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Real knowledge is to know the extent of one's ignorance. Knowledge without justice ought to be called cunning rather than wisdom. Module 1 PPTs by Dr. Kasamsetty Sailatha Dr.Kasamsetty Sailatha
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Introduction to Financial Management

Dec 18, 2014

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Page 1: Introduction to Financial Management

Real knowledge is to know the

extent of one's ignorance.

Knowledge without justice ought to

be called cunning rather than

wisdom.

Module – 1

PPTs by Dr. Kasamsetty Sailatha

Dr.Kasamsetty Sailatha

Page 2: Introduction to Financial Management

Contents • Introduction

• Meaning and definition of financial management;

• Approaches to financial management;

• Scope of financial management;

• Functions of financial management;

• Corporate objectives: – Profit Maximization and

– Wealth Maximization

– Other objectives

• Social implications of corporate objectives

• Concept of cash flow

• Time value of money

Dr.Kasamsetty Sailatha

Page 3: Introduction to Financial Management

Introduction

• Business concern needs finance to meet their requirements in the economic world. Any kind of business activity depends on the finance.

• Hence, it is called as lifeblood of business organization. Whether the business concerns are big or small, they need finance to fulfill their business activities.

• In the modern world, all the activities are concerned with the economic activities and very particular to earning profit through any venture or activities.

• The entire business activities are directly related with making profit. (According to the economics concept of factors of production, rent given to landlord, wage given to labour, interest given to capital and profit given to shareholders or proprietors), a business concern needs finance to meet all the requirements. Hence finance may be called as capital, investment, fund etc., but each term is having different meanings and unique characters. Increasing the profit is the main aim of any kind of economic activity.

Dr.Kasamsetty Sailatha

Page 4: Introduction to Financial Management

• Though it was a branch of economics till 1890, as a separate activity or discipline it is of recent origin.

• The subject of financial management is of immense interest to both academicians and practicing mangers.

• It is of great interest to academicians because the subject gained very important place in the business world.

• It also gained its importance because there are still certain areas where controversies exist for which no unanimous solutions have been reached as yet.

• Practicing managers are interested in this subject because among the most crucial decisions of the firm are those which relate to finance, and an understanding of the theory of financial management provides them with conceptual and analytical insights to make those decisions skillfully.

Dr.Kasamsetty Sailatha

Page 5: Introduction to Financial Management

Meaning and Definition of Financial

Management

• Before understanding the word financial management, let us understand the meaning of finance.

• Meaning of finance: it may be defined as the art and science of managing money. The major areas of finance are: – Financial services and

– Managerial finance/corporate finance/financial management.

• Meaning of financial management: – Financial management is that activity which is concerned

ith the pla i g a d o t olli g of the fi s fi a ial resources.

– Financial management is an integral part of overall management. It is concerned with the duties of the financial managers in the business firm.

Dr.Kasamsetty Sailatha

Page 6: Introduction to Financial Management

Definition of Financial Management:

• The term financial management has been defined by Solo o , “It is co cer ed with the efficient use of an i po ta t e o o i esou e a el , apital fu ds .

• The most popular and acceptable definition of financial management as given by S.C. Kuchal is that “Fi a cial Management deals with procurement of funds and their effective use i the usi ess .

• Howard a d Upto : Fi a cial a age e t “as a application of general managerial principles to the area of financial decision-making.

Dr.Kasamsetty Sailatha

Page 7: Introduction to Financial Management

• Westo a d Brigha : Fi a cial a age e t “is a area of financial decision-making, harmonizing i di idual oti es a d e te p ise goals .

• Joshep a d Massie : Fi a cial a age e t “is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations.

• Thus, Financial Management is mainly concerned with the effective funds management in the business. In simple words, Financial Management as practiced by business firms can be called as Corporation Finance or Business Finance.

Dr.Kasamsetty Sailatha

Page 8: Introduction to Financial Management

Approaches to financial management • There are two approaches of financial management

namely (a) traditional approach and (b) modern approach.

a) Traditional approach: according to this approach the following functions, that a finance manager of a business firm will perform:

1. Arrangement of short-term and long-term funds from financial institutions;

2. Mobilization of funds through financial instruments like equity shares, preference shares debentures, bonds etc.; and

3. Orientation of finance function with the accounting function and compliance of legal provisions relating to funds procurement, use and distribution.

Dr.Kasamsetty Sailatha

Page 9: Introduction to Financial Management

b) Modern approach: according to this approach

the finance manager is expected to analyze

the firm and to determine the following :

1. The total funds requirement of the firm;

2. The assets to be acquire, and

3. The pattern of financing the assets.

Dr.Kasamsetty Sailatha

Page 10: Introduction to Financial Management

SCOPE OF FINANCIAL MANAGEMENT Financial management is one of the important parts of overall

management, which is directly related with various functional departments like personnel, marketing and production. Financial management covers wide area with multidimensional approaches. The following are the important scope of financial management.

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

2. Financial Management and Accounting: Accounting records includes the financial information of the business concern. Hence, we can easily understand the relationship between the financial management and accounting. In the olden periods, both financial management and accounting are treated as a same discipline and then it has been merged as Management Accounting because this part is very much helpful to finance manager to take decisions. But nowadays financial management and accounting discipline are separate and interrelated.

Dr.Kasamsetty Sailatha

Page 11: Introduction to Financial Management

3. Financial Management or Mathematics: Modern approaches of the financial management applied large number of mathematical and statistical 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 statistical tools 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 multiple the money into profit. Profit of the concern depends upon the production performance. Production performance needs finance, because production department requires raw material, machinery, wages, operating expenses etc. These expenditures are decided and estimated by the financial department and the finance manager allocates the appropriate finance to production department. The financial manager must be aware of the operational process and finance required for each process of production activities.

Dr.Kasamsetty Sailatha

Page 12: Introduction to Financial Management

5. Financial Management and Marketing: Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements. The financial manager or finance department is responsible to allocate the adequate finance to the marketing department. Hence, marketing and financial management are interrelated and depends on each other.

6. Financial Management and Human Resource: Financial management is also related with human resource department, which provides manpower to all the functional areas of the management. Financial manager should carefully evaluate the requirement of manpower to each department and allocate the finance to the human resource department as wages, salary, remuneration, commission, bonus, pension and other monetary benefits to the human resource department. Hence, financial management is directly related with human resource management.

Dr.Kasamsetty Sailatha

Page 13: Introduction to Financial Management

Functions of financial management:

It may be difficult to separate the finance functions

from production, marketing and other functions. The

functions of raising funds, investing them in assets and

distributing returns earned from assets to shareholders

are respectively known as financing, investment and

dividend decisions. While performing these functions,

a firm attempts to balance cash inflows and outflows,

this is known as liquidity decision. Hence, the finance

functions are classified as follows:

1. Investment or long-term asset-mix decision;

2. Financing or capital-mix decision;

3. Dividend or profit allocation decision and

4. Liquidity or short-term asset-mix decision.

Dr.Kasamsetty Sailatha

Page 14: Introduction to Financial Management

1. Investment decision/function (capital budgeting):

– this involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future.

– Two important aspects of the investment decision are:

a) The evaluation of the prospective profitability of new investment and

b) The measurement of cut-off rate against that the prospective return of new investments could be compared.

– Because of the uncertain future, investment decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both expected return and risk.

Dr.Kasamsetty Sailatha

Page 15: Introduction to Financial Management

• The investment decisions of a financial manager cover the following areas: 1. Ascertainment of total volume of funds, a firm can

commit;

2. Appraisal and selection of capital investment proposals;

3. Measurement of risk and uncertainty in the investment proposals;

4. Prioritizing of investment decisions;

5. Funds allocation and its rationing;

6. Determination of fixed assets to be acquired;

7. Determination of levels of investments in current assets viz. inventory, receivables, cash, marketable securities etc and its management;

8. Buy or lease decisions;

9. Asset replacement decisions;

10. Restructuring, reorganization, mergers and acquisitions; and

11. Securities analysis and portfolio management.

Dr.Kasamsetty Sailatha

Page 16: Introduction to Financial Management

2. Financing Decision/ Capital Structure Decisions or Function:

– Financing decision/function is the second important function to be performed by the financial manger.

– The financial manager must decide when, where and how to acquire funds to meet the fi s investment needs.

– The central issue before the manager is to determine the proportion of equity and debt.

– The mix of debt and equity is known as the fi s capital structure.

– The financial manger must strive to obtain the best financing mix or the optimum capital structure for the firm.

Dr.Kasamsetty Sailatha

Page 17: Introduction to Financial Management

– The fi s capital structure is considered to be optimum

when the market value of share is maximized.

– The use of debt affects the return and risk of

shareholders. It may increase the return on equity funds

but it always increases risk.

– When the sha eholde s return is maximized with

minimum risk, the market value per share will be

maximized and the fi s capital structure would be

considered optimum.

– Once the financial manger is able to determine the best

combination of debt and equity, he or she must raise the

appropriate amount through the best available sources.

In practice, a firm considers many other factors such as

control, flexibility, loan convenient, legal aspects etc. in

deciding it s capital structure. Dr.Kasamsetty Sailatha

Page 18: Introduction to Financial Management

• The finance manger involve in the following finance decisions:

1. Determination of degree or level of gearing (Gearing is a easu e of a o pa s fi a ial le e age a d sho s the e te t

to which its operations are funded by lenders versus shareholders.);

2. Determination of financing pattern of long-term funds requirement;

3. Determination of financing pattern of medium and short-term funds requirement;

4. Raising of funds through issue of financial instruments viz. equity shares, preference shares, debentures, bonds etc.;

5. Arrangement of funds from banks and financial institutions for long-term, medium-term and short-term needs;

6. Arrangement of finance for working capital requirement;

7. Consideration of interest burden on the firm;

8. Co side atio of de t le el ha ges a d its i pa t o fi s bankruptcy;

9. Taking advantage of interest and depreciation in reducing the tax liability of the firm;

10. Consideration of various modes of improving the earnings per share and the market value of the share;

Dr.Kasamsetty Sailatha

Page 19: Introduction to Financial Management

11. Taking advantage of interest and depreciation in reducing the tax liability of the firm;

12. Consideration of various modes of improving the earnings per share and the market value of the share;

13. Consideration of cost of capital of individual components and weighted average cost of capital to the firm;

14. Analysis of impact of different levels of gearing on the firm and individual shareholder;

15. Optimization of financing mix to improve return to the equity shareholders and maximization of wealth of the fi a d alue of the sha eholde s ealth;

16. Portfolio management;

17. Consideration of impact of over capitalization and u de apitalizatio o the fi s p ofita ilit ;

18. Consideration of foreign exchange risk exposure of the firm and decisions to hedge the risk;

Dr.Kasamsetty Sailatha

Page 20: Introduction to Financial Management

19. Study of impact of stock market and economic

condition of the country on modes of financing;

20. Mai te a e of ala e et ee o e s apital to outside capital;

21. Maintenance of balance between long-term

funds and short-term funds;

22. Evaluation of alternative use of funds;

23. Setting of budgets and review of performance for

control action; and preparation of cash flow and

funds flow statements and analysis of

performance through ratios to identify the

problems areas and its correction, etc.

Dr.Kasamsetty Sailatha

Page 21: Introduction to Financial Management

3. Dividend Decision/function:

– Dividend decision is the third major financial decision. The financial manger must decide whether the firm should distribute all profits, or retain them or distribute a portion and retain the balance.

– Like debt-equity policy, the dividend policy should be determined in terms of its impact on the sha eholde s alue.

– The optimum dividend policy is one that a i izes the a ket alue of the fi s sha es.

– Thus, if shareholders are not indifferent to the fi s di ide d poli , the fi a ial a ge must determine the optimum dividend-payout ratio.

Dr.Kasamsetty Sailatha

Page 22: Introduction to Financial Management

–The payout ratio is equal to the percentage

of dividends to earnings available to

shareholders. The financial manger should

also consider the questions of dividend

stability, bonus shares and cash dividends

in practice.

–Most profitable companies pay cash

dividends regularly. Periodically, additional

shares, called bonus shares or stock

dividends are also issued to the existing

shareholders in addition to the cash

dividend. Dr.Kasamsetty Sailatha

Page 23: Introduction to Financial Management

• The finance manager will involve in taking the following dividend decisions:

1. Determination of dividend and retention policies of the firm;

2. Consideration of impact of levels of dividend and retention of earnings on the market value of the share and the future earnings of the company;

3. Consideration of possible requirement of funds by the firm for expansion and diversification proposals for financing existing business requirements;

4. Reconsideration of distribution and retentions policies in boom and recession periods; and

5. Considering the impact of legal and cash flow constrains on dividend decisions.

Dr.Kasamsetty Sailatha

Page 24: Introduction to Financial Management

4. Liquidity Decision/function:

– Cu e t assets a age e t that affe ts a fi s liquidity is yet another important finance function, in addition to the management of long-term assets.

– Current assets should be managed efficiently for safeguarding the firm against the dangers of illiquidity and insolvency.

– I est e t i u e t assets affe ts the fi s profitability, liquidity and risk. .

– A conflict exists between profitability and liquidity while managing current assets.

– If the firm does not invest sufficient funds in current assets, it may become illiquid. But it would lose profitability as idle current assets would not earn anything.

Dr.Kasamsetty Sailatha

Page 25: Introduction to Financial Management

– Thus, a proper trade-off must be achieved between

profitability and liquidity. In order to ensure that

neither insufficient nor unnecessary funds are

invested in current assets, the financial manger

should develop sound techniques of managing

u e t assets. He/she should esti ate fi s eed for current assets and make sure that funds would

be made available when needed.

– It would thus be clear that financial decisions

di e tl o e the fi s de isio to a ui e o dispose off assets and require commitment or

recommitment of funds on a continuous basis.

Dr.Kasamsetty Sailatha

Page 26: Introduction to Financial Management

• Finally, a firm performs finance functions

simultaneously and continuously in the normal

course of the business. They do not necessarily

occur in a sequence. Thus, finance functions

call for skillful planning, control and execution

of a fi s a ti ities.

Dr.Kasamsetty Sailatha

Page 27: Introduction to Financial Management

• Corporative Objectives of Financial Management

– Effective procurement and efficient use of finance

lead to proper utilization of the finance by the

business concern. It is the essential part of the

financial manager. Hence, the financial manager

must determine the basic objectives of the

financial management. Objectives of Financial

Management may be broadly divided into four

parts such as:

I. Profit maximization objectives;

II. Wealth maximization objectives;

III. Value maximization objectives and

IV. Other maximization objectives.

Dr.Kasamsetty Sailatha

Page 28: Introduction to Financial Management

Figure – Corporate Objectives

Others

Wealth

Profit

Corporate

Objectives

Value

Dr.Kasamsetty Sailatha

Page 29: Introduction to Financial Management

I. Profit Maximization

– Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization consists of the following important features.

1. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization.

2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern.

3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern.

4. Profit maximization objectives help to reduce the risk of the business. Dr.Kasamsetty Sailatha

Page 30: Introduction to Financial Management

• Favourable Arguments for Profit Maximization

– The following important points are in support of the profit maximization objectives of the business concern:

1. Main aim is earning profit.

2. Profit is the parameter of the business operation.

3. Profit reduces risk of the business concern.

4. Profit is the main source of finance.

5. Profitability meets the social needs also.

• Unfavourable Arguments for Profit Maximization

– The following important points are against the objectives of profit maximization:

1. Profit maximization leads to exploiting workers and consumers.

2. Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc.

3. Profit maximization objectives leads to inequalities among the stake holders such as customers, suppliers, public shareholders, etc. Dr.Kasamsetty Sailatha

Page 31: Introduction to Financial Management

• Drawbacks of Profit Maximization:

– Profit maximization objective consists of certain drawback also:

1. It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern.

2. It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during particular period.

3. It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern.

Dr.Kasamsetty Sailatha

Page 32: Introduction to Financial Management

II. Wealth Maximization:

–Wealth maximization is one of the modern

approaches, which involves latest innovations

and improvements in the field of the

business concern. The term wealth means

shareholder wealth or the wealth of the

persons those who are involved in the

business concern.

–Wealth maximization is also known as value

maximization or net present worth

maximization. This objective is an universally

accepted concept in the field of business. Dr.Kasamsetty Sailatha

Page 33: Introduction to Financial Management

• Favourable Arguments for Wealth Maximization

1. Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders.

2. Wealth maximization considers the comparison of the value to cost associated with the business concern. Total value detected from the total cost incurred for the business operation. It provides extract value of the business concern.

3. Wealth maximization considers both time and risk of the business concern.

4. Wealth maximization provides efficient allocation of resources.

5. It ensures the economic interest of the society. Dr.Kasamsetty Sailatha

Page 34: Introduction to Financial Management

• Unfavourable Arguments for Wealth Maximization

1. Wealth maximization leads to prescriptive (narrow) idea of the business concern but it may not be suitable to present day business activities.

2. Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization.

3. Wealth maximization creates ownership-management controversy.

4. Management alone enjoy certain benefits.

5. The ultimate aim of the wealth maximization objectives is to maximize the profit.

6. Wealth maximization can be activated only with the help of the profitable position of the business concern.

Dr.Kasamsetty Sailatha

Page 35: Introduction to Financial Management

• Social implications of Profit maximization and wealth maximization objectives:

– In the large companies, there is a divorce between management and ownership.

– The decision-taking authority in a company lies in the hands of managers.

– Shareholders as owners of the company are the principals and mangers are their agents.

– Thus there is principal-gent relationship between shareholders and managers.

– In theory, mangers should act in the best interest of shareholders; that is, their actions and de isio s should lead to sha eholde s ealth maximization.

Dr.Kasamsetty Sailatha

Page 36: Introduction to Financial Management

– In practice, mangers may not necessarily act in

the best interest of shareholders, and they may

peruse their own personal goals.

– The conflict between the interests of shareholders

and managers is referred to as agency problem

and it results into agency cost.

– Agency cost include the less than optimum share

value for shareholders and cost incurred by them

to monitor the actions of mangers and control

their behaviour.

Dr.Kasamsetty Sailatha

Page 37: Introduction to Financial Management

– Take the ex. of the 2008 Great Recession and one

of the causes of it - the near big bank failures on

Wall Street. Were those banks being socially

responsible? No. They were worrying about their

investment portfolios instead of loaning money to

customers, which is their charge. Those

investment portfolios were filled with toxic assets

(Toxic assets are largely investments backed by

risky subprime mortgages) and eventually brought

most of the big banks down. Their share prices fell

right along with them. They were not being

socially responsible.

Dr.Kasamsetty Sailatha

Page 38: Introduction to Financial Management

– On the other hand, look at General Motors. After

almost failing in the Great Recession, GM turned

itself around, repaid its debt, and developed

"greener" vehicles. As it did that, it's share price

started climbing. Why? GM was taking on the

mantle of social responsible rather than just

searching for profits. Business firms cannot exist

and profit in the long run without being socially

responsible.

Dr.Kasamsetty Sailatha

Page 39: Introduction to Financial Management

III. Value Maximization Objective:

– The goal of firm is to maximize the present wealth

of the owners i.e. equity shareholders in a company.

– A company's equity shares are actively traded in the

stock markets. The wealth of the equity

shareholders is represented in the market value of

the equity shares.

Dr.Kasamsetty Sailatha

Page 40: Introduction to Financial Management

Dividend

distribution

Fi s ealth a i izatio

Value maximization of equity shareholders

through increase in stock market price of

share

Short term funds Long term funds

Acquire temporary

working capital

Acquire fixed assets and

permanent working

capital

Generate net

cash inflows

from operation

Service debt obligations Retained earnings available

for re-investment

Use

d t

o

Use

d t

o

Figure - Fir s’ Cash flow and Value Maximization

Dr.Kasamsetty Sailatha

Page 41: Introduction to Financial Management

– The prime goal for company is to maximize the market value of

equity shares of the company.

– The market price of a share serves as an index of the

performance of the company .

– It takes into account present and prospective future earnings per

share, risk associated with the business, dividend and retention

policies of the firm, level of gearing etc.

– The sha eholde s ealth is a i ized o l he the a ket value of the share is maximized.

– Therefore, the term wealth maximization of financial

management is redefined as value maximization.

– In company form of business, the wealth created is reflected in

the market value of its shares. Therefore, the financial decisions

will cause to create wealth and it is indicated or reflected in

a ket p i e of o pa s sha es. – Hence, the prime objective of financial management is to

maximize the value of the firm. Dr.Kasamsetty Sailatha

Page 42: Introduction to Financial Management

IV. Other maximization objectives

1. Sales maximization objectives;

2. Growth maximization objectives;

3. Maximization of ROI; and

4. Social Objectives;

1. Sales maximization objective: the interest o

the company are best served by the

maximization of sales revenue. Which brings

with it the benefits of growth, market share

and status. The size of the firm, prestige, and

aspirations are more closely identified with

sales revenue than with profit. Dr.Kasamsetty Sailatha

Page 43: Introduction to Financial Management

2. Growth maximization objective:

– Managers will seek the objectives which give

them satisfaction, such as salary, prestige, status

and job security. On the other hand, the owners

of the firm are concerned with market values

such as profit, sales and market share.

– These differing sets of objectives are reconciled

by concentrating on the growth of the size of the

firm, which brings with it higher salaries and

status for mangers and larger profits and market

share for the owners of the firm.

Dr.Kasamsetty Sailatha

Page 44: Introduction to Financial Management

3. Maximization of ROI:

– The strategic aim of a business enterprise is to earn a return on capital.

– If in any particular case, the return in the long-run is not satisfactory, then the efficiency should be corrected or the activity be abandoned for a more favourable one.

– Measuring the historical performance of an investment centre calls for a comparison of the profit that has been earned with capital employed. The rate of return on investment is determined by dividing net profit or income by the capital employed or investment made to achieve that profit.

– ROI analysis provides a strong incentive for optimal utilization of the assets of the company.

Dr.Kasamsetty Sailatha

Page 45: Introduction to Financial Management

4. Social Objective:

– The business enterprise is an integral par t of the

functioning of a country.

– As such, in return for the privileges and rights

granted to it b the state. The business firm should

be made increasingly responsible for social

objectives.

Dr.Kasamsetty Sailatha

Page 46: Introduction to Financial Management

Cashflow Analysis

Dr.Kasamsetty Sailatha

Page 47: Introduction to Financial Management

Cash Flow Analysis

• Introduction

• Meaning

• Meaning of certain terms

• Classification of cash flows

• Procedure in preparation of cash flow

statement

• Direct method

• Indirect method

Dr.Kasamsetty Sailatha

Page 48: Introduction to Financial Management

• Introduction:

– Cash flow statement provides information about

the cash receipts and payments of a firm for a

given period.

– It provides important information that

compliments the profit and loss account and

balance sheet.

– The information about the cash flows of a firm is

useful in providing users or financial statements

with a basis to assess the ability of the enterprise

to generate cash and cash equivalents and the

needs of the enterprise to utilize these cashflows.

Dr.Kasamsetty Sailatha

Page 49: Introduction to Financial Management

• Meaning of Cash Flow Statement:

– Cash flow statement is a statement which shows the sources of cash inflow and uses of cash out-flow of the business concern during a particular period of time.

– It is the statement, which involves only short-term financial position of the business concern.

– Cash flow statement provides a summary of operating, investment and financing cash flows and reconciles them with changes in its cash and cash equivalents such as marketable securities.

– Institute of Chartered Accountants of India issued the Accounting Standard (AS-3) related to the preparation of cash flow statement in 1998.

Dr.Kasamsetty Sailatha

Page 50: Introduction to Financial Management

• Meaning of Certain Terms:

1. Cash o p ises ash o ha d a d de a d deposit with banks;

2. Cash e ui ale ts a e sho t te , highl li uid interments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value. Ex. of cash equivalents are T-bills, commercial paper etc.

3. Cash flo s a e i flo s a d outflo s of ash a d cash equivalents. It means the movement of cash into the organization and movement of cash out of the organization. The difference between the cash i flo s a d outflo s is k o as et ashflo which can be either net cash inflow or net cash outflow.

Dr.Kasamsetty Sailatha

Page 51: Introduction to Financial Management

• Classification of cashflow: 1. Cashflows from operating activities;

2. Cashflows from investing activities and

3. Cashflows from financing activities.

1. Cashflows from operating activities: a. Cash receipts from the sale of goods and rendering of

services.

b. Cash receipts from royalties, fees, commissions, and other revenue.

c. Cash payments to suppliers for goods and services.

d. Cash payments to and on behalf of employees

e. Cash receipts and payments of an insurance enterprise for premiums and claims, annuities and other policy benefits.

f. Cash payments or refunds of income-tax unless they can be specifically identified with financing and investing activities and

g. Cash receipts and payments relating to future contracts, forward contracts, option contracts and swap contracts when the contracts are held for dealing or trading purposes.

Dr.Kasamsetty Sailatha

Page 52: Introduction to Financial Management

2. Cashflows from investing activities:

– Investing activities are the acquisition and

disposal of long-term assets and other

investments and not included in cash

equivalents.

– Investing activities include transactions and

events that involve the purchase and sale of

long-tem productive assets ex. Land, building

plant and machinery etc not held for resale and

other investments.

Dr.Kasamsetty Sailatha

Page 53: Introduction to Financial Management

• The following are examples of cash flows arising from investing activities: a. Cash payments to acquire fixed assets;

b. Cash receipts from disposal of fixed assets including intangibles;

c. Cash payments to acquire shares, warrants or debt instruments of other enterprises and interests in joint venture;

d. Cash receipts from disposal of shares, warrants, or debt instruments of other enterprises and interests in joint ventures;

e. Cash advances and loans made to third parties;

f. Cash receipts from the repayments of advances and loans made to third parties; and

g. Cash receipts and payments relating to futures contracts, forward contracts, option contracts and swap contracts except when the contracts are held for dealing or trading purposes, or the receipts and payments are classified as financing activities.

Dr.Kasamsetty Sailatha

Page 54: Introduction to Financial Management

3. Cashflows from Financing Activities:

– Financing activities are activities that result in change in the size and composition of the o e s apital a d o o i gs of the e te p ise. Following are the examples of cash flows arising from financing activities:

a. Cash proceeds from issuing shares or other similar instruments;

b. Cash proceeds from issuing debentures, loans notes, bonds and other short term borrowings;

c. Cash repayments of amounts borrowed, i.e. redemption of debentures, bonds, etc.

d. Cash payments to redeem preference shares and

e. Payment of dividend. Dr.Kasamsetty Sailatha

Page 55: Introduction to Financial Management

• Procedure in preparation of cash flow: – The procedure used for the preparation of cashflow

statement is as follows:

a. Net increase or decrease in cash and cash equivalents accounts: The difference between cash and cash equivalents for the period may be computed by comparing these accounts given in the comparative balance sheets. The results will be cash receipts and payments during the period responsible for the increase or decrease in cash and cash equivalents items;

b. Calculation of the net cash provided or used by operating activities: It is by the analysis of profit and loss account, comparative balance sheet and selected additional information.

c. Calculation of the net cash provided or used by investing and financing activities. All other changes in the balance sheet items must be analyzed taking in to account the additional information and effect on cash may be grouped under the investing and financing activities.

Dr.Kasamsetty Sailatha

Page 56: Introduction to Financial Management

d. Preparation of a cash flow statement: it may be

prepared by classifying all cash inflows and

outflows in terms of operating, investing and

financing activities. The net cashflow provided

or used in each of these three activities may be

highlighted.

e. Ensure that the aggregate of net cashflow from

operating, investing and financing activities is

equal to net increase or decrease in cash and

cash equivalents.

f. Report any significant investing, financing

transactions that did not involve cash or cash

equivalents in a separate schedule to the

cashflow statement

Dr.Kasamsetty Sailatha

Page 57: Introduction to Financial Management

• Direct Method:

– Under this method, cash receipts from operating revenues and cash payments for operating expenses are arranged and presented in the cashflow statement.

– The difference between cash receipts and cash payments is the net cash flow from operating activities.

– In this method, each cash transaction is alyzed separately and the total cash receipts and payments for the period is determined.

– we may convert accrual basis of revenue and expenses to equivalent cash receipts and payments. Need o follow uniform procedure for converting accrual base items to cash base items.

Dr.Kasamsetty Sailatha

Page 58: Introduction to Financial Management

• Indirect Method:

– Under this method the net profit/loss is used as

the base and convert it to net cash provided or

used in operating activities.

– This method adjusts net profit for items that

affected net profit but did not affect cash.

– Noncash and non-operating charges in the profit

and loss a/c are added back to the net profit while

noncash and non-operating credits are deducted

to calculate operating profit before working

capital changes.

Dr.Kasamsetty Sailatha

Page 59: Introduction to Financial Management

The Time Value of Money

26th Oct, 2013

Dr.Kasamsetty Sailatha

Page 60: Introduction to Financial Management

• Contents :

– Introduction

– Meaning

– Reasons that are considered for time value of

money

– Terminologies of time value of money

Dr.Kasamsetty Sailatha

Page 61: Introduction to Financial Management

Introduction

• What is Time Value?

– We say that money has a time value because that

money can be invested with the expectation of

earning a positive rate of return

– I othe o ds, a upee e ei ed toda is o th o e tha a upee to e e ei ed to o o

– That is e ause toda s upee a e i ested so that we have more than one rupee tomorrow

Dr.Kasamsetty Sailatha

Page 62: Introduction to Financial Management

Meaning

• The ti e alue of o e is the p i iple that a certain currency amount of money today has

a different buying power than the same

u e a ou t of o e i the futu e.

Dr.Kasamsetty Sailatha

Page 63: Introduction to Financial Management

Reasons that are considered for time value

of money

• An important financial principle is that the

value of money is time dependent. This

principle is based on the following four

reasons:

1. Inflation;

2. Risk;

3. Personal consumption preference; and

4. Investment opportunities.

Dr.Kasamsetty Sailatha

Page 64: Introduction to Financial Management

The Terminology of Time Value 1. Simple Interest: It is the interest calculated on the original

principal only for the time during which the money let is

being used. Simple interest is paid or earned on the principal

amount lent or borrowed. Simple interest can be calculated

from the following formula:

PTR /100 or PTR or Pnr or P (1+nr)

P = Principal amount

T/n = time period/number of year

R/r = rate of interest per annum (should express in decimal)

Dr.Kasamsetty Sailatha

Page 65: Introduction to Financial Management

2. Compound Interest :

– If interest for one period is added to the principal to get the principal for the next period, it is called compound interest.

– The time period for compounding the interest may be annual, semiannual, or any other regular period of time.

– The period after which interest becomes due is alled i te est pe iod o o e sio pe iod.

– If the conversion period is not mentioned, interest is to be compounded annually.

– The compound interest can be calculated as follows:

Dr.Kasamsetty Sailatha

Page 66: Introduction to Financial Management

1. Compound interest annually:

A = P (1+i)n

2. Half-yearly:

A = P (1+i/2)2n

3. Quarterly: A = P (1+i/4)4n

4. Monthly: A = P (1+i/12)12n

5. Weakly:

A = P (1+i/52)52n

6. Daily:

A = P (1+i/365)365n

Dr.Kasamsetty Sailatha

Page 67: Introduction to Financial Management

3. Present Value – It is an amount of money

today, or the current value of a future cash

flow. The formula to compute the PV is as

follows.

PV0 = FVn (PVIFin)

N

N

i

FVPV

1

Dr.Kasamsetty Sailatha

Page 68: Introduction to Financial Management

Annuities

• An annuity is a series of nominally equal payments equally

spaced in time

• Annuities are very common: – Rent

– Mortgage payments

– Car payment

– Pension income

• The timeline shows an example of a 5-year, Rs.100 annuity

0 1 2 3 4 5

100 100 100 100 100

Dr.Kasamsetty Sailatha

Page 69: Introduction to Financial Management

The Principle of Value Additivity

• How do we find the value (PV or FV) of an annuity?

• First, you must understand the principle of value additivity:

– The value of any stream of cash flows is equal to the sum of the values of the components

• In other words, if we can move the cash flows to the same time period we can simply add them all together to get the total value

Dr.Kasamsetty Sailatha

Page 70: Introduction to Financial Management

4.Present value annuity:

We can use the principle of value additivity to

find the present value of an annuity, by

simply summing the present values of each of

the components:

Or

PVAn = R/(1+r)1 + R/(1+r)2 + R/(1+r)n

NNN

t

t

t

A

i

Pmt

i

Pmt

i

Pmt

i

PmtPV 1111

2

2

1

1

1

Dr.Kasamsetty Sailatha

Page 71: Introduction to Financial Management

Annuities Due

• Thus far, the annuities that we have looked at begin their

payments at the end of period 1; these are referred to as

regular annuities

• A annuity due is the same as a regular annuity, except that its

cash flows occur at the beginning of the period rather than at

the end

0 1 2 3 4 5

100 100 100 100 100

100 100 100 100 100 5-period Annuity Due

5-period Regular Annuity

Dr.Kasamsetty Sailatha

Page 72: Introduction to Financial Management

5. Present Value of an Annuity Due

• We can find the present value of an annuity due in the same

way as we did for a regular annuity, with one exception

• Note from the timeline that, if we ignore the first cash flow,

the annuity due looks just like a four-period regular annuity

• Therefore, we can value an annuity due with:

PV Pmt

i

iPmt

AD

N

1 1

11

Dr.Kasamsetty Sailatha

Page 73: Introduction to Financial Management

6. Future Value - An amount of money at some

future time period.

Dr.Kasamsetty Sailatha

Page 74: Introduction to Financial Management

Capital Budgeting Decisions

Module – 2 (Part-I)

PPTs by Dr. Kasamsetty Sailatha

Page 75: Introduction to Financial Management

Contents • Introduction

• Meaning and definition of Capital Budgeting

• Need and Importance of Capital Budgeting

• Capital Budgeting Process

• Evaluation techniques

• NPV Vs IRR

• Multiple IRRs

• Capital Rationing

• Risk Analysis in Capital Budgeting

• Measurement of Risk

• Project variance

• Expected NPV

Dr. Kasamsetty Sailatha

Page 76: Introduction to Financial Management

Introduction

• The word Capital refers to be the total

investment of a company in tangible and

intangible assets.

• Whe eas udgeti g defi ed the Rowland

a d Willia it ay be said to be the art of

building budgets.

• Budgets are blue print of a plan and action

expressed in quantities and manners.

Dr. Kasamsetty Sailatha

Page 77: Introduction to Financial Management

• Capital budgeting is a long term planning exercise in selection of the projects which generates returns over a number of years in future and the heavy expenditure is to be incurred in the initial years of the project to generate returns over the life of the project. Therefore, this includes the investment decision.

• Investment decision/ capital budgeting decision is a decision concerned with allocation of funds to get proper yield from project. So that it can recover the cost associated with each source of fund and earn required amount of profit to compensate the risk involved in the business.

Dr. Kasamsetty Sailatha

Page 78: Introduction to Financial Management

• The examples of capital expenditure:

1. Purchase of fixed assets such as land and

building, plant and machinery, good will, etc.

2. The expenditure relating to addition,

expansion, improvement and alteration to the

fixed assets.

3. The replacement of fixed assets.

4. Research and development project.

Dr. Kasamsetty Sailatha

Page 79: Introduction to Financial Management

Meaning and Definition

• Capital Budgeting: It is process of planning for

capital expenditure which is to be made to

maximize the long-term profitability of the

organization.

Dr. Kasamsetty Sailatha

Page 80: Introduction to Financial Management

Definition • According to the Charles T. Hrongreen, apital udgeti g is a

long-term planning for making and financing proposed capital

out lays.

• According to G.C. Philippatos, apital udgeti g is o er ed with the allo atio of the fi s fi a ial esou es a o g the available opportunities. The consideration of investment

opportunities involves the comparison of the expected future

streams of earnings from a project with the immediate and

subsequent streams of earning from a project, with the

i ediate a d su se ue t st ea s of e pe ditu e . • According to the Lyrich, apital udgeti g o sists i pla i g

of available capital for the purpose of maximizing the long-term

p ofita ilit of the o e .

Dr. Kasamsetty Sailatha

Page 81: Introduction to Financial Management

Need and Importance of Capital Budgeting

1. Huge investments: Capital budgeting requires huge

investments of funds, but the available funds are

limited, therefore the firm before investing projects,

plan are control its capital expenditure.

2. Long-term: Capital expenditure is long-term in

nature or permanent in nature. Therefore financial

risks involved in the investment decision are more. If

higher risks are involved, it needs careful planning of

capital budgeting.

3. Irreversible: The capital investment decisions are

irreversible, are not changed back. Once the decision

is taken for purchasing a permanent asset, it is very

difficult to dispose off those assets without involving

huge losses. Dr. Kasamsetty Sailatha

Page 82: Introduction to Financial Management

4. Long-term effect: Capital budgeting not only

reduces the cost but also increases the

revenue in long-term and will bring significant

changes in the profit of the company by

avoiding over or more investment or under

investment. Over investments leads to be

unable to utilize assets or over utilization of

fixed assets. Therefore before making the

investment, it is required carefully planning

and analysis of the project thoroughly.

Dr. Kasamsetty Sailatha

Page 83: Introduction to Financial Management

CAPITAL BUDGETING PROCESS • Capital budgeting is a difficult process to the investment of

available funds. The benefit will attained only in the near future

but, the future is uncertain. However, the following steps followed

for capital budgeting, then the process may be easier are.

1. Identification of various investments proposals: The capital

budgeting may have various investment proposals. The proposal

for the investment opportunities may be defined from the top

management or may be even from the lower rank. The heads of

various department analyse the various investment decisions, and

will select proposals submitted to the planning committee of

competent authority.

2. Screening or matching the proposals: The planning committee

will analyse the various proposals and screenings. The selected

proposals are considered with the available resources of the

concern. Here resources referred as the financial part of the

proposal. This reduces the gap between the resources and the

investment cost. Dr. Kasamsetty Sailatha

Page 84: Introduction to Financial Management

3. Evaluation: After screening, the proposals are evaluated with the help of various methods, such as pay back period proposal, net discovered present value method, accounting rate of return and risk analysis. The proposals are evaluated by.

(a) Independent proposals

(b) Contingent of dependent proposals

(c) Mutually exclusive proposals.

• Independent proposals are not compared with another proposals and the same may be accepted or rejected.

• Whereas higher proposals acceptance depends upon the other one or more proposals. For example, the expansion of plant machinery leads to constructing of new building, additional manpower etc.

• Mutually exclusive projects are those which competed with other proposals and to implement the proposals after considering the risk and return, market demand etc.

Dr. Kasamsetty Sailatha

Page 85: Introduction to Financial Management

4. Fixing property: After the evolution, the planning

committee will predict which proposals will give more

profit or economic consideration. If the projects or

p oposals a e ot suita le fo the o e s fi a ial condition, the projects are rejected without

considering other nature of the proposals.

5. Final approval: The planning committee approves the

final proposals, with the help of the following:

(a) Profitability

(b) Economic constituents

(c) Financial violability

(d) Market conditions.

• The planning committee prepares the cost estimation

and submits to the management.

Dr. Kasamsetty Sailatha

Page 86: Introduction to Financial Management

6. Implementing: The competent authority spends the money and implements the proposals. While implementing the proposals, assign responsibilities to the proposals, assign responsibilities for completing it, within the time allotted and reduce the cost for this purpose. The network techniques used such as PERT and CPM. It helps the management for monitoring and containing the implementation of the proposal.

7. Performance review of feedback: The final stage of capital budgeting is actual results compared with the standard results. The adverse or unfavourable results identified and removing the various difficulties of the project. This is helpful for the future of the proposals.

Dr. Kasamsetty Sailatha

Page 87: Introduction to Financial Management

Evaluation techniques • By matching the available resources and projects it can

be invested. The funds available are always living funds. There are many considerations taken for investment decision process such as environment and economic conditions. The methods of evaluations are classified as follows:

(A) Traditional methods (or Non-discount methods)

(i) Pay-back Period Methods

(iii) Accounts Rate of Return

(B) Modern methods (or Discount methods)

(i) Net Present Value Method

(ii) Internal Rate of Return Method

(iii) Profitability Index Method

Dr. Kasamsetty Sailatha

Page 88: Introduction to Financial Management

Pay-back Period

• It is one of the non-discounted cash flow

methods of capital budgeting. Pay-back

period is the time required to recover the

initial investment in a project.

• Formula to calculate PBP for even cashflows:

Initial investment

Pay-back period =

Annual cash inflows

Dr. Kasamsetty Sailatha

Page 89: Introduction to Financial Management

(c) 10 K 22 K 37 K 47K 54 K

Payback Solution for uneven

cashinflows

PBP = a + ( b - c ) / d

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7 K

Cumulative

Inflows

(a)

(-b) (d)

Dr. Kasamsetty Sailatha

Page 90: Introduction to Financial Management

• Thumb Rule for PBP:

– If the calculated PBP is less than the standard PBP

Accept.

– If the calculated PBP is higher than the standard

PBP Reject.

• Thumb Rule for Ranking PBP:

– Shorter the PBP – Higher Ranking

– Longer the PBP – Lower Ranking

Dr. Kasamsetty Sailatha

Page 91: Introduction to Financial Management

• Merits of Pay-back method: The following are the important merits of the pay-back method:

1. It is easy to calculate and simple to understand.

2. Pay-back method provides further improvement over the accounting rate return.

3. Pay-back method reduces the possibility of loss on account of obsolescence.

• Demerits

1. It ignores the time value of money.

2. It ignores all cash inflows after the pay-back period.

3. It is one of the misleading evaluations of capital budgeting.

Dr. Kasamsetty Sailatha

Page 92: Introduction to Financial Management

PBP Strengths and

Weaknesses

Strengths:

– Easy to use and understand

– Can be used as a measure of liquidity

– Easier to forecast ST than LT flows

Weaknesses:

– Does not account for TVM

– Does not consider cash flows beyond the PBP

– Cutoff period is subjective

Dr. Kasamsetty Sailatha

Page 93: Introduction to Financial Management

Accounting Rate of Return

• It is also k o as A e age ate of etu , ‘ate of return, return on investment or return on capital e plo ed .

• It is based on the accounting information rather than the cashinflows.

• The ARR may be defined as “the annualized net income earned on the average funds invested in a project.” The annual returns of a project are expressed as a percentage of the net investment in the project.

Dr. Kasamsetty Sailatha

Page 94: Introduction to Financial Management

• We determine the average profits by adding

up the after-tax profits expected for the each

year of the profits life and dividing the result

by the number of years.

Dr. Kasamsetty Sailatha

Page 95: Introduction to Financial Management

• The average investment is determined by

dividing the net investment by 2.

Or

Or

Or

Dr. Kasamsetty Sailatha

Page 96: Introduction to Financial Management

• The following formula is generally used to determine

the ARR.

or

• The ARR is determined based on the Total Income

method as:

Dr. Kasamsetty Sailatha

Page 97: Introduction to Financial Management

• On the basis of Original Investment Method:

• On the basis of Average Investment Method:

Dr. Kasamsetty Sailatha

Page 98: Introduction to Financial Management

• Thumb Rule For ARR:

– Accept the project if the ARR is more than the

minimum rate of return or the rate of return

predetermined by the financial manger.

– Reject the project if the ARR is less than the

minimum rate of return or the rate of return

predetermined by the financial manager.

• Thumb Rule for Ranking the ARR:

– Higher the ARR – Higher the Rank

– Lower the ARR – Lower the Rank

Dr. Kasamsetty Sailatha

Page 99: Introduction to Financial Management

Particulars Rs.

Sales Xxx

Less: Operating Cost Xxx

Earnings before depreciation, interest and tax Xxx

Less: Depreciation xxx

EBIT xxx

Less: Interest xxx

EBT xxx

Less: Tax xxx

EAT xxx

Add: Depreciation xxx

Net Cashflows (CFAT) xxx

Proforma to Find the Net Cashinflows

Dr. Kasamsetty Sailatha

Page 100: Introduction to Financial Management

• Advantages of ARR:

1. It is easy to calculate because it makes use of

readily available accounting information;

2. It is not concerned with cashflows rather based

upon profits which are reported in annual

accounts and sent to shareholders.

3. Unlike payback period method, this method

does take into consideration all the years

involved in the life of the project.

4. It high profits are required, this is certainly a way

of achieving them.

Dr. Kasamsetty Sailatha

Page 101: Introduction to Financial Management

• Disadvantages of ARR: 1. It does not take into account the time value of

money;

2. It uses straight line method of depreciation, once a change in method of depreciation takes place, the method will not be easy to be used wand will not work properly;

3. This method fails to distinguish the xize of investment required for individual projects;

4. It is biased against short-term projects;

5. Several concepts of investment are used for working out accounting rate of return. Thus, different managers have different meaning when they refere to ARR; and

6. ARR does not indicate whether an investment should be accepted or rejected, unless the rate of return is compared with arbitrary management targets.

Dr. Kasamsetty Sailatha