Financial Management

Unit I

Reena Talwar

Chapter 1

Concepts of FM

Introduction to FM
Overview of FM

Relationship with closely related fields

Its functions Scope Objectives

Introduction to FM
FM has undergone fundamental changes in its scope

and coverage
In the early years of its evolution, it was treated

synonymously with raising of funds.

In the current scenario, a broader scope is being

universally recognized which includes efficient use of resources in addition to procurement of funds.

Finance and Related Disciplines

FM is not a totally independent area.

Draws heavily on related disciplines and fields of

study such as economics, accounting, marketing, production and quantitative methods.

For e.g. Financial managers should consider impact

of new product development and promotion plans made in marketing as they will require capital outlays. Changes in production process may also necessitate capital expenditures which financial managers must evaluate.

Finance and Economics

Macro

Economics concerned with overall institutional environment in which firm operates.

Since business firms operate in macro economic

environment, it is imp for financial managers to understand broad economic environment. Specifically, they should

Understand how monetary policy affects cost and availability of funds. Be versed with fiscal policy and its effects on economy. Be aware of various financial institutions

Finance and Economics

Micro Economics deals with economic decisions of

individuals and organizations.

Concepts and theories of micro economics which are

relevant to financial management are:

Supply and demand relationships and profit maximization strategies Concept of marginal analysis financial decisions to be made on basis of comparison of marginal revenue and marginal cost.

Finance and Accounting

Closely related as accounting is an imp input in

financial decision making.

It is a necessary input into finance function. Information

contained in financial statements prepared by an organization such as balance sheet, income statement and statement of changes in financial system assists financial managers in assessing past performance and future directions of the firm.

Finance and Accounting

Though they are closely related, there are key differences

between finance and accounting: 1. Treatment of Funds :- Measurement of funds in accounting is based
on accrual principle revenue is recognized at the point of sale and not when collected. Expenses are recognized when they are incurred rather than when actually paid. Finance is based on cash flows i.e. revenues are recognized when actually received in cash (cash inflow) and expenses are recognized on actual payment. Financial manager is concerned with maintaining solvency of the firm by providing cash flows necessary to satisfy its obligations. 2. Decision Making:- Primary Purpose of accounting is collection and presentation of financial data while financial managers major responsibility relates to financial planning, controlling and decision making.

Scope of FM
The approach to the scope and functions of FM is

divided into two brad categories: Traditional Approach Modern Approach

Traditional Approach: Implied a very narrow scope for financial management. Concerned with procurement of funds by corporate enterprise to meet their financing needs. Ignored the important dimension of allocation of capital.

Modern Approach
Provides a conceptual and analytical framework for

decision making.
Covers both acquisition of funds and efficient and

wise allocation of funds to various uses.

Concerned with solution of three major problems

relating to financial operations of a firm.

Modern Approach
Financial Management addresses the following three questions:
What investments should Investment Decision the firm engage in

How can the firm raise the money for the required investments Financing Decision How should the firm deal with profits distribute or retain Dividend Decision

Investment Decision
Selection of assets in which funds will be

invested by a firm

Long term assets which yield a return over a period of time in future Short term or current assets which in the normal course of business are convertible into cash without diminution in value, usually within a year.

The Balance-Sheet Model of the Firm

Total Value of Assets: Current Assets Total Firm Value to Investors: Current Liabilities Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

Shareholder's Equity

The Balance-Sheet Model of the Firm

The Capital Budgeting Decision
Current Assets

Current Liabilities
Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

What longterm investments should the firm engage in?

Shareholder's Equity

The Balance-Sheet Model of the Firm

The Net Working Capital Investment Decision
Current Liabilities
Net Working Capital

Current Assets

Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

How much shortterm cash flow does a company need to pay its bills?

Shareholder's Equity

Financing Decision
Concerned with financing mix or capital

structure or leverage.
Relates to choice of proportion of sources of

funds (debt and equity capital) to finance the investment requirements.

The Balance-Sheet Model of the Firm

The Capital Structure Decision
Current Assets

Current Liabilities
Long-Term Debt

How can the firm raise the money for the required Fixed Assets investments? 1 Tangible
2 Intangible

Shareholders Equity

Dividend Policy Decision

Two alternatives are available in dealing with profits

of the firm: They can be distributed to shareholders in form of dividends They can be retained in business itself.
Decision regarding dividend pay out ratio will depend

on preference of shareholders and investment opportunities available within the firm.

The Financial Manager

To create value, the financial manager should:

Try to make smart investment decisions.

Try to make smart financing decisions.

The Firm and the Financial Markets

Firm
Invests in assets (B) Firm issues securities (A) Retained cash flows (F) Short-term debt

Financial markets

Current assets Cash flow from firm (C) Fixed assets

Dividends and debt payments (E)

Taxes (D)

Long-term debt
Equity shares

Ultimately, the firm must be a cash generating activity.

Government

The cash flows from the firm must exceed the cash flows from the financial markets.

Objectives of FM
There are two widely discussed approaches:

Profit Maximization approach Wealth Maximization approach

Profit Maximization Decision Criterion

Actions that increase profits should be undertaken

and those that decrease profits are to be avoided.

Investment, financing and dividend policy decisions

of a firm should be oriented to maximization of profits.

A firm should select assets, projects and decisions

which are profitable and reject those which are not.

Profit Maximization Decision Criterion

Rationale behind profit maximization as a guide to

financial decision making:

Provides the yardstick by which economic performance can be judged. It leads to efficient allocation of resources as resources tend to be directed to uses which in terms of profitability are the most desirable.

This criterion has been questioned and criticized on

several grounds:

Ambiguity Timing of Benefits Quality of Benefits

Time Pattern of Benefits

Alternative A (profits in lakhs) Period I 50 Alternative B (lakhs)

Period II
Period III Total

100
50 200

100
100 200

If profit maximization is the decision criterion, both the alternatives would be ranked equally. However, alternative A provides higher returns in earlier years whereas returns from alternative B are larger in later years. Thus, they are not identical. Profit max does not consider distinction between returns received in different time periods and treats all benefits as equally valuable irrespective of timing.

Quality of Benefits
State of Economy Recession (Period I) Alternative A (profits in cores) 9 Alternative B 0

Normal (Period II)

Boom (Period III) Total

10
11 30

10
20 30

If profit maximization is the decision criterion, both the alternatives would be ranked equally on total returns.

However, earnings associated with alt B are more uncertain (risky) as they fluctuate widely depending on state of economy. So alt A is considered feasible in terms of risk and uncertainty.
Profit max fails to reveal this.

Wealth Maximization Decision Criterion

Also known as value maximization or net present

worth maximization. It is universally recognized as an appropriate operational decision criterion for FM Its operational features satisfy all three requirements of a suitable operational objective of financial courses of action:

Exactness Quality of benefits Time Value of Money

Wealth Maximization Decision Criterion

Concept is based on cash flows generated by

decision rather than accounting profit. Cash flow is a precise concept with a definite connation as it avoids ambiguity. Value of cash flows is calculated by discounting its element back to present at a capitalization rate that reflects both time and risk. Capitalization rate is the rate that reflects time and risk preferences of owners or suppliers of capital. Large capitalization rate is the result of higher risk and longer time period.

Organization of Finance Function

Responsibilities of FM are spread throughout the organization.
Nevertheless FM is highly specialized in nature and is

handled by specialists.

Organization of Finance Function

Board of Directors Managing Director/Chairman Vice President/Director (Finance)

Treasurer

Controller

Chapter 2

Sources of Finance

Classification
Long term funds

Medium term
Short term funds

Short term sources of funds:

Useful for investment in current assets. Range from a period of one day to max of one year. Sources

are trade credit, factoring, and forfeiting, bill discounting, overdrafts and cash credits from banks and borrowings against receivables.

Classification
Long term sources of funds:
are for acquisition of long term fixed assets or in decisions to

start a new venture or expand its current business. are needed for a period of 5 to 25 years for investments Sources are from internal resources like retained earnings and external sources are from equity capital, debentures, bonds, preference shares, term loans and innovative instruments.

Medium term sources of funds:

are required to make permanent additions to working capital or

to buy fixed assets. are for a period of 1 to 5 years. Sources are leasing and hire purchase and fixed deposits from general public and directors of the company.

Security Financing
is a method of getting external source of financing for

the company.
Important securities which help in raising funds for a

company are: Equity Shares Preference Shares Debentures/Bonds

Equity Shares
Are called ownership shares Are also called high risk securities

Advantages:
Permanent source of funds

Does not have repayment liability

Does not have to pay dividends if company is not making profit.

Disadvantages:
Cost of funds is high
No tax deductible advantages for the company. Floating cost of issuing equity capital is high.

Preference Shares
Have a preferential right to receive dividends before equity

shareholders Do not have voting rights and have fixed dividends. Is a hybrid security Advantages: Do not create a charge on assets of the company Do not have an effect on control pattern of the company Are cheaper in financing compared to equity shares. Disadvantages: Are not tax deductible Have a claim over equity shareholders on assets of company, so their control is diluted.

Types of Preference Shares

Cumulative and Non-Cumulative Preference Shares
Redeemable and Irredeemable Participating and Non-participating Convertible and Non-Convertible Shares

Debentures/Bonds
Are debt securities Have a specific rate of interest and date of maturity

Advantages: Cost of debentures/bonds is low due to tax deduction of interest payments Do not create any dilution of control as holders do not have any voting rights Disadvantages: Creates a financial burden on company Suits only those companies which have a stable return Have a right to charge on property and assets of company in case of liquidation.

Types of Bonds/Debentures
Redeemable and Irredeemable

Secured and Unsecured Bonds/Debentures

Tax free Bonds Zero Coupon Bonds

Deep Discount Bonds

Participating Debentures Convertible Bonds/Debentures Floating rate Bonds Regular Income Bonds Retirement Bonds Inflation Bonds, warrant bonds etc

Loan Financing
Long term loans are taken at time of starting a new business for

expanding their activities. Loans are for period of 5 to 10 years In India, such loans are being disbursed by financial institutions like IDBI, ICICI and IFCI. Features: Security Interest Rate Repayment of loans Restrictive provisions

Loan Financing
Advantages: Are attractive as they have low rate of interest and have low financial burden Interest charges are tax deductible Disadvantages: Have restrictions on working of the company. Some covenants are negative and functioning of company becomes difficult Flexibility is reduced and company has to work acc to rules and regulations framed by lender until loan is returned.

Project Financing
Managing

and financing infrastructural projects.

economic

activities

of

large

High cost with large volume of funds such as power stations,

fertilizer plants, satellites, oil, gas and hotel projects are some of the infrastructural projects in which special techniques are required to manage its finances.
Is a series of techniques for assessing risks and calculation of

cash flows generated by a project.

Loan Syndication
Is a service provided by merchant bankers for financing a

project or for working capital requirements of a company.

Financial institutions like IFCI, IDBI, ICICI, LIC, UTI, GIC and

SFCs are suppliers of finance for loan syndication. Steps Involved: Preparation of detailed project report by merchant bankers Identification of lenders Holding meetings and discussions and negotiate with lenders on loan amount, rate of interest and other terms Prepare a loan application and submit completed app to financial institution Merchant banker obtains letter of intent

Loan Syndication
Steps Involved contd: Negotiations regarding security offered on loans are made with financial institutions. When loan document is complete, merchant banker assists financial institution to disburse the loan to borrower. Advantages: Merchant bankers helps company to identify potential sources of finance for taking loans for a fee. Best Price Disbursal of loan quickly. Disadvantages: Payment of fees

New Financial Institutions & Instruments

In India, several reforms were made to strengthen financial

system after 1991.

Financial reforms were intended to move from controlled

economy to a free economy with following objectives:

Develop financial sector infrastructure Bring about financial supervision for investor protection Financial liberalization for moving from controlled economy to efficient market driven economy. Bring about improvement in quality of services and bring in confidence amongst the savers for encouraging savings Introduce new financial instruments for giving options to investor Emphasize requirement of protection of investors from fraudulent bills.

New Financial Institutions & Instruments

Contributors to Financial System Household sector which are suppliers of funds
Firms that are engaged in commercial activities and require

funds for carrying on business activities

Government which regulates the market through policies and

regulations and gives direction.

Financial institutions which play role of giving funds and

putting savers and investors together.

Financial instruments which facilitate transfer of money within

a country and internationally.

Book Building
New Issue market/Primary market performs functions of

providing an environment for sale and purchase of new issues. Stock market has the function of trading in securities after new securities are allotted and then listed with it. Book Building is used in context of sale of a new security offered for the first time in New Issue market before trading of this share begins in stock market. Process of offering shares to public in new issue market through public demand by bidding for the shares. Based on bids, price is discovered. A price band is given and public is asked to bid for price within that band. Fairly new concept and one of the developments in financial sector to bring about a fair and just system of issuing shares through openness and public demand.

Depository or Paperless trading

Dematerialization of securities for electronic trading of shares is

one of the major steps for improving and modernizing stock market and enhancing level of investor protection. Advantages: Eliminates risk as it does not have physical certificates. Expedite transfer of shares through electronic transfer. De-mat account which provides client identification number and depository identification number. Account statement which is similar as in case of a bank. No Stamp duty on transfer of securities as there is no physical transfer. Allows a nomination facility Automatic credit of bonus amount and other benefits of consolidation or merger

Factoring
Is a financial service for financing credit sales in which

receivables are sold by a company to specialized financial intermediary called factor. Factor provides several services to a company that draws an agreement for managing its receivables.

Parties to factoring: Seller sells goods on credit to buyer. He gives delivery invoice and instructs buyer to pay amount due on credit sales to his agent or factor. Buyer makes an agreement with seller after negotiating terms and signing a memorandum of understanding. Factor is a financial intermediary between buyer and seller. He is an agent of seller. Factor pays 80% of price in advance and receives payment from buyer on due date, then remits balance to seller after deducting his commission.

Types of Factoring
With Recourse Factoring : factor does not take credit risks

which is associated with receivables. Factor has the right to receive commission and his expenses for maintaining sales ledger.
Without Recourse Factoring: Factor has to bear all losses that

arise out of irrecoverable receivables. For this he charges a higher commission which is premium for higher risk. Factor takes a great interest in business matters of client in this type of factoring.

Venture Capital
Is a private equity investment fund through which funds are

borrowed by investors who have technical know how.

Venture capitalists make an agreement whereby they support

the project and fund it, in return for monetary gains, shareholding and acquisition rights in business financed by them.
Fist venture capital in India was established by IFCI in 1975. Other venture capital funds in India are IDBI Venture capital fund ICICI venture funds management company limited

Credit Rating
Is a service provided by a credit rating agency for evaluating a

security and rating it by grading it according to its quality.

In India credit rating had its inception n 1987 with incorporation

of firsts service company named CRISIL Credit Rating Information Services of India Four rating agencies in India which are registered and regulated by SEBI:

CRISIL ICRA Investment Information and Credit Rating Agency of India CARE Credit analysis and Research Ltd. Duff and Phleps.

Objectives of Credit Rating

To analyze the risks of the company Provide information to investor for selecting debt securities Express an opinion of company by grading of debt securities

with technical expertise.

Debenture Rating Symbols
AAA AA A Highest Safety High Safety Adequate safety

Fixed Deposit Rating Symbols

FAAA FAA FA FB Highest Safety High Safety Adequate safety Moderate safety

BBB moderate safety

Commercial Paper (CP)

Is an unsecured short term negotiable instrument with fixed

maturity. Used for raising short term debt.

Is a promise by borrowing company to return loan on specified

date of payment.
Unsecured promissory note which is issued for a period of 7

days and three months.

In India CP are popularly used between 91 to 180 days. Corporate organization can directly issue commercial papers to

investors (direct paper) or can be indirectly issued through a bank or a dealer (dealer paper).

Certificate of Deposit (CDs)

Is a securitized short term deposit issued by banks at high rates

of interest during period of low liquidity. Liquidity gap is met by banks by issuing CDs for short period. In India, CDs are being issued by banks directly or through dealers. Are part of bank deposits and issued for 90 days but maturity period vary acc to corporate organizations Min issue of CDs to single investor is 10 lakh rupees.

Advantages: Reliable Liquidity Flexible Trading

International Depository Receipts

American Depository Receipts Are a method of raising funds in America in US stock markets. First ADR was issued in 1920 to invest in oversees markets and to provide a base to non-USA companies to invest in stock market in USA. ADRs could be traded only in USA. European Depository Receipts EDRs are issued in Europe and denominated in European currency. EDRs have a small market and are not attractive instruments. Are not well developed like ADRs and GDRs.

International Depository Receipts

Global Depository Receipts
Are a method of raising equity capital by organizations which

are in Asian countries. Are placed in USA, Europe and Asia. Have a low cost and help in bringing liquidity. Govt of India allowed Indian cos to mobilize funds from foreign markets through Euro issues of GDRs and foreign currency convertible bonds. Cos with good track record can issue GDRs for developing infrastructure projects in power, telecommunications and petroleum and in construction and development of roads, airports and ports in India.

International Depository Receipts

Indian Depository Receipts
Are like ADRs and GDRs. A new instrument as a source of raising finance. Instrument provides global companies to have an entry in Indian

capital market. Global companies can issue IDRs and raise money from India. Although this instrument has been accepted as an international financial instrument for raising funds, legal formalities are still being worked out by Department of Company Affairs.

Chapter 3

Concepts in Valuation

Time Value of Money

Value of a unit of money is different in different time

periods i.e. Value of a sum of money received today is more than its value received after sometime.
Due to reinvestment opportunities for funds which are

received early.
Since a rupee received today has more value,

rational investors would prefer current receipts to future receipts.

Time Value of Money

Mr. X has option of receiving Rs 1000 now or one

year later. What would be his choice?

He can deposit this amount received now and earn

nominal rate of interest (3%). At the end of the year, amount accumulates to Rs 1030.
As a rational person, he should be expected to prefer

the larger amount (Rs 1030 here).

Same principle applies to a business firm.

Relevance of Time Value of Money

Money received today is higher in value than after a

certain period because of uncertainties, inflation and preference for current consumption and opportunities for reinvestment to get a higher yield.
Importance of money can be analyzed for three

reasons: Compensation for Uncertainty Preference for Current Consumption Reinvestment Opportunity

Techniques of Time Value of Money

Basic techniques are:

Compounding for Future Values Discounting for present Value

Future Value
If you were to invest Rs 10,000 at 5-percent interest for one

year, your investment would grow to Rs 10,500 Rs 500 would be interest (Rs 10,000 .05) Rs 10,000 is the principal repayment (Rs10,000 1) Rs 10,500 is the total due. It can be calculated as: Rs10,500 = Rs10,000(1.05). The total amount due at the end of the investment is call the Future Value (FV).

Compound / Future Value

In the one-period case, the formula for FV can be written as: FV = PV (1 + i)n
Where PV is cash flow today (time zero), present value i is the appropriate interest rate for 1 period n is the number of years

Compound / Future Value

In the multi- period case, the formula for FV can be written as: FV = PV (1 + i/m)nm
Where PV is cash flow today (time zero), present value i is the appropriate interest rate for 1 period n is the number of years m is number of compounding per year

Compound Value of Annuity

Compound Value = Annuity Amount * Compound Value Annuity Factor FV = A * CVAF

Present Value
PV can be calculated through discounting approach. If you were to be promised Rs10,000 due in one year when

interest rates are at 5-percent, your investment be worth Rs9,523.81 in todays rupees. RS 9523.81 = Rs 10000/1.05 The amount that a borrower would need to set aside today to be able to meet the promised payment of Rs10,000 in one year is call the Present Value (PV) of Rs10,000. Note that Rs10,000 = Rs9,523.81(1.05).

Present Value
In the one-period case, the formula for PV can be written as: PV = FV/ (1 + i)n
Where PV is cash flow today (time zero), present value i is the appropriate interest rate for 1 period n is the number of years

Present Value
In the multi- period case, the formula for FV can be written as: PV = FV/ (1 + i/m)nm
Where PV is cash flow today (time zero), present value i is the appropriate interest rate for 1 period n is the number of years m is number of compounding per year

Practical Applications

Valuation of Securities
Valuation of Debentures

Valuation of Preference shares

Valuation of Equity Shares