B Com 3rd YEAR FINANCIAL MANAGEMENT

UNIT I
FINANCIAL MANAGEMENT
Financial management is concerned with management of fund. It may be defined as ―acquisition of fundat optimum
cost and its utilization with minimum financial risk.‖ Financial management is the application of planning and
control to the finance function. It aims at ensuring that adequate cash is on hand to meet the required current and
capital expenditure. It facilitates ensuring that significant capital is procured at the minimum cost to maintain
adequate cash on hand to meet any exigencies that may arise in the course of business. Financial management helps
in ascertainingand managing not only current requirements but also future needs of an organization.
GOALS OF FINANCIAL MANAGEMENT
Profit Maximisation
Traditionally the basic objective of financial management was profit maximization but later on this wasoverruled by
shareholders’ (owners) wealth maximization. Presently wealth maximization is the real objectiveof financial
management. Profit maximization was overruled by wealth maximization because of followinglimitations:
 It is vague: Objective of profit maximization does not clarify what exactly it means e.g. whichprofits are to
be maximized—short run or long run, rate of profit or the amount of profit.
 It ignores timing: The concept of profit maximization does not help in making a choice between projects
giving different benefits spread over a period of time.
 It ignores qualitative aspect: The person who wants to expand his market will procure qualitativeinput
material which will incur substantial cost, which in turn will bring down margin and henceprofit. Thus the
quality aspect is contrary to the concept of profit maximization.
Wealth maximization
 Shareholders’ wealth maximization is the real objective of financial management because it helpsthe
management in financial decisions viz. Financing decision, Investment management and dividend decision.
 Shareholders’ wealth maximization is also referred as firm’s value maximization.
 Shareholders’ wealth maximization i.e. value maximization is also goal of the firm.

KEY AREAS OF FINANCIAL MANAGEMENT

The key areas of financial management are discussed in the followingparagraphs.
 Estimating the Capital requirements of the concern. The FinancialManager should exercise maximum
care in estimating the financial requirementof his firm. Every business enterprise requires funds not only
for long-term purposes for investment in fixed assets, but also for short term so as tohave sufficient
working capital. The financial requirements of theenterprise can be estimated by by preparing budgets of
various activities.
 Determining the Capital Structure of the Enterprise. The CapitalStructure of an enterprise refers to the
kind and proportion of differentsecurities. The decisions regarding an ideal mix of equity and debt as well
as short-termand long-term debt ratio will have to be taken in the light of the cost of raisingfinance from
various sources, the period for which the funds are required and soon.
 Finalising the choice as to the sources of finance. The capital structurefinalised by the management
decides the final choice between the varioussources of finance. The important sources are share-holders,
debenture-holders,banks and other financial institutions, public deposits and so on
 Deciding the pattern of investment of funds. The Financial Manager mustprudently invest the funds
procured, in various assets in such a judicious manneras to optimise the return on investment without
jeopardising the long-termsurvival of the enterprise. He can takeproper decisions regarding the investment
of funds only when he succeeds instriking an ideal balance between the conflicting principles of
safety,profitability and liquidity.
 Distribution of Surplus judiciously. The Financial Manager should decidethe extent of the surplus that is
to be retained for ploughing back and the extentof the surplus to be distributed as dividend to shareholders.
 Efficient Management of cash. Cash is absolutely necessary formaintaining enough liquidity. The
Company requires cash to—(a) pay offcreditors; (b) buy stock of materials; (c) make payments to
labourers; and (d)meet routine expenses. It is the responsibility of the Financial Manager to makethe
 necessary arrangements to ensure that all the departments of the Enterpriseget the required amount of cash
in time for promoting a smooth flow of alloperations.

AGENCY CONFLICT: Managers versus Shareholders’ Goals

 There is a Principal Agent relationship between managers and shareholders.
 In theory, Managers should act in the best interests of shareholders.
 In practice, managers may maximise their own wealth (in the form of high salaries and perks) at the cost of
shareholders.
 Managers may perceive their role as reconciling conflicting objectives of stakeholders. This stakeholders’
view of managers’ role may compromise with the objective of SWM.
 Managers may avoid taking high investment and financing risks that may otherwise be needed to maximize
shareholders’ wealth. Such ―satisfying‖ behaviour of managers will frustrate the objective of SWM as a
normative guide.
 This conflict is known as Agency problem and it results into Agency costs.

Agency Costs
Agency costs include the less than optimum share value for shareholders and costs incurred by them to
monitor the actions of managers and control their behaviour.

TIME VALUE OF MONEY

TIME PREFERENCE OF MONEY
Time preference for money is an individual’s preference for possession of a given amount of money now, rather than
the same amount at some future time.Three reasons may be attributed to the individual’s time preference for money:
 risk
 preference for consumption
 investment opportunities
TIME VALUE ADJUSTMENT
Two most common methods of adjusting cash flows for time value of money:
 Compounding—the process of calculating future values of cash flows by applying the concept
of compound interest, and
 Discounting—the process ofcalculating present values of cash flows.
FUTURE VALUE OF LUMPSUM

FUTURE VALUE OF ANNUITY

PRESENT VALUE
Present value of a future cash flow (inflow or outflow) is the amount of current cash that is of equivalent value to the
decision-maker. The interest rate used for discounting cash flows is also called the discount rate.
PRESENT VALUE OF LUMPSUM

PRESENT VALUE OF ANNUITY

 UNIT II
CAPITAL BUDGETING
CAPITAL BUDGETING
 Capital budgeting is the process of planning for purchases of long-term assets. In other words, Capital
Budgeting is a process of undertaking Project Decision/Capital Investment Decision/Long-term Investment
Decision or Capital Expenditure Decision.The investment decisions of a firm are generally known as the
capital budgeting, or capital expenditure decisions.
 The firm’s investment decisions would generally include expansion, acquisition, modernisation and
replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment
decision.
Features of Investment Decisions
 The exchange of current funds for future benefits.
 The funds are invested in long-term assets.
 The future benefits will occur to the firm over a series of years.
Types of Investment Decisions
 One classification is as follows:
 Expansion of existing business
 Expansion of new business
 Replacement and modernisation
 Yet another useful way to classify investments is as follows:
 Mutually exclusive investments
 Independent investments
 Contingent investments
INVESTMENT EVALUATION CRITERIA
 Three steps are involved in the evaluation of an investment:
1. Estimation of cash flows
2. Estimation of the required rate of return (the opportunity cost of capital)
3. Application of a decision rule for making the choice
Investment Decision Rule
 It should maximise the shareholders’ wealth.
 It should consider all cash flows to determine the true profitability of the project.
 It should provide for an objective and unambiguous way of separating good projects from bad projects.
 It should help ranking of projects according to their true profitability.
 It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are
preferable to later ones.
 It should help to choose among mutually exclusive projects that project which maximises the shareholders’
wealth.
 It should be a criterion which is applicable to any conceivable investment project independent of others.
EVALUATION CRITERIA
 Discounted Cash Flow (DCF) Criteria
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)
 Non-discounted Cash Flow Criteria
 Payback Period (PB)
 Discounted payback period (DPB)
 Accounting Rate of Return (ARR)
1. Net Present Value Method
 C C2 C3 Cn 
NPV   1     C0
 (1  k ) (1  k ) (1  k )
2 3
(1  k ) n 
n
Ct
NPV    C0
t 1 (1  k )
t
 Acceptance Rule
 Accept the project when NPV is positive NPV > 0
 Reject the project when NPV is negative NPV< 0
 May accept the project when NPV is zero NPV = 0
2. Internal Rate of Return
 The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash
inflow received after one period. This also implies that the rate of return is the discount rate which makes
NPV = 0.

Acceptance Rule
 Accept the project when r > k
 Reject the project when r < k
 May accept the project when r = k
3. Profitability Index
 Profitability indexis the ratio of the present value of cash inflows, at the required rate of return, to the initial
cash outflow of the investment.
 The formula for calculating benefit-cost ratio or profitability index is as follows:

Acceptance Rule
 Accept the project when PI is greater than one. PI > 1
 Reject the project when PI is less than one. PI < 1
 May accept the project when PI is equal to one. PI = 1
4. Payback Period
Payback is the number of years required to recover the original cash outlay invested in a project. If the project
generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual
cash inflow.
Initial Investment C0
Payback = 
Annual Cash Inflow C
Acceptance Rule
The project would be accepted if its payback period is less than the maximum or standard paybackperiod set by
management.
5. Discounted Payback Period
The discounted payback period is the number of periods taken in recovering the investment outlay on the present
value basis.
6. Accounting Rate of Return
The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The
average investment would be equal to half of the original investment if it were depreciated constantly.
Acceptance Rule
This method will accept all those projects whose ARR is higher than the minimum rate established by the
management and reject those projects which have ARR less than the minimum rate.
7. Modified Internal Rate of Return (MIRR)
The modified internal rate of return (MIRR) is the compound average annual rate that is calculated with a
reinvestment rate different than the project’s IRR.
 UNIT III
LEVERAGES
Financial Leverage
The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners’ equity in
the capital structure, is described as financial leverage orgearingortrading on equity. The financial leverage
employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or
deficit) will increase (or decrease) the return on the owners’ equity.
EPS, ROE and ROI are the important figures for analysing the impact of financial leverage.

EPS = Profit after taxes = PAT

No. of Shares N

ROE = Profit after taxes

Value of Equity

Effect of Leverage on ROE and EPS Favourable ROI > i

Unfavourable ROI < i

Neutral ROI = i

Operating Leverage
Operating leverageaffects a firm’s operating profit (EBIT).The degree of operating leverage(DOL) is defined as the
percentage change in the earnings before interest and taxes relative to a given percentage change in sales.
DOL = %Change in EBIT
%Change in Sales

Degree of Financial Leverage

The degree of financial leverage (DFL) is defined as the percentage change in EPS due to a given percentage change
in EBIT:
DFL = %Change in EPS
%Change in EBIT

Degree of Combined Leverage

% Change in EBIT % Change in EPS % Change in EPS
  
% Change in Sales % Change in EBIT % Change in Sales
 UNIT IV
DIVIDEND DECISIONS
Dividend policy involves the balancing of the shareholders’ desire for current dividends and the firm’s needs for
funds for growth.
Issues in Dividend Policy
 Earnings to be distributed – High Vs Low Payout.
 Objective – Maximize Shareholders Return.
 Effects – Taxes, Investment and Financing Decision.

DIVIDEND RELEVANCE THEORIES:

1. WALTER’S MODEL
Assumptions:Walter’s model is based on the following assumptions:
 Internal financing
 Constant return and cost of capital
 100 per cent payout or retention
 Constant EPS and DIV
 Infinite time

Optimum Payout Ratio

 Growth Firms – Retain all earnings
 Normal Firms – Distribute all earnings
 Declining Firms – No effect
2. GORDON’S MODEL
Assumptions: Gordon’s model is based on the following assumptions:
 All-equity firm
 No external financing
 Constant return
 Constant cost of capital
 Perpetual earnings
 No taxes
 Constant retention
 Cost of capital greater than growth rate
Market value of a share is equal to the present value of an infinite stream of dividends to be received by
shareholders.

DIVIDEND IRRELEVANCE: THE MILLER–MODIGLIANI (MM) HYPOTHESIS

According to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant as it does not affect
the value of the firm. They argue that the value of the firm depends on firm earnings which results from its
investment policy. Thus when investment decision of the firm is given, dividend decision is of no significance.
Assumptions: It is based on the following assumptions:-
 Perfect capital markets
 No taxes
 Investment policy
 No risk
FACTORS AFFECTING DIVIDEND DECISIONS:
  Firm’s Investment Opportunities and Financial Needs
 Shareholders’ Expectations
 Legal restrictions
 Liquidity
 Financial condition and borrowing capacity
 Access to the capital market
 Restrictions in loan agreements
 Inflation
 Control
FORMS OF DIVIDENDS
1. Cash Dividends:Regular cash dividend – cash payments made directly to shareholders, usually every
year.
2. Bonus Shares (Stock Dividend):Instead of declaring cash dividends, the firm may decide to issue
additional shares of stock free of payment to the shareholders years. This stock dividend is popularly
known as bonus issue of shares.
SHARE SPILIT
A share split is a method to increase the number of outstanding shares through a proportional reduction in the par
value of the share. A share split affects only the par value and the number of outstanding shares; the shareholders’
total funds remain unaltered.
Reasons for Share Split
 To make trading in shares attractive
 To signal the possibility of higher profits in the future
 To give higher dividends to shareholders
BUYBACK OF SHARES
The buyback of shares is the repurchase of its own shares by a company. As a result of the Companies Act
(Amendment) 1999, a company in India can now buy back its own shares.
 UNIT V
WORKING CAPITAL MANAGEMENT
CONCEPTS OF WORKING CAPITAL
1. Gross working capital (GWC)
GWC refers to the firm’s total investment in current assets. Current assets are the assets which can be converted into
cash within an accounting year (or operating cycle) and include cash, short-term securities, debtors, (accounts
receivable or book debts) bills receivable and stock (inventory).
2. Net working capital (NWC)
NWC refers to the difference between current assets and current liabilities. Current liabilities (CL) are those claims
of outsiders which are expected to mature for payment within an accounting year and include creditors (accounts
payable), bills payable, and outstanding expenses. NWC can be positive or negative.
 Positive NWC= CA > CL
 Negative NWC = CA < CL

PERMANENT AND VARIABLE WORKING CAPITAL

1. Permanent orfixedworking capital
A minimum level of current assets, which is continuously required by a firm to carry on its business
operations, is referred to as permanent or fixed working capital.
2. Fluctuating or variable working capital
The extra working capital needed to support the changing production and sales activities of the firm is
referred to as fluctuating or variable working capital.
DETERMINANTS OF WORKING CAPITAL
1. Nature of business
2. Market and demand
3. Technology and manufacturing policy
4. Credit policy
5. Supplies’ credit
6. Operating efficiency
7. Inflation
ESTIMATING WORKING CAPITAL
 Current assets holding period: To estimate working capital requirements on the basis of average holding
period of current assets and relating them to costs based on the company’s experience in the previous years.
This method is essentially based on the operating cycle concept.
 Ratio of sales: To estimate working capital requirements as a ratio of sales on the assumption that current
assets change with sales.
 Ratio of fixed investment:To estimate working capital requirements as a percentage of fixed investment.

INVENTORY MANAGEMENT
Inventory: Stocks of manufactured products and the material that make up the product.
Components:
 raw materials
 work-in-process
 finished goods
 stores and spares (supplies)
Need for Inventories
 Transaction motive
 Precautionary motive
 Speculative motive
Objectives of Inventory Management
 To maintain a large size of inventories of raw material and work-in-process for efficient and smooth
production and of finished goods for uninterrupted sales operations.
 To maintain a minimum investment in inventories to maximize profitability.
INVENTORY CONTROL SYSTEMS
 ABC Inventory Control System
 Just-in-Time (JIT) Systems
 Out-sourcing
 Computerized Inventory Control Systems

RECEIVABLES MANAGEMENT
The basic objective of management of sundry debtors is to optimise the return on investment on these assets known
as receivables. Large debtors involve chances of more bad debts while low investment in debtors means restricted
sales. Thus, management of receivable is an important issue and requires proper policies and their implementation.
MANAGEMENT OF RECEIVABLES
There are basically three aspects of management of sundry debtors:
1. Credit Policy: It involves a trade-off between profit on additional sales that arise due to credit being
extended on one hand and the cost of carrying those debtors and bad debt losses on the other. It seeks to
decide credit period, cash discount etc.
2. Credit Analysis: This requires the finance manager to determine how risky it is to advance credit to a
particular party.
3. Control of Receivables:This requires the finance manager to follow up debtors and decide about a suitable
credit policy.