

OBJECTIVES OF FINANCIAL MANAGEMENT

Discuss wealth maximization and shareholder value maximization as objectives of financialmanagement. Or corporate houses today are increasingly moving towards wealth maximization.Comment on this movement. Or the objective of financial management is ‘wealth maximizationand not profit maximization’. Comment.

Ans:

Objectives

Wealth

Profit

Objectives of Financial Management

Clear objectives are required for wise decision-making. Objectives provide a framework foroptimum financial decision-making. Two of the most widely discussed approaches are:

1. Profit maximization approach

2. Wealth maximization approach

Profit Maximization Decision Criterion

Under this approach, actions that increase profits should be undertaken and those that decreaseprofits are to be avoided. In specific operational terms, the profit maximization criterion implies that

Department - 1

Forecasting Funds

FinancialManager

Investing Funds

Department - II

Acquiting

Funds

Departm

ent-II

Man

agin

gFu

nds

Dep

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ent-

IV


the investment, financing and dividend policy decisions of a firm should be oriented towards themaximization of profits. The rationale behind profit maximization as a guide to financial decision-making, is due to following reasons:

1. Profit is a test of economic efficiency. It provides the yardstick by which economicperformance can be judged.

2. It leads to efficient allocation of resources tend to be directed to uses, which in terms ofprofitability are the most desirable.

3. It ensures maximum social welfare. This is so because the quest for value drives scarceresources to their most productive uses and their most efficient users. The more effectivelyresources are deployed, the more robust will be the economic growth and the rate ofimprovement in the standard of living.

The profit maximization criterion, however, has been questioned and criticized on severalgrounds. It suffers from the following limitations:

1. Profit in absolute terms is not a proper guide to decision-making. It has no preciseconnotation. It can be expressed either on a per share basis or in relation to investment. Also,profit can be long term or short term, before tax or after tax, it may be the return on totalcapital employed or total assets or shareholder’s equity and so on. If profit maximization istaken to be the objective, which of these variants of profit should a firm try to maximize?Therefore, a loose term like profit cannot form the basis of operational criterion for financialmanagement.

2. It leaves considerations of timing and duration undefined. There is no guide for comparingprofit now with profit in future or for comparing profit streams of different durations.

3. It ignores risk factor. It cannot, for example, discriminate between an investment project,which generates a certain profit of ` 50 lakhs and an investment project, which has avariable/uncertain profit outcome of ` 50 lakhs. It does not take into account level of risk.

Wealth Maximization Decision Criterion

This is also known as value maximization or net present worth maximization. The focus offinancial management is on the value to the owners or suppliers of equity capital. The wealth of theowners is reflected in the market value of the shares. So, wealth maximization implies themaximization of the market price of shares. It has been universally accepted as an appropriateoperational decision criterion for financial management decisions as it removes the technicallimitations, which characterize the earlier profit maximization criterion. Its operational features satisfyall the three requirements of a suitable operational objective of financial courses of action, namelyexactness, quality of benefits and the time value of money. Maximization of the wealth ofshareholders (as reflected in the market value of equity) appears to be the most appropriate goal forfinancial decision-making.

Wider than profit maximization is the principle of corporate governance. The fundamentalobjective of corporate governance is the “the enhancement of the long-term shareholder value while at


the same time protecting the interests of other stakeholders.” As such, this definition emphasizes theneed for a company to strike a balance at all times between the need to enhance shareholders’ wealthand protecting the interest of other stakeholders in the company such as suppliers, customers, creditors,bankers, employees of the company, government and society at large.

If these factors are ignored, a company cannot survive for long. Profit maximization at the cost oflegal, social and moral obligations is a short-sighted policy [e.g., Sahara].

Hence, it is commonly agreed that the objective of a firm is to maximize its value or wealth.Value is represented by the market price of the company’s common stock. The market price of afirm’s stock represents the judgement of all market participants as to what the value of the particularfirm is. The market price serves as a performance index of the firm’s progress; it indicates how wellmanagement is doing on behalf of shareholders. [On 13.6.14, Infosys Ltd. stock hit all-time high onappointment of Vishal Sikka as CEO].

An increasingly popular measure of wealth is EVA (Economic Value Added).

Economic Value Added (EVA) can be defined as the net operating profit that a company earnsabove its costs of capital. It is a trademark of Stern Stewart & Co.

EVA can be calculated as follows:

EVA = Net operating profit after taxes – (Weighted average cost of capital × Capital invested)

= NOPAT – (WACC × Capital)

Conceptually, EVA is superior as a measure of value creation because it recognizes the cost ofcapital and, hence, the riskiness of a firm’s operations. There is a strong correlation between EVA andthe market price of a company’s stock. Maximizing any accounting profit or accounting rate of returnas a way of increasing shareholder’s wealth often leads to an undesired outcome. A company shouldaim at long-term wealth maximization and not short-term.

Therefore, wealth maximization should be the objective of financial management since it:

1. Considers risk.

2. Uses cash flows and not profits.

3. Considers time value of money.

4. Implies taking care of interest of both shareholders and other stakeholders (corporategovernance).

‘Agency Problem’ in Achievement of Objectives of Financial Management

Ans:

A characteristic feature of corporate enterprise is the separation between ownership andmanagement as a corollary of which the latter enjoys substantial autonomy in regard to the affairs ofthe firm. With widely diffused ownership, scattered and ill-organized shareholders hardly exercise anycontrol/influence on management, which may be inclined to act in its own interests rather than thoseof the non-promoter owners. However, shareholders as owners of the enterprise have the right tochange the management. Due to the threat of being dislodged for poor performance, the management


would have a natural inclination to achieve a minimum acceptable level of performance, to satisfy theshareholder’s requirements/goals, while focussing primarily on their own personal goals. Thus, infurtherance of their objective of survival, management would aim at satisfying instead of maximizingshareholders’ wealth. Anil Agarwal (Vedanta), Mukesh Ambani (Reliance), Anil Ambani (Reliance)etc. are guilty of ‘Agency Problem’.

However, the conflicting goals of management objective of survival and maximizing owner’svalue/wealth can be harmonized by:

1. Incentives to Management: The incentives to management are of various types. Some ofthem are follows:

(i) Stock options: Confer on management the right to acquire shares of the enterprise at aspecial/concessional price.

(ii) Performance shares are given based on the performance of the management.

(iii) Cash bonus: Linked to specified performance targets.

2. Monitoring of Managers:

(i) Auditing financial statements and limiting decision-making by the management. The AuditControl procedures and limiting managerial decisions are intended to ensure that the actionsof management subserve the interests of shareholders.

(ii) Shareholder activism, specially of financial institutions to safeguard interest of non-promotershareholders.

(iii) Rotation of Audit Partners.

(iv) Overview by CAG, PAC, SEBI, IT. Department, CVC etc. is also required to overcomeagency problem.

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