CH 9

FINANCIAL
MANAGEMENT
Introduction

 Every business enterprise, whether big or

small, needs finances to carry on its
operations. The importance of finance has
increased tremendously these days because of
mass production and the use of capital-
intensive techniques. As a result, finance is
considered as the life-blood of any business.
MEANING OF BUSINESS FINANCE

 Business finance refers to the money

required for carrying out business
activities. It is basically concerned
with acquisition of funds, use of
funds distribution of profits by a
business enterprise.
Need for Business Finance
 To start and establish a business
 To run day-to-day activities of business like
payment for raw material salaries, etc.
 To modernize, expand and diversify the business
 To purchase assets (tangible assets like machinery,
land, building, etc. and intangible assets like
trademarks, patents, etc.).
 Availability of adequate finance is very crucial for
the survival and growth of business.
FINANCIAL MANAGEMENT

“Financial Management is concerned

with optimal procurement as well
as the usage of finance.”
 Two Aspects of Financial Management

 1. Procurement of funds:
 2. Usage of finance:
Objectives of financial
management
DIFFERENCE BETWEEN THE
TWO
 MEANING
 PERSPECTIVE
 MEANS
 SCOPE
 APPROACH
Financial Decisions
 I. INVESTMENT DECISION
 RESOURCES SCARCE ALTERNATIVE
USE
 WHERE TO INVEST HIGHEST RETURNS

INVESTMENT PROPOSALS

LONG TERM SHORT TERM

LONG TERM AND SHORT TERM INVESTMENT
DECISION

 OTHER NAME
 EXAMPLE
 WHAT ALL IS AFFECTED
 INGREDIENTS
FACTORS AFFECTING CAPITAL BUDGETING
DECISIONS:

 Cash flows of the project:

BUSINESS OPTION OPTION B OPTION
PROPOSAL A C

CASH FLOW Rs. 6.5 CR Rs. 7 CR Rs. 9 CR

FROM THE
PROECT OVER ITS
LIFETIME

LIFE TIME OF 5 YEARS 5 YEARS 5 YEARS

INVESTMENT
 The Rate of Return: (R-R MATRIX)
INVESTMENT OPTION A OPTION B OPTION C
PROPOSAL
RATE OF RETURN 23% 30% 21%
(EXPECTED)

LEVEL OF RISK MODERATE MODERA MODERAT

TE E
The Investment Criteria Involved:

 INVESTMENT PROPOSAL FEASIBILITY (E, M, T, F)

– F&RA---BASED ON----PARAMETERS
 BASIC PARAMETERS----NPV, BENEFIT TO COST
RATIO, IRR, PAYBACK PERIOD, ETC ------------(CBT)
 VIABILITY OF THE PROPOSAL – M AND T
 Mike: Can we build this bridge by tomorrow?
 You:
 Mike: We can keep the company in business by taking out
loans.
 You:
 II. FINANCING DECISION
 This decision is about the quantum of finance to be
raised from various long-term sources and short-
term sources and selecting the cheapest one with
considerable risk.
 PRUDENT FINANCIAL MANAGER---
NEEDS---MIX----TO MAXIMIZE ----

 DEBT AND EQUITY

WHY DEBT ???????
1. IS CHEAPER
2. RISK AND EXPECTATIONS
BUT??????
DEPENDENCE??????

Financial risk increases

WHAT ABOUT EQUITY????

 NO COMMITMENT
 BUT????? EXPECTATIONS
 FACTORS AFFECTING FINANCING
DECISION

 Cost
 Risk
 Flotation Cost
 CASH FLOW POSITION
 LEVEL OF Fixed Operating Costs
 Control Considerations
 State of Capital Markets
III. DIVIDEND DECISION
 Dividend decision is whether to distribute earnings
to shareholder as dividends or to retain earnings to
finance long-term projects of the firm.
 The dividend decisions are taken keeping in view
the overall objective of maximizing shareholder’s
wealth
 FACTORS AFFECTING
DIVIDEND DECISIONS
 Amount of Earnings/ STABILITY OF EARNINGS
 Stability of Dividends
 Growth Opportunities
 Cash Flow Positions
 Shareholders preference
 Taxation Policy
 Stock Market Reaction
 Access to Capital Market
 Legal constraints
 Contractual Constraints
Identify the type of decisions
 Ravi wants to open a restaurant and is looking for a proper place to open it.
He is also thinking of the amount of funds which will be required for some of
the set ups like food making and storing machineries.
 Ravindra is running a toy manufacturing company. He thinks of expanding
his business. He meets his uncle and asks him for a sum of Rs. 2 crores. His
uncle asks for a high interest rate. He agrees to it and promises to pay the
money back within 2 years.
 A leading marketing company has decided to raise money through the stock
market. It issued IPO in the market last year. The company knows there are
going to be sizeable floatation costs involved in it.
 A company which has 10 branches in the city has decided to open its 11th
branch. The company has taken this branch on rent. In this way the company
has saved money which it would otherwise have invested in purchasing it.
 A company has decided to plough back the money in the form of retained
earnings. This decision will save the company at least ‘50 crores. These funds
can be used for the long term growth of the business.
ANSWERS
 Investment decision
 Financing decision
 Financing decision
 Investment decision (short-term investment
decision/working capital)
 Dividend decision
 FINANCIAL PLANNING

 THE PROCESS OF ESTIMATING THE FUNDS

REQUIREMENT OF BUSINESS AND
SPECIFYING THE SOURCES OF FUNDS.
DIFFERENCE BETWEEN------

BASIS FINANCIAL FINANCIAL

MANAGEMENT PLANNING
MEANIN P AND U OF FUNDS E AND S OF
G FUNDS

SCOPE NARROW WIDER

OBJECTI PRIME OBJECTIVE TWIN

VE OBJECTIVE
1. ENSURE
2. SEE
• DOESN’T RAISE
REOURCES 2
NEEDLESSLY
• AVAILABILTY OF
1
FUNDS
OBJECTIVE
PROCESS OF FINANCIAL PLANNING
4.
REQUIREMEN
1. SALES
T OF
FORECAST
EXTERNAL
2.
FUNDS
FINANCIAL 5.
STAEMENTS
PREPARATION VARIOUS
SOURCES 7.
ARE CASH
3. IDENTIFIED BUDGET IS
APPROXIMATIO LAYED DOWN
N ABOUT 6.
EXPECTED EVALUATED
PROFITS
IMPORTANCE OF FINANCIAL PLANNING

ENSURE
S
FACILITAT HELPS
ES IN

IMPORTANC
E
HELPS FACILITA
TO TE

PROVID INCREASES
ES
 CAPITAL STRUCTURE

 MIX BETWEEN OWNER AND BORROWED

FUNDS
 AFFECTS BOTH PROFITABILITY AND
FINANCIAL RISK
FINANCIAL LEVERAGE
 SOMETHING USED TO TAKE ADVANTAGE
OF
 PROPORTION OF DEBT
 =DEBT/EQUITY OR DEBT/D+E
 CLASSIFIED INTO
HIGH
FINANCIAL LOW
LEVERAGE FINANCIAL
LEVERAGE
 FAVOURABLE
Return On
UNFAVOURABLE Investment
ROI IS LESS THAN EXCEEDS Rate Of
ROI Interest ----
TRADING ON
EQUITY
FINANCIAL LEVERAGE
 IMPACT OF FINANCIAL
LEVERAGE ON
PROFITABILITY

Earning Before Int and

Tax- Earning Per
Share ANALYSIS
EXAMPLE
 TOTAL FUNDS EMPLOYED:
Rs. 50 Lakhs
 Situation- 1 : 5,00,000 equity shares of Rs. 10

each; Debt: Nil

 Situation- 2 : 4,00,000 equity shares of Rs.10

each., 10% Debt: Rs. 10 Lakhs

 Tax rate : 30%

 EBIT: Rs. 8,00,000

 FAVOURABLE
ROI EXCEEDS ROI
---- TRADING ON
EQUITY
TABULATE
SOURCES SITUATION SITUATION 2
1
EQUITY SHARES @ 10 EACH 5000000 4000000
DEBT @10% NIL 1000000
TOTAL CAPITAL 5000000 5000000
EBIT 800000 800000
(-) INT 10% NIL 100000
EBT 800000 700000
(-) TAX 30% 240000 210000
EAT 560000 490000
NO OF EQUITY SHARES ISSUED 500000 400000
EPS 1.12 1.23
 EPS
=
____EAT_________________________
NO. OF EQUITY SHARES ISSUED
FAVOURABLE SITUATION??????

SITUATION:::: 2

WHY???

THIS IS::::: TOE

 ROI>ROI
 RATE OF INTEREST : 10%

 RETURN ON INVESTMENT
= EBIT/TOTAL INVEST*100
= 800000/50,00000*100
= 16%
ANOTHER EXAMPLE:::
SOURCES SITUATION SITUATION 2
1
EQUITY SHARES @ 10 EACH 50,00,000 40,00,000
DEBT @10% -NIL- 10,00,000
TOTAL CAPITAL 50,00,000 50,00,000
EBIT 4,00,000 4,00,000
(-) INTEREST @ 10% - 100000
EBT 400000 300000
(-) TAX @ 30% 120000 90000
EAT 280000 210000
NO. OF EQUITY SHARES ISSUED 500000 400000
EPS 0.56 0.52
 RATE OF INTEREST : 10%

 RETURN ON INVESTMENT
= EBIT/TOTAL INVEST*100
=400000/5000000*100
=8%
ANOTHER EXAMPLE:::
SOURCES SITUATION SITUATION SITUATION
1 2 3

EQUITY SHARES @ 10 EACH 30,00,000 20,00,000 10,00,000

DEBT @10% ------------ 10,00,000 20,00,000
TOTAL CAPITAL 30,00,000 30,00,000 30,00,000
EBIT 4,00,000 4,00,000 4,00,000
(-) INTEREST @ 10% ------------ 100000 200000
EBT 4,00,000 300000 200000
(-) TAX @ 30% 120000 90000 60000
EAT 280000 210000 140000
NO. OF EQUITY SHARES 300000 200000 100000
ISSUED
EPS 0.93 1.05 1.4
 RATE OF INTEREST : 10%

 RETURN ON INVESTMENT
= EBIT/TOTAL INVEST*100
=400000/3000000*100
=14.33%
ANOTHER EXAMPLE:::
SOURCES SITUATION SITUATION SITUATION
1 2 3

EQUITY SHARES @ 10 EACH 3000000 2000000 1000000

DEBT @10% ------------ 10,00,000 20,00,000
TOTAL CAPITAL 30,00,000 30,00,000 30,00,000
EBIT 2,00,000 2,00,000 2,00,000
(-) INTEREST @ 10% ----------- 100000 200000
EBT 200000 100000 NIL
(-) TAX @ 30% 60000 30000 ----
EAT 140000 70000 ----
NO. OF EQUITY SHARES 300000 200000 ----
ISSUED
EPS 0.46 0.35 ---
 RATE OF INTEREST : 10%

 RETURN ON INVESTMENT
= EBIT/TOTAL INVEST*100
=200000/3000000*100
= 6.67%
BUT………
FR
CHOOSE::::::::

R-R
COMBINATIO
N
FOR
??????
 FACTORS AFFECTING CHOICE OF CAPITAL
STRUCTURE

1. CASH FLOW POSITION

GOOD WEAK

DEBT EQUITY
 2. ICR
 ICR= EBIT/ INTEREST
 Ex: Loan : Rs. 500000 @10% and EBIT is Rs.
1,00,000
 So, ICR =
 100000/50000= 2 DEBT EQ
UIT
2 TIMES Y
3. DSCR: DEBT SERVICE COVERAGE RATIO

 CALCULATION: PAT+INTEREST+ NON CASH

EXP.
PREF.DIV+INT+REPAY. OBLIGN

USE DEBT OPT EQUITY

4. ROI
 CALCULATION: EBIT * 100
TOTAL CAP.

USE DEBT OPT EQUITY

5. COD: COST OF DEBT

COD

HIGH LOW

ISSUE
EQUIT
OF
Y
DEBT
6. TAX RATE

TAX RATE

HIGH LOW

ISSUE
DEBT EQUIT
Y
7. COST OF EQUITY
 EQUITY SHARE CAPITAL IS ----- RISK
CAPITAL
 SHAREHOLDERS EXPECT ---- RR MATCH
 DEBT SHARE HOLDERS RISK INCREASES
 EXPECT RETURNS
 SHARE PRICES EVEN IF EPS IS
 AGAINST THE OBJECTIVE
8. FLOATATION COST

 COST OF RAISING THE FUNDS

 LESS IS BEST
9. RISK CONSIDERATION

FINANCIA BUSINESS TOTA

L RISK RISK L
RISK
10. FLEXIBILITY

 HIGH DEBT ------ MORE----

M_R_A_G_E
 KEEP PROVISIONS
11. CONTROL

CONTROL

DEBT EUITY

DOES’N
T DILUT
EFFEC ES
T
12. REGULATORY
FRAMEWORK

 AVOID LEGAL COMPLICATIONS

 NORMS TO BE FOLLOWED
13. CAPITAL STRUCTURE OF OTHER COMPANIES

 GUIDELINES
 NOT TO BE FOLLOWED
 JUSTIFICATION REQUIRED
14. STOCK MARKET CONDITIONS

BULLISH
BEARISH
FACTORS AFFECTING FIXED
CAPITAL REQUIREMENT
Nature of Business:
Scale of Operation:

Technique of Production:

Technology Up-gradation:

Growth Prospects:

Diversification:

Availability of Finance and Leasing Facility

Level of Collaboration/Joint Ventures:
FACTORS AFFECTING
WORKING CAPITAL
REQUIREMENT
1. NATURE OF BUSINESS

NATURE OF
BUSINESS

TRADING MANUFACTURING

LESS MORE
2. SCALE OF OPERATIONS

SCALE OF
OPERATIONS

SMALL LARGE

LESS MORE
3. BUSINESS CYCLE

BOOM DEPRESSION

 DEMAND-
 SALE –
 PRODUCTION –
 REQUIRES -
4. SEASONAL FACTORS

PEAK SEASON LEAN SEASON

 DEMAND-
 SALES-
 PRODUCTION-
 REQUIRES-
5. PRODUCTION CYCLE

CYCLE

LONGER SHORTER

MORE LESS
6. CREDIT ALLOWED

CREDIT ALLOWED

YES NO

MORE LESS
7. CREDIT AVAILED

CREDIT AVAILED

YES NO

LESS MORE
8. OPERATING EFFICIENCY

OPERATING
EFFICIENCY

HIGH LOW

LESS MORE
9. AVAILABILITY OF RAW MATERIAL
(REMEMBER LEAD TIME)

AVAILABILITY OF RM

EASY DIFFICULT

LESS MORE
10. GROWTH PROSPECTS

GROWTH PROSPECTS

YES NO

MORE LESS
11. LEVEL OF COMPETITION

LEVEL OF
COMPETITION

HIGH LOW

MORE LESS
12. INFLATION

INFLATION

HIGH LOW

MORE LESS
 Wooden Peripheral Pvt. Ltd. is counted among the top furniture
companies in Delhi. It is known for offering innovative designs and
high quality furniture at affordable prices. The company deals in a wide
product range of home and office furniture through its eight showrooms
in Delhi. The company is now planning to open five new showrooms
each in Mumbai and Bangalore. In Bangalore it intends to take the
space for the showrooms on lease whereas for opening showrooms in
Mumbai, it has collaborated with a popular home brand, ‘Creations.’
 1. Identify the factors mentioned in the paragraph which are likely to
affect the fixed capital requirements of the business for opening new
showrooms both in Bangalore and Mumbai separately.
 2. “With an increase in the investment in fixed assets, there is a
commensurate increase in the working capital requirement.” Explain
the statement with reference to the case above.
 ‘Sarah Ltd.’ is a company manufacturing cotton yarn. It has been
consistently earning good profits for many years. This year too, it has
been able to generate enough profits. There’re is availability of enough
cash in the company and good prospects for growth in future. It is a
well managed organization and believes in quality, equal employment
opportunities and good remuneration practices. It has many
shareholders who prefer to receive a regular income from their
investments. It has taken a loan of Rs. 40 lakhs from IDBI and is bound
by certain restrictions on the payment of dividend according to the
terms of loan agreement. The above discussion about the company
leads to various factors which decide how much of the profits should be
retained and how much has to be distributed by the company.
 Quoting the lines from the above discussion identify four such factors.