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    FM Part 1 - Rotated

    Uploaded by

    Saumya Singh

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    © All Rights Reserved
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    PAGE 15 L7 rgenization of the buok 19 sailed Outline of Financial Management Syllabus uw Ls 123 : FINANCIAL MANAGEMENT : AN INTRODUCTION 3 ‘THE MATHEMATICS OF FINANCE 19 ee upstage os GTERN SIMENT DECISIONS: CAPITAL BUDGETING. CAPITAL BUDGETING : AN INTRODUCTION ” CAPITAL BUDGETING : TECHNIQUES OF EVALUATION, 37 COST OF CAPITAL, 103 FINANCING DECISION: LEVERAGE ANALYSIS ns FINANCING DECISION : EBIT-EPS ANALYSIS BI LEVERAGE, COST OF CAPITAL AND VALUE OF THE FIRM 171 CAPITAL STRUCTURE: PLANNING AND DESIGNING 193 DIVIDEND DECISION AND VALUATION OF THE FIRM 20s DIVIDEND POLICY : DETERMINANTS AND CONSTRAINTS 223 IANAGEMENT-OF CURRENT ASSETS: WORKING CAPITAL: PLANNING AND MANAGEMENT 237 WORKING CAPITAL : ESTIMATION AND CALCULATION 259 MANAGEMENT OF CASH AND MARKETABLE SECURITIES 27 RECEIVABLES MANAGEMENT 207 INVENTORY MANAGEMENT 315 14 CHAPTER-HEADS cee race bist, Laas re pee ey g VALUATION OF SECURITIES 333 APPENDICES: APPENDIX: FINANCIAL DECISION MAKING WITH EXCEL 355 APPENDECHT: PAST YEAR QUESTION PAPERS WITH SUGGESTED ANSWERS 10 PRACTICAL QUESTIONS 309 295 APPENDIX IT; MATHEMATICAL TABLES fae eee . sce 33 3554 3694 3954 Contents ener eee is de nn i Preface 19 orn te hk in eld tof anc angen abs tu toepar he a ere IBY: DacKGROUND ed - FINANCIAL MANAGEMENT : AN INTRODUCTION a Seana srmeecets as ; Teste oat re cre 4 ¢ Finance as an Area of Study ‘ Glee mearean : ¢ Foal oregon ing : vce ena ing elev Gro : « hol an aun se ete ate Deo ® + Financial Management and other areas of Management R I cetacean cn eastas pane a siemens i Ones teen ‘3 ‘THE MATHEMATICS OF FINANCE, fy seems ae : + Compounding Technique 15 conrents nace + Discounting Technique baa i (* Other Specific Cash Flows s mt * Applications of the Concept of TVM pas a Points to Remember * ba co Graded Mlustrations 2 rs Objective Type Questions = - Mutiiple Choice Questions e Assignmenis eat 5 Problems: i a = CAPITAL BUDGETING [5 co + CAPITAL BUDGETING : AN INTRODUCTION, at ‘ Problems and Ditticulties in Capital Budgeting i : c ‘+ Types of Capital Budgeting Decisions 3 : c ‘© Capital Budgeting Decisions and Funds availability, o : ‘ Capital Budgeting Decisions. Assumptions and Procedure. _ Les ‘© Estimation of Costs and Benefits of a Proposal fm ee ‘# Incremental Approach to Cash Flows on ic ® Taxation and Cash Flows = 8 oa + Depreciation, Non-cash tris and Cash Flows ae ‘* Treatment of depreciation and Profit/Loss on Sate/Scr rapping of an Asset “« Grae * Financial Cash Flows: i ae Points to Remember bit ba Graded Htustrations oi ae Objective Type Questions a ee ee Multiple Choice Questions i fe sssponene : sph Problems * 4 aN (4) 20; L +0; CAPITAL BUDGETIN« ECHNIQUES OF EVALUATION °F ‘ Evaluation of Proposals : The Background _ ie ** Capital Budgeting - Techniques of Evaluation a fe '* Traditional or Non-discounting Techniques: a rin Payback Period Fa ate Accounting Rate of Return or Average Rate of Return (ARR) ee Mate, @ Discounted Cash Flows ur Time: “Adjusted Techniques, a Assis: Discounting Procedure: A common ingredient ta Discounted Cash flow Techniques: @ Probl. Net Prosont Value (NPV) Mest Discounted Payback Period ~ Internal Rate of Return UR) een Modified Inte™nal Rate of Return (MIRR) ae ‘* Capital Budgeting Decisions - Some cases bea + Capital Budgeting with Unequal Lives of Proposals i Rick Analysis in Capital Budgeting a *# Conventional Techniques uf Risk Analysis Sh Selecting the Appropriate Technique CONTENTS ee. points 0 Remember (Graded Mustrations ‘Capital Budgeting Problems based on Block of Assets Concept tive Type Questions Multiple Choice Questions ssignments 32: Problems 24 ait eine ares | iG Bana FINANCING DECISION COST OF CAPITAL «Concept of Cost of Capital ed Factors Affecting the Cost of Capital ie se ME Types of Cost of Capital ie of Cost of Cita ps Cost of Long-term Debt and Bonds ie ‘Cost of Preference Share Capital Ve Cost of Equity Share Copitl it SOMME: ¢ Cost of Retained Earnings a Meighied Average Cost of Capital ia SMMC Nacinal Cost of Capital a“ 6 1510 Remember a $6 Ged Mlustrations i ST MER obective Type Questions = ‘Altiple Choice Questions ee Heurients My Soa roblems BI ‘6 {ANCING DECISION : LEVERAGE ANALYSIS concept of Leverage i Operating Leverage = 4 » Financial Leverage ne a ‘Combined Leverage ’ ts to Remember bd “Graed tustrations Be F Ojecivn Type Questions i 1 Mtiple Choice Ouestions a TBE assgrmers - Dag: Probiems a FINANCING DECISION : EBIT-EPS ANALYSIS Constant EIT and Change in the Financing Patterns id Varying EBIT with Different Patterns fe § Fancial Break-even Level te §infercnce Pint/Level te 158 7 Short falls of EBIT-EPS Analysis PAGE Point to Remember eae ” Graded Wustrations ye = Objective Type Questions rte: Multiple Choice Questions ‘ ie ° Assignments ie rien eee [3] 7 Sy . LEVERAGE, COST OF CAPITAL AND VALUE OF THE FIKM ° ‘* Capital Structure Theories am fe ‘ Net Income Approach Capital Structure matters a ka ¢ Net Operating income Approach Capital Structure doesnot matter mit * Traditional Approach : A Practical Viewpoint ied Ga ‘ Modigliani-Miller Mode| Behavioural Justification of the NOL Approach ee ob # The Arbitrage Provess By ow ‘* MM Model with Taxes a As: Points tq Remember bel Grad thatratoe i | Objective Type Questions Pa Multiple Choice Questions a Assignments a Problems er [3] a CAPITAL STRUCTURE : PLANNING AND DESIGNING eee * Factors determining Capital Structure Pd oe * Profitability and Capital Structure : EBIT-EPS Analysis i io nl ‘© Liquidity und Capital ‘Structure : Cash Flow Analysis _ bal Points to Remember 7 haat Graded Mustrations ae 0b} Objective Type Questions bs Mul Multiple Choice Questions bait er Assignmenis Ca {ai PART IV DIVIDEND DECISION see we a * Relevance of Dividend Poticy oa Gra ® Walter's Model oe aa ‘® Gordon's Model oe. a # Irrelevance of Dividend Policy 4 pe Sra ay oa Graded lilustrations 4 Objective Type Questions 7 3 Multiple Choice Questions a a Assignments ae ea Problemy 2 Ga) DIVIDEND POLICY : DETERMINANTS AND CONSTRAINTS Dividend Payout Ratio «# Stability of Dividends # Constant DP Ratio ‘ Steady Dividend per Share ¢ Steady Dividends plus extra : ¢ Legel and Procedural Considerations Scrip Dividend or Bonus Shares ‘¢ Informational Contents of Dividends Points to Remember Graded Mustrations Objective Type Questions Multiple Choice Questions Assignments 12 WORKING CAPITAL : PLANNING AND MANAGEMENT ‘¢ The Operating Cycle and Working Capital Needs ¢ Factors Determining Working Capital Requirement ‘© Working Capital: Policy and Management ‘Financing of Current Assets # Working Capital: Monitoring and Control Points to Remember * Graded Mustrations * Objective Type Questions Matiple Choice Questions Assignments [13] WORKING CAPITAL : ESTIMATION AND CALCULATION ‘© Working Capital as a Percentage of Net Sales ‘© Working Capital as a Percentage of Total Assets or Fixed Assets ‘© Working Capital Based on Operating Cycle Points to Remember Graded Itustrations Assignments Problems (u] MANAGEMENT OF CASH AND MARKETABLE SECURITIES Motives for Holding Cash Cash Management : Theoretical Framework Cash Management : Planning Aspec CONTENTS 224 2s 25 2s 226 226 27 228 20 29 Bi BE Be 239 ey 22 26 250 251 251 255 255 237 260 260 261 263 263 270 270 218 275 276 ¢ Cash Budget - + Cash Management : Control Aspects Managing the Float # Optimurn Cash Balance : A few Mudels © Baumol’s Model © Miller Orr Model ‘+ Management of Marketable Securities Points 10 Remember Graded Illustrations Objective Type Questions ‘Multiple Choice Questions Assignmems Problems [73] : RECEIVABLES MANAGEMENT © Costs of Receivables © Benefits of Receivables * Credit Policy + Credit Evaluation * Control of Receivables ‘¢ Evaluation of Credit Policies Points ro Remember Graded Illustrations Objective Type Questions Multiple Choice Questions Assignments Probleris 16 INVENTORY MANAGEMENT © Types of Inventories # Inventory Management Reasons and Benefits of Inventories ‘© Costs of Inventory Cost of Stockouts (A hidden cost) + Techniques of Inventory Management 4 ABC Analysis Economie Order Quantity Model # Reorder Level ‘Safety Stock or Minimum Inventory level Quantity Discounts and Order Quantity Poinis to Remember Graded Mustrations Objective Type Questions Multiple Choice Questions Assigunents Problems CONTENTS PAGE 27 280 281 282 282 28k 24 25 36 wm 3 ra sees ci . . CONTENTS Hq se SBART.VI : VALUATION : a | a 9 [7] | Br eee } 21 4} VALUATION oF SECURITIES | ae + concept of valuation al to A Reged Rae of Rew 33) 234 Basic Valuation Model 334 a @ Bond Valuation - 334 285 3 = Bond Value in case of Semi-Annual Interest 334 22% ¢ Yield to Maturity (YTM) 334 283% ¢ Valuation of Convertible Debentures: 7 cd Valuation of Deep Discount Bonds (DDB) 24 ‘¢ Valuation of Preference Shares ia 4 Valuation of Equity Shares By Valuation of Equity Shares based on Accounting Information 340 _ Valuation of Equity Shares based on Dividends 546 wed = Valuation of the Share Currently net paying Dividends 343 a a = Valuation of Equity Shares based on Earnings eal 38 HE rans faronbor Ms i Graded Mlustrations 345 et Objective Type Questions bats tiple Chace Questions > - 5a | ‘ 20 assignment 3 Pedions 303. i (35t 310 APPENDICES awe = 32 APPENDIXT: FINANCIAL DECISION MAKING WITH EXCEL 35 32 penne 1: rast Yeah QUESTION PAPERS WITH SUGGESTED ANSWERS TOPRACTCN, CHES FI ere ANCIAL MANAGEMENT, BCOM: (8. UNIVERSITY OF DELI so. + NovEMBER 2013 (eMESTER ¥) 36! NOVEMBER 2014 (SEMESTER V) x, «NOVEMBER 205 (SEMESTER V) an © NOVEMBER 2016 (SEMESTER V) (381 EB (© NOVEMBER 2017 (SEMESTER V) 38. ee «+ NovEMBER 208 SEMESTER V) 39 38 APPENDIX IT]: MATHEMATICAL TABLES Retention Ratio (-DP ratio} Bond Value at present Betatactor (CAPM) Book Value (Also Balance Sheet Value) Cost at Present [Initial cost} cu Capital Assets Pricing Model Certainty Equivalent Cash Flows Cash Flow Statement Current Liabilities Capital Market Line Assets Cumubative Value Annuity Factor Cumulative Value Factor Coefficient of Variation Debt Dividend on Equity Shares Degree of Combined Leverage Depreciation Degree of Financial Leverage Degree of Operating Leverage Dividend Pay out Ratio Divider Equity oF Value of Equity Equivalent Anauity Method Earnings bolore biverest & Taxes (also NOP) Earnings before Taxes iso PAT) Economie Order Ousntiy Per Share Earnings Per Share Fixed Assets Fixed Cost Financial Levers Future Value (also DFL) Lor Int Nev PVAF PvP Abbreviations and Notations Growth Rate Gross Profit Interest Risk-free Rate of Interest Internal Rate of Interest Rate of discount/Required rate of return Cost of Debt Cost of Equity Capital Overall Cost of Capital (also WACC) Cost of Preference Share Capital Cost of Retained Earnings Market Price Number of Years Net Operating Profit (als EBIT) Net Profit (also PAT) Not Present Value Net Worth ‘Operating Cycle Operating Leverage (also DOL) Current Market Price of Share Market Price after 1 year Market Price after n years, Profit After Tax (also NP) Payback Period. Profit before Interest & Taxes (also EBM! Poofit before Tax (also EBT) Preference Dividend Ratio Price: Profitability lndex Present Value Present Value Annuity Factor rings Ratio Present Value Factor Required Rate of Return ta ABBREVIATIONS AND NOTATIONS: Ry _Rateof Return on Market Portfolio V, Value of Levered Firm R, Required Rate of Return of a Security V, Value of Unlevered Firm 7 ROA — Raturnon Assets VC Variable Cost RO} Return on investment wW Weight ROR — Rateof Return WACC Weighted average Cost of Capital. ky RV Redemption Value ‘ WC Working Capital SEBI Securities and Exchange Board of India WDV Written Down Value SF Shareholders Funds WIP Work in Process (or Progress) SLM Straight Line Method (of Depreciation) WMCC Weighted Marginal Cost of Capital : Tax Rate YIM Yield Till Maturity v Value of the Firm Financial Managementis concerned with creation and maintenance of wealth in 8 rational way. Inits endeavour, it focuses on the dacision making. Almost all decisions taken by an individual or 2 firm have financial aspects ‘and implications. Financial management is the study of decisions that have financial implications. In order to ‘make optimal decisions, the firm must have a goal for evaluating the efficiency of such decision process. In financial management, this goalis definecas the maximization of Wealth of Shareholders, The basic foundation of the theory of financial management may be found in two concepts /., the time value of money and tho risk: rotum trade-off. Money received today is worth more than received after a year from now. In financial ‘management, benefits and cost occurring a different pointoftime are made comparableby applyingthe concept of ime value of money. In the decision making process, the other concept, commonly applies, is that the return of an option must be commensurate with the risk involved. The basic notion is that no investors ready to take additional iskunless he is compensated with additionat return, With reference tobusiness fms, every financial manager undertakes the financial decision making process to answer three basic questions namely 1, How should the scarce resources be allocated? (Investment Decisions) 2. How should these investments be financed? (Financing Decisions) 3. How much profits generated by these investments be distributed and how much be reinvested? ( Decisions) ‘While taking these decisions, the financial manager has to o return dimension; that there isa time value of money, and tha ecisions. Part | attempts to provide an introduction to Financial Management and Time Value of M learning objectives are: ‘= What is Finance and Financial Decision Making? ‘= What is the objective of Financial Management? ‘= What is the Risk-Return dimension of Financial Dacisions? 1 How is Financial Management related to other Functional Areas? = What is Time Value of Money and how is # applied in Financial Management? CONTENTS FINANCIAL MANAGEMENT - AN INTRODUCTION (Dividend lonsider: That every decision has a risk as well as t cash is a better measure of evaluating financial jondy. The CHAPTER + CHAPTER 2 ‘THE MATHEMATICS OF FINANCE Financial Management - An Introduction it Liidsblandlng Gf Yiriacial theories, conceit, took"and Weak 5 ice Male Die gai eSmstarg testior Mprerenidsite 20: HiqleSis U0 ‘¢ Evolution of Finance as a Discipline. 4 The Scope of Finance Funetion f= The Investment Decisions. f= The Financing Decisions, 1 The Dividend Decisions. ‘The Financial Decision Making. f= Identification of the Relevant Groups ‘= Identification of the Objectives. Profit Maximization Versus Wealth Maximization Risk-Return Dimension of Financial Decision Making. Financial Management and Other Areas of Management asic Propositions and Axioms of Financial Management. Treasury Management, Financial Management 2nd Financial Accounting. Financial System and Environment in India, 3 7 PART | BACKGROUND eae eee EC EEE EE eee eee eto eee eee ere or nancial management can be defined as the manage- __pracess and the persons involved inthe processwere of fo tment of flow of funds andi deal with the Fancial—_lessermportance " iscision making, lt encompasses the procurement of (i) The focus uf attention was on the long term resources fT! the funds in the most economic and prudent manner and noe ene ne aes of any concn The fs cmmplorment of these funds in the most optimum way '© Soneept of working capital and iis warwagement wee fy ‘maximize the return for the owner. Since raising of funds and Seat hoc Sais a their best utilization isthe key to the success of any business organization, the financial management asa functional aren 0) Thetreatmentof differentaspectsoffinancewasmreat fi has gota place of primerelevanceinevery firm Allbusiness descriptive nature rather than analytical. tn fac, there decisions have financial implications, and therefore, financial ‘were no analytical financial decision making as such. management is inevitably related to almost every aspect of (vf Finance was concerned with procutingoffund primaniy gj business operations. Broadly speaking, thefinancialmanige- by issue of securities such 28 equity shates, relerence ‘mentincludes any decision made by abusiness/investor that _ shares and deb instruments. So, a knowledge of the affects its finances. The present work makes an atlempt to sources of funds, what securities to sell to whomand by discuss the financial concepts tos techniques procedures, that techniques to sll was needed ot Sters.and the erations required to optimize the Business Graguatly, the scopeo finance function widenedandéayan. 7 lecsions dayproblems of finance were aloincorporated.Fundsanaly, 4 ™ Sivandontrolon arugula bais,ratherthanon acasual basa EVOLUTION OF FINANCE AS A DISCIPLINE Started. There was, infact, an extension af 7 : wand early fifties when the scope of fnance To begin the study of financial management, what is needed Phase and around early fi 7 E isto address to two central sues First, what is financial "#AeHonstarted expanding in bie way. Fi ‘management and what is the role of finance manager? Sec- " = financtal management? Asarresult of the gradual increase incompetition and growth i. tese Financehasemergedasadistinctareeof study duringsecond _ in business at an accelerated rate, together with regular fe TO half of the"twentieth century. But even before that some ~ occurrence af boom and recession in economic activities, the tat director indirect references fo finance function were made finance function has become increasingly analytcel and 9 fat ‘a casual basis. The evolution of finance function and the decision oriented. The scope of finance functionhaswaiened 1 fob. changes in its scape appeared due to two factors namicly further and includes not only the measures of procuring () the continuous growth and diversity in business, and funds at episodic events but slso the optimum utilization @)the gradual appearance of new financial analytical tools. through data based analytical cision making. The finance f PC Broadly speaking there are thrte overlapping phases of evo. manager has emerged as a professional manager inwlved A () lation of finance Function. witheapital funds tobe raised by thefirm, with he llocation i : ofthese funds to different projects and withthe mesure Finance upto 1950 - iti ‘meat of the resus of each allocation, Significant contribu. i Peas jreaiuonal Phee tions to the development of modern theory of finsncial ‘ Initially, finance was a part of economics and no separate management are “ attention was paid to finance, Business owners were more i a " () Theory of Portfolio Management developed by Harry cerned with operational actives. The finance manager var of Ponsa Management Sevcloped ty ery | used to be concerned with record keeping, preparing differ- with risky investments. This theory uses statistical con- Ee cnt report, and managing cash. finance manager was.called ‘cepts to quantify che risk-return characteristics of sold ¥ eare Famticulor only when his speciality was required toe teak of securities, investments or emets Mf (i) T cats new sources af funds whenever there was need fet 2 STS Pr a aco buirtenkel ff for the funds. The traditional phase can be summarized as in anna a : follows oneiwesiorisvewedinitsttaltyratherthanevalutng 9 : the risk of one security only. This theory ata latersiage JF ( Pinancefunetion was concerned withprocuringotTunds Jen wo the development of Capital Asset Pricing Nadel Lofinance theespansion ur diversification activitksand which dels with pricing of risky assets and the elaion- thus the occurrence uf finance Function wis epic in Ship helwec ish ond rota, ine ature Financelunctionwasnotapartoleularmani- > aHe Theory of Leverage and Valuation of Fem dvveh serial operations oped by Modiganiand Mill in 1958. They have shows 4 ¢ (9 In order to finance business growth, there was an emer- br introducing analytial approach as to how the finan senceofiastitutionaltinancingandiastisionalbanking cial decision making in any firm be oriented towards fT iving rise to finance industy. sraximination ofthe value ofthefirm and themaximize: fp (ii) Finance function was viewed particularly from the point _tion ofthe shareholders weal 8 of view of supplier of funds ie, the lenders, both indi- These developments are infact the start of the development u Niduals and institutions. The emphasis was to consider Fan integrated theory of financial management which ao ry of efficint capital markets, dividend poles theinterestof theouisiders. Theinternal decision making tisk and uncertainty dimensions to the financial decision ‘making, valuation models, working capital management, etc ‘Themoclern phase ofthe evolution f finance function can be summarized as Fallows () The scope has widened to include the optimum wtiliza- tion of funds through analytical decision making. {The finance funetion is now viewed from the point of view of the insiders ée. those who are taking decisions in the firm, 18) The knowledge of the securities, financial markets and institutions is also necessary and the scope of finance manager's function has expanded beyond being nearly descriptive into analytical in nature ‘The subject matter of finance function is still developing and many new theories as well as refinement to existing theories ray bein the offing, FINANCE AS AN AREA OF STUDY "Finance as an area of study is concerned with two distinct namely the financing and the investing, Financing deals wilh the management of sources of capital. The financing «fea concentrate on the type, size and composition of capital sources. Investing, on the other hand deals with manage- iment of uses of capital The investing area; therefore, concen: Sn the type, size and composition of investment of ‘pital. Both these areas of study are considered as part of ‘Gnancial studies, Types of financial actions :- Financial actions in different ipes of firms may be divided into different groups such as: fo{0. The Financial Management of Trading or Manufactur Bing Fitms:Incaseof tradingor manufacturing firms, the E central question is how to acquire funds and how to invest these funds. In this case, the finance manager ‘acquires the funds from financial market by offering different types of securities and invest these funds in G purchasing real and tangible assets. For example. firm E lssuessharesand invest the proceedsin purchasing fixed Bi assets such as plant ete. This may be known as Core “nancial Management. Fancal Management of Financ Institution The ‘nancial institutions raise funds in financial marketsand F Slsoinvest these funds in financial markets For example, wancial institutions raise Fads from in tors in one Financial market and invest these funds in other financial markets if Fnancial Activities Relating tolnvestment Management: This area of finance deals with finding out the best Coletion or portaioof financial asstsandshusfocuses #2 Steotion on allocation of funds once they arc acquired «This area focuses attention whether an investor should ‘but all his money in one financial asset or in a combina. tion of different financial assets. This may be called tovestment/ Portfolio Management ge hese thre areas are complementary in the sense that ‘Study of one area involves study of the other areas also, NT“ AN INTRODUCTION 5 [A financial manager of a firm has to deal with financial institutions as wel as investors while issuing securities in the eapital market. Inthe preseat work, primary lacus is nfinancial managementof trading firms bul other areas have also been touched wherever necessary International Finance : This area focuses attention on flow of funds beyond national boundazies. Balance of Payment, Foreign Exchange Risk Management, ic, are some special points aud wunisiderations of this srea, Public Finance : This area of financial management covers the funds management of a Government (Na: tional Stateor alocal authority). Tax Management, other cess, efc are considered and studied here. Funds are received from differentsourcesand are used as per given policies of the Government. ‘SCOPE OF FINANCE FUNCTION Initially, the finance manager was co ’ ai the advent of an cvent requiring funds, The finance man. ager was formally given atargel amount of funds be raised dnd was given the responsibilty of procuring these funds. His iuinction was limited to raising funds as and when the need was elu Oncethe Funds were procured, his function was over. However, over a period of time, the seope of his Function has tremendously widened. His présence is required at evry snioment whenever any deision havingineolvement of funds Fstobe taken Now-a-days, the financial managers required to look into the financial implications of any decision inthe firm. The function of finance manager now is to manage the funds, In particular, the finance manager has to Focus his attention on () Procuring the required quantum of funds as and when necessary, a the lowest cos (i Aavesting these funds in various assets in the most pro- Fitable way, and (Gi, Distributing returns to the shareholders in order to sat isfy their expectations from the firm. “These three Functions of the finance manager encompasses ‘most of the financial events in any firm. Thus, the functions, of finance manager may be summarized to include the fol Towing. (9. Overall financial planning and control (id. Roising Fonds from different sources, (ity Selection of fixed assets, iv) Management of working capital, andl (1 Any oth While performing these functions, finance manager has 10 operate as intermediary between the firm's operations one hand and the capital market on the other. The role of finance manaper as. intermediary arises because of two-way cash flows between the firm and theinvestors. In thefirst instance, the investors provide funes through capital market, to the Tam, and second, the firm distributes profits among the 1e form of interest or dividends. The firm r2ises individual financial event funds by sellmg ownership securities or debt securities or borrowingsin the capital market. The Funds raised in this way ‘become the pool ofthe investible funds which are committed fo the investment decisions of the firm, The investment projects genevate profit which are either distributed to the -— Capital Market Financial Assets | onl Manager | Pre tse PART |: BACKGR | |_—of “hts reseed] Fir ese sas acquired by the uno suppl oF invesible funds or retained in the business fo fot reincestmentin the futureprojects Thefinancemanagerhag th rotake carcof theinterestof theinvestorsas wellasthe finns. of His position as an intermediar has been depicted in the [ah Figure 11 o bo @ af eee een de Cash Outflow in tvs of dividends i [Profits Geveraied_] ss [em on the bass of doesn | HIG. 1.1: ROLE OF FINANCE MANAGER AND TWO-WAY CASH FLOWS T0 CAPITAL MARKET The finance manager is usually faced with the following distinct scenarios (9 What should be the size of firm and how fast should it grow ? The sizeof the firm is measured by the value ofits total assets as shown in the balance sheet. The firm's ‘growth can bemeasuredby the yearly percentage change in the assets of the firm. The finance manager has to decide about the size as wells the growth pattern of the assets. He should recognize that large assets and growing evenlarger need not necessarily be good forthe firm and, therefore, should take the decisions accordingly What are the various types of assets to be acquired ? or, What should be the composition of the assets ofthe firm? Wheneverand whichever assetsareacquired bythefirm, the finance manager has to evaluate as to how sit going toconitribute tothe wealth of the firm, Thisisalsoknown as the Investment Decision, (Gi) What should be the pattern of raising funds from various, sources? or, What should be the composition of the liabilities of the firm? The liabilities and capital represent the financing sources which the firm uses to raise funds to make investments. The raising of funds from these sources in varying compasitions has different implica tions. Deciding about the best msix of the liabilities and capital is referred ty as the Financing Decision. a Depending upon th nature and size ofthe firm, the finance managers requived to perform allor some of these functions, from time to time. While performing these functions, he is, Fequited to take different decisions which can be broadly classified into three groups - Those relating to resource allocation (the investment decision), those covering the fi nancing of these investments (the financing or capital struc ture decision) and those determining how much cash be taken out and hav much reinvested (the dividend decision) er () Investment Decisions: Fiems have scarce resources that must be allocated among competitive uses. The financial management provides a framework for firms to take these decisions wisely. The investment decisions include not only those that create revenuesand profits(eg, introducing anew product line) but also those that save money (e.g, introducing nore efficient distribution system). So, the investment Gecisions are the decisions relating to assets composition of 4 How m,Assetsrepresentinvestmentor usesolthetundsthet be the firm makes in expectation of earning & return for is" ands investors. Broadly, these asets can be clasiid into fed rede assetsand current asses, and therefore, the investment ec “can sions can also be bifurcated into Capital Budgeting decisions (relating to fined assets) and the Working Capital Manage: Si" meni (relating to current assets). of th ‘The fixed assets ofa firm are the primary factors andthe “pes determinants of the profitability of a firm. The earnings of the Leve firmare basislly caused by the fied asets composition andi als © so the total fixed asetsvis-awistotsl assets ofthe firm. The for Capital Budgeting decisions are more crucial for any firm. A empl finance manager may be asked to decide sbout (1) which tere ssvst should be purchased aut of diferent amative oF ay 1 tions. 2)roaw an asset oro get itan kas. (3) to produces: | art of the final producto to procure it {rom some over supplier. (to buyer notanaherfiem asa running eoncera, ge *h (5) propos of merger father group fim to avai he gf POF is of consolidation, er All hese decisions have long ‘anifications and are generally iveversible. The obj tiveof Capital Budgeting decisions isto Wentiy those assets PO which are worth more than they cost A finance manage therefore, as tb take utmost care in dealing wth thee oth decisions. The Chapters 3 and of hisbook deal with Coptalgg. Bualgeting decisions - Working Captat Management,on the ther hand deals wil) hae the management af current assets of the firm. Though the current assets do not contribute ditectly 10 the earnings. yet their existence is necessitated for the proper, efficient and ‘optimum utilization of fixed assets, There are dangers of buth the excessive working capital as well as the shortage of ‘working capital, A Finance manager has to ensure sufficient pndadequate workingcapitalto the firm. The working capital management has been discussed in Chapters 12 10 16 of the book. (a Financing Decisions: Another group of decisionstaken by a finance manager is known as Financing Decisions, which deal with the financing pattern of the firm. As firms make decisions concerning where to invest these resources, they thavealso todecidehow they should raisesesources.Thereare ‘wo main sourees of finance for any firm, the shareholders funésand the borrowed funds. These sources have their own peculiar features and characteristics, The key distinction , Hewen these tv soueat i inthe fied commitments created by borrowed funds to pay interest and the principal The borrowed Funds are always repayable (except when the bL instrument is convertible into shares) and require pay- Ffient ofa committed cost in the form of Interest on a periodic “basis. The borrowed funds are relatively cheaper but always, E> eauila risk. This risk is knownas the financial risk ie, therrisk dfinsolvency due to non-payment of interest oF non repay: pent of capital amount “The sharcholders funds is the shain sounce of funds to any fim. This may comprise of the:equity share capital. prefer~ “z1ce share capital and the accumulated profits. There is no Jgommitted outflow for equity shares eapital neither in the ‘of a return nor in the form of repayment of capital ver, the preference share capital has a commitment 10 paid a minimum dividend (which is of course conditional) Efitdalso for repayment of eapital when these shares are 10 be fedecmed after some time (as the preference share in India fan only the redeemable preference shares}. Starting with the Fundamental propositionthatthecharacter~ sof thefinancing should closely matchthe characteristics the assets being financed, he has to undertake different pes of analysis and has to consider a whole lot of factors. yerage Analysis, EBIT-EPS analysis,Capitalstructure mod: ‘ete. are some of the tools available to a finance manager EF this purpose. The financing decision and the processes loyed by afinance manager have been analyzed in Chap- #5 109 of the book ls. These Wese profits are available to he distributed among, fhe shareholders (subject 10 legal provisions) oF ean be 2d by che firm lor reinvestment wittin the firm. ‘The ‘ate nol distributed are impliedly retained inthe Allfirms whether small or big, have to decide how much profits should be reinvested back in the business and ¥Much should be taken out in form of dividends ie fon capital. Ononchad, payingout more to theowners Tielp satis{ying their expectations, onthe other, doing so other impliesations is a business that reinvests less will to prow slower, There canal be any readymade policy + FINANCIAL MANAGEMENT - AN INTRODUCTION for any firm regarding how much profit isto be distributed tind how muuch portion isto beretained, Retention of profits bf course related to 1 Reinvestment opportunities available tothe firm, 2. The opportunity sate of return of the shareholders, ‘Thedistributionof profitsby any firm isrequired tosatisfy the expectations of the shareholders, The profits can be distr tuned to sharcholdets either as current revenue (ie. the Gividends) or as capital receipt (de. bonus share). These have their own tax implications in the hands ofthe sharcholders as, Wellas the firm, Both have their effect on the market value of thefirm also, The finance manager is required to take various decisions regarding distribution of profit as dividend or as bonus shares. In his attempt, he has to Took into the funds eauirements of the firm and the shareholders interest. The tradeoff on Dividend decision has been analyzed in Chapters 1 and 11 of the book ‘Thus, a finance manager is concerned with, (the overall financial analysis and planning, (i managing the asset structure of the firm, and (ii) managing the financial structure of the firm, FINANCIAL DECISION MAKING In the previous section, it has been stated that the finance manager has to take different types of decisions from time to time, Some of these decisions may be taken once while eg. 1 capital structure decision or a capital budgeting decision. However, the decisions regarding the working capital man- agement are taken on a regular basis. The dividend decision seleo almost a regular decision in the sense that itis taken ‘Shenever the firm wants to distribute interim dividend. final ividend or bonus shares to the shareholders In order to makethis processof financial decision making. an efficient and effective one, itis necessary = (d) to identify the groups whose interest is to be considered and {@) 10 idemify the goals, the achievement of which helps in measuring the impact of these decisions on the relevant group. Financial Decision MakingandtheRelevantGroups “The various groups which may have stakes in the decision making of a firm and, therefore, requirsd wo be Considered while taking financial decisions are 1. The shareholders, 2 The debt investors, 3, Theemployees, 4, Thecustomer and the suppliers, 5, The public, 6. The Government, and 7. ‘The management ‘These groups have different perceptions of the firm and the Finn hau different relives importance for these petceptions ‘The shareholders are no daub of primary concera to any firmand theirintecest spat one top prom. Traditional the public intrest get the lost prot, but de To the legislative measures andthe work ot efferomtnon.CGovern "ment orgatations the public terest has also emerged a2 the stakeholder inthe financial decisions making proces any firm, fe i 4 Financial management, the techniques and pres agement the techniques and processes of financial decisions making re based on the sosumption that I only the shareholders group whose interest isto Be considered snd proected. thas ot who reson The extent of the effect ofa particular financial desion on the shareholders interest can be easily, fairly and accurately measured whereasthe ffecton othe goupssdifcuttobe measured and often depends upon the subjective conse ation. Bus it doesnot mean that the interests ofthe other soups are inimportant nae, interestsol the other EoUups are protected and thera iter bythe Government o protect the interes af the publi, the employees et Atthis stage there fs question as to how the interest ofthe Shareholders can be protected and measured ? Whet the goal oF obiecive which i achieved wil result in protecting sdsafeuarding thenterest ofthe shareholsero Goal or Objective of the Financial Decision Making ‘goal of thefirm may be defined as atarget against which the firm's operating performance can be measured. Regardless of how they are determined or what they are, the goals serve 88 a point of reference to a decision maker. The objective ‘specifies what the decision maker is trying to-accomplish and, by doing so, provides a frame-work for analyzing different Vides a frame-work for optimuin financial decision makings Without a well defined goal, the finance inanager may wat det without a divection. The gverall goal of aay firm will tot serve the purpose here: Rather, such an opecationally uselul criterion is required, which helps in choosing the best out of several mutually exclusive opportunitiesin the given circum stances on the basis of the available data, Several goals of financial management have been cited e., maximization of sales revenue, net profit, return of invest. ment, size of the firm, percentage market share, ete. It is PART 1: BACKGROUND already discussed that the mait stakeholder group forthe financial management is the sharcholders group. Therefore the probleinis identify onc out ofthese several goals wich willgive the best reflection of theeffect ofthe decision on the Shareholders interest. Thefllowing twoare often considsred as the objectives ofthe financial management 1. Maximization ofthe profits ofthe firm, and 2. Maximization ofthe shareholders! wealth Inthefotlowingparagraphs these objectveshavebeen cic ly evuluated as operationally feasible objective ofthe finan cial management Maximization of the Profits ofthe Fiem : For any business firm themaxinization ofthe proftsisoften consideredasthe implied objective, and therefore, itis natural to retain the maximizetion.of profit as the goal of the financial manage. ment also Verious types of financial decisions be taken with a view to maximize the profit ofthe Firm. Out of differen paatualy thetone should heselected which will result in maximum increase in profi This profit can be ‘measured in terms ofthe total accounting profit available io the shareholders. ‘The profit maximization asthe objectiveof financial manage. iment hasa builtin favour foritschoice.The profitisregerded as a yardstick for the economic efficiency of any firm. all business firms of the sgeiety are working towards profit maximization then the economic resources ofthe society as whole would have been most elfcienty, economically end profitably used. The profit maximization by one firm and i targeted by all, will ensure the maximization ofthe welfarcof the society. The profit maximization as objective of financial management will eesult in efficient allocation of resources not only from the point of view of th frmbut also forthe society as such However, the profit maximizationas the objectiveof financial management faistodeliverthe oodsinitsoperstionalterns Asalzeady stated that various parties have stake in the firm Though the stake of the shareholders is of prime relevance, yet the interest of other partis such as lenders, erediers, Society, ete, cannot be ignored. The finance manager hase faceatough task of reconciling the interestofall these partis. The profit maximization overlooks the interest of other pe ties than the shareholders. There ae vatious problems with the profit maximization as the objeciveof financial manage- ment Some of these are as follows {ignores the risk. The profit maximization dacs no take ‘umount of tsk whic the fiem under 1 into account the takes in attempting to ineres maximization as the objective, the management may undertake all profiableiavestment opporvanities regan less of the associated risk, whereas that investment my not be worth the risk, despite its potential profitability, 2. ‘The profit maximization concentrates on the profitability only and ignores the financing aspect of that deciston and the risk associated with that financing. For example, in. ‘order to Finance a profitable investment, afirm may even borrow beyond! capacity 3. It ignores the timings of costs and returns and thereby ‘qnoresthe time valucof money. Allthemonctary benefits and costs are considered in the absolute value terms without adjusting For time value. 44 The profit maxlmlzation as an objective ts vague ambiguous. Dées it refer to masiimization of short term profit or longterm profit after tax profit or profit before {ax profit from the point of view of total funds employed or from the point of view of shareholders ony, et? ‘The profit muxtmtantion may widen the gap between the perception ofthe management and that of the sharehold= fre Since the profit maximizationis not directly related to anymeasurc of shareholders enefis,tisprincipleseems tobestlf-centeredatthecostof loosing attention fromthe interest of the shercholders, which should be of utmost importance to any firm The profit faxinlzation borrows the concept of profit from the eld of eccountingand thus tends o concentrate ‘onthe mmedtatectfect of afingncial decision asreflected nthe increase inthe profit ofthat year orin near future. This will not necessarily be correct because many deci- dons have their costs and benefits scattered over many pe years $0, the profit maximization fails to be an operationally Yeasble objective of financial management. A goal as SRady stated should be precise, well defined and must be

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