Assignment No.

01 Financial Management
Question No. 1

Define financial management. What are the three major functions of financial management? How they related?

Financial Management:
The process of managing the financial resources, including accounting and financial reporting, budgeting, collecting accounts receivable, risk management, and insurance for a business.

Major functions of financial management:
1. Accounting: Typically includes: (a) planning the program within delegated limits; (b) developing, revising, and/or adapting accounting systems; (c) executing day-to-day ledger maintenance and related operations for the classification and other recording of financial transactions; (d) analyzing the results and interpreting the effects of transactions upon the financial resources of the organization; (e) applying accounting concepts to solve problems, render advice, or to meet other needs of management; and (f) managing the total accounting program, including supervision of subordinate accountants, accounting technicians, voucher examiners, payroll clerks, and other similar supporting personnel. 2. Budgeting: Typically includes: (a) the formulation -- developing instructions, calls for estimates, preparing estimates, reviewing and consolidating estimates; (b) the presentation -- either within the organization or at hearings (within the agency, at the budget bureau, or

subcommittee); and (c) the execution -- funds control, program adjustments, review of reports and preparation of reports. 3. Managerial-Financial Reporting: Typically includes not only the recurring budget, accounting, and financial reports but also program operation evaluation and statistical reports and other work performance type reports, both regular and one-time in nature. Managerial-financial reporting is the process of providing appropriate data to key officials at all levels of management for the purpose of helping to achieve the most effective program and financial management. Stress is placed on aiding in the making of management

decisions. Normally, much of such data will be of a financial character, developed from the accounting and the budget systems; however, frequently data will be a combination of both financial and non-financial information and, in some cases, the data may be entirely nonfinancial in nature. In its ideal form, the data are so integrated as to represent a single total data system. Since in good managerial-financial reporting, concern is given to the development of the systems that will provide the essential data, one of the normal responsibilities of the Financial Manager is the development, revision and/or adaptation of the managerial-financial reporting system. 4. Advice to Management: Typically includes: advising from a financial point of view and serving as the technical expert on the financial aspects of all matters. B. Functions directly related to the management of financial resources and which may be included: 1. Management Analysis: Typically includes: administering, supervising, or performing study, analysis, evaluation, development or improvement of managerial policies, practices, methods, and procedures; 2. Records or Paperwork Management: typically includes: operating, maintaining, or administering one or more administrative control systems, services, processes or functions such as those for forms control, the handling of correspondence, directives control, the disposition of records; 3. Auditing: Typically includes: the establishment and improvement of audit policies, programs, methods, and procedures, and the achievement of a high standard of auditing; the proper timing and coverage of audits; the disposition of technical accounting questions developed in audits, including disposition through negotiations and conferences with affected business establishments or other interested organizations; responsibility for all auditing and related activities in connection with payments and cost analyses; and shaping, directing, and administering the audit activities; 4. Statistics: Typically includes: administering or performing professional work, or providing professional consultation in the application of statistical theories, techniques, and methods to the gathering and/or interpretation of quantified information; or advising on, administering, supervising, or performing work involved in collecting, editing, computing, compiling, analyzing; and presenting statistical data, where the work requires knowledge and application of statistical methods and procedures, and techniques, but does not require professional knowledge of the mathematical or statistical theories, assumptions, or principles upon which they are based.

Question No. 3
Explain the procedure of cash flow estimation for the capital budgeting decision. Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting. In the form of either debt or equity, capital is a very limited resource. There is a limit to the volume of credit that the banking system can create in the economy. Commercial banks and other lending institutions have limited deposits from which they can lend money to individuals, corporations, and governments. In addition, the Federal Reserve System requires each bank to maintain part of its deposits as reserves. Having limited resources to lend, lending institutions are selective in extending loans to their customers. But even if a bank were to extend unlimited loans to a company, the management of that company would need to consider the impact that increasing loans would have on the overall cost of financing. In reality, any firm has limited borrowing resources that should be allocated among the best investment alternatives. One might argue that a company can issue an almost unlimited amount of common stock to raise capital. Increasing the number of shares of company stock, however, will serve only to distribute the same amount of equity among a greater number of shareholders. In other words, as the number of shares of a company increases, the company ownership of the individual stockholder may proportionally decrease. The argument that capital is a limited resource is true of any form of capital, whether debt or equity (short-term or long-term, common stock) or retained earnings, accounts payable or notes payable, and so on. Even the best-known firm in an industry or a community can increase its borrowing up to a certain limit. Once this point has been reached, the firm will either be denied more credit or be charged a higher interest rate, making borrowing a less desirable way to raise capital. Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management must identify the projects that will contribute most to profits and, consequently, to the value (or wealth) of the firm. This, in essence, is the basis of capital budgeting.

Basic Data Year 0 1 2 3 Expected Net Cash Flow Project L Project S ($100) ($100) 10 70 60 50 80 20

II. Basic Steps of Capital Budgeting 1. 2. 3. 4. 5. Estimate the cash flows Assess the riskiness of the cash flows. Determine the appropriate discount rate. Find the PV of the expected cash flows. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or payback < policy

III. Evaluation Techniques A. Payback period B. Net present value (NPV) C. Internal rate of return (IRR) D. Modified internal rate of return (MIRR) E. Profitability index

Definitions: Independent versus mutually exclusive projects. Normal versus nonnormal projects.

A. PAYBACK PERIOD Payback period = Expected number of years required to recover a project’s cost. Project L Expected Net Cash Flow Project L Project S ($100) ($100) 10 (90) 60 (30) 80 50

Year 0 1 2 3

PaybackL = 2 + $30/$80 years = 2.4 years. PaybackS = 1.6 years. Weaknesses of Payback:

If the projects are mutually exclusive, accept Project S since NPVS > NPVL. Note: NPV declines as k increases, and NPV rises as k decreases. C. INTERNAL RATE OF RETURN

1. Ignores the time value of money. This weakness is eliminated with the discounted payback method. 2. Ignores cash flows occurring after the payback period. B. NET PRESENT VALUE

IRR :
Project L:

CFt n = $0 = NPV . ∑ t = 0 (1 + IRR ) t

CFt n NPV = ∑ t = 0 (1 + k) t

0

1

2 60 18.1%

3 80

Project L:

0 −100.00 9.09
49.59 60.11 NPVL = $ 18.79 NPVS = $19.98

1 10

2 60

3 80

−100.00 10 8.47 18.1% 18.1% 43.02 48.57 $ 0.06 ≈ $0

If the projects are independent, accept both.

IRRL = 18.1% IRRS = 23.6% If the projects are independent, accept both because IRR > k. If the projects are mutually exclusive, accept Project S since IRRS > IRRL. Note: IRR is independent of the cost of capital.

NPV ($) 50

k 0% 5 10 15 20

NPVL $50 33 19 7 (4)

NPVS $40 29 20 12 5

40 Crossover Point = 8.7%

30

20

IRRS = 23.6%

10

0 5 -10 10 15 20 25 k(%)

IRRL = 18.1%

1. ADVANTAGES AND DISADVANTAGES OF IRR AND NPV A number of surveys have shown that, in practice, the IRR method is more popular than the NPV approach. The reason may be that the IRR is straightforward, but it uses cash flows and recognizes the time value of money, like the NPV. In other words, while the IRR method is easy and understandable, it does not have the drawbacks of the ARR and the payback period, both of which ignore the time value of money. The main problem with the IRR method is that it often gives unrealistic rates of return. Suppose the cutoff rate is 11% and the IRR is calculated as 40%. Does this mean that the management should immediately accept the project because its IRR is 40%. The answer is no! An IRR of 40% assumes that a firm has the opportunity to reinvest future cash flows at 40%. If past experience and the economy indicate that 40% is an unrealistic rate for future reinvestments, an IRR of 40% is suspect. Simply speaking, an IRR of 40% is too good to be true! So unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a yardstick to accept or reject a project. Another problem with the IRR method is that it may give different rates of return. Suppose there are two discount rates (two IRRs) that make the present value equal to the initial investment. In this case, which rate should be used for comparison with the cutoff rate? The purpose of this question is not to resolve the cases where there are different IRRs. The purpose is to let you know that the IRR method, despite its popularity in the business world, entails more problems than a practitioner may think.

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