WOLLO UNIVERSITY

KOMBOLCHA INSTITUTE OF TECHNOLOGY

COLLEGE OF ENGINEERING
SCHOOL OF TEXTILE, LEATHER AND FASHION
TECHNOLOGY

LEATHER ENGINEERING DEPARTMENT (BSc.)

Business Management
5th YEAR 1st SEMISTER
CHAPTER FOUR
Financial Management
 Finance

▪ Finance may be defined as an art & science managing money.

▪ The major areas of finance are,

❑ Financial Services

❑ Financial Management
 Financial Services

▪ Financial services are economic services provided by finance industry.

▪ Finance industry encompasses of:

• Bank

• Stock brokerages

• Credit card companies

• Govt, sponsored enterprises

 Financial Management

▪ Financial management is the application of planning & control function

to the finance function.

▪ It concern with duties of financial managers in the business firm.

▪ They manage the financial affairs of any types of business.

 Scope of Financial management
▪ Scope of financial management includes:

• Anticipation

• Acquisition

• Allocation

• Appropriation

• Assessment
▪ Anticipation: Financial management estimates the financial needs of the
company.

• That is, it find out how much finance is required.

▪ Acquisition: It collects finance for the company from different

sources.

▪ Allocation: It uses this collected finance to purchase fixed & current

assets for the company.
▪ Appropriation: It divides the company’s profits among the
shareholders, debenture holders etc. It keeps a part of the profit as
reserves.

▪ Assessment: It also controls all financial activities of the company

such as production management, marketing management, personnel
management.
Financial Management & Accounting

▪ Accounting records the financial information of business concern.

▪ Olden days both financial management & accounting have same

discipline.

▪ Now it was merged with management accounting & it is very helpful

for decision making.

 Financial Management & Production
Management

▪ Production Management is the operational part of the business concern

which helps to convert the money into profit.

▪ Profit of the concern depends upon the production performance.

Financial Management & Marketing

▪ Finished goods are sold in the market with new innovations & modern

approaches.

▪ For this marketing department needs finance to meet their

requirements.
 Definition of Finance Function

▪ The Finance function is the process of acquiring and utilizing funds of a

business.

▪ Financing consists of raising , providing , managing of all the money,

capital or funds of any kind to be used in connection with the business.

Finance function has classified into two.

▪ Long-term financial function (decision)

▪ Short term financial function(decision)

 Long-term finance function

1. Financing Decisions - These decisions basically deal with acquiring

funds & deployment of funds

2. Investment Decisions - These decisions are related with selection of

assets.

▪ Assets are classified into two types:

- Fixed Assets

- Current Assets
3. Dividend Policy Decisions - Whatever profit company earns; the

owners are entitled to receive them. These decisions are related with

distribution of dividends i.e to decide how much profit we should

distribute as dividend & how much should be retained in business.

 Short-term finance function
Liquidity Decision
▪ Liquidity refers to how easily an asset can be converted into cash in a
short time frame without losing value.

▪ Investment in current assets affects the firm’s profitability and

liquidity.

▪ Current assets management that affect firms' liquidity is yet another

important finance function.

▪ Current asset should be managed efficiently for safe the firm against
the risk of illiquidity.
 3 concepts of finance function in
relation to business
1) Provide funds needed by the enterprise in terms that are most

favorable the light of its objectives.

2) Concerned with everything that take place in the context of a

business directly or indirectly as mean in cash.

3) Concerned with procurement of funds and its effective utilization in

the business.
Treasury vs. controller functions
▪ The treasurer is generally concerned with the organization’s financial
matters such as raising and management of cash.
▪ On the other hand, the Controller looks after operating matters with a
view to assist management in decision making.
▪ The Controller provides managers with specialized services such as
advice and help in budgeting, analyzing variances, pricing decisions,
special decisions.
▪ The Controller is considered an organization’s top accounting officer.
▪ Sometimes, the Controller prepares the annual accounts and financial
statements for external users.
 What is Wealth Maximization?
Advantages & disadvantages Explained
▪ Wealth maximization is a strategy for companies that seek to maximize

profits while meeting the needs of all stakeholders.

▪ It also helps a business build reserves for future growth, recognize

the value of regular dividends, and retain a fair market price for its

stock.

▪ In the case of a business, the primary objective of wealth

maximization is to maximize the value of the business, which then

increases the value of stockholders.

Time value of money
 DEFINITION of 'Time Value of Money-
TVM'

▪ The idea that money available at the present time is worth more than

the same amount in the future due to its potential earning capacity.

▪ This core principle of finance holds that, provided money can earn

interest, any amount of money is worth more the sooner it is received.

 EXPLAINS 'Time Value of Money -TVM'
▪ Everyone knows that money deposited in a savings account will earn
interest.

▪ Because of this universal fact, we would prefer to receive money today

rather than the same amount in the future.

▪ For example, assuming a 5% interest rate, $100 invested today will be

worth $105 in one year ($100 multiplied by 1.05). Conversely, $100
received one year from now is only worth $95.24 today ($100 divided by
1.05), assuming a 5% interest rate.
▪ The time value of money impacts business finance, consumer finance, and
government finance.

▪ Time value of money results from the concept of interest.

▪ This overview covers an introduction to simple interest and compound

interest, illustrates the use of time value of money tables, shows a
matrix approach to solving time value of money problems, and introduces
the concepts of intrayear compounding, annuities.

▪ A simple introduction to working time value of money problems on a

financial calculator is included as well as additional resources to help
understand time value of money.
 Simple Interest

▪ Simple interest is a topic that most people cover in elementary school.

▪ Interest may be thought of as rent paid on borrowed money.

▪ Simple interest is calculated only on the beginning principal.

▪ For instance, if one were to receive 5% interest on a beginning value of

$100, the first-year interest would be:

▪ Interest Continuing to receive 5% interest on the original $100
amount, over five years the growth of the original investment would
look like:

Year 1: 5% of $100 = $5 + $100 = $105

Year 2: 5% of $100 = $5 + $105 = $110
Year 3: 5% of $100 = $5 + $110 = $115
Year 4: 5% of $100 = $5 + $115 = $120
Year 5: 5% of $100 = $5 + $120 = $125
 Compound Interest
▪ Compound interest is another matter.
▪ It's good to receive compound interest, but not so good to pay
compound interest.
▪ With compound interest, interest is calculated not only on the beginning
interest, but on any interest accumulated in the meantime.
▪ For instance, if one were to receive 5% compound interest on a
beginning value of $100, the first-year interest would be the same as
simple interest on the $100, or $5.
▪ The second year, though, interest would be calculated on the beginning
amount of year 2, which would be $105.
▪ So, the interest would be: $105 x .05-or-$5.25 in Interest

▪ This provides a balance at the end of year two of $110.25.

▪ If this were to continue for 5 years, the growth in the investment would
look like:
Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00
Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
Year 3: 5% of $110.25 = $5.51 + $110.25 = $115.76
Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63
 Compound Interest Formula

▪ Instead of calculating interest year-by-year, it would be simple to see

the future value of an investment using a compound interest formula.

▪ The formula for compound interest is:

• Pn = P0(1 + I)n
• where: Pn = Value at end of n time periods
• Po = Beginning Value
• I = Interest
• n = Number of years
▪ For example, if one were to receive 5% compounded interest on $100
for five years, to use the formula, simply plug in the appropriate values
and calculate.

• Pn = P0(1 + I)n

so,
Pn = $ 100 (1.05)5- or -Pn = $127.63
▪ If there was a factor that summarized the part of the compound
interest formula highlighted in red in the equation below, then to find
future values all that would be necessary is to multiply that factor by
the beginning values.
pn = p0(1 + I)n
Capital Budgeting
 Definition of capital budgeting

▪ "The decision-making process by which a firm evaluates the purchase

of major fixed assets.

▪ It involves firm's decision to invest its current funds for addition,

disposition, modification and replacement of fixed assets”.

Capital budgeting Process

1. Project generation

2. Project Evaluation

3. Project Selection

4. The follow up
Factors influencing Capital Budgeting

1. Business Risk

2. Company's Tax Exposure

3. Financial Flexibility

4. Management Style

5. Growth Rate

6. Market Conditions
 Methods of Capital Budgeting

Traditional methods

▪ Payback period

▪ Accounting rate of return method

Discounted cash flow methods

▪ Net present value method

▪ Profitability index method

 Traditional Method

Payback Period
▪ In case they are even, the formula to calculate payback period is:

Initial Investment
Payback Period =
Cash Inflow per Period
Example 1: Even Cash Flows

Company C is planning to undertake a project requiring initial investment

of $105 million. The project is expected to generate $25 million per

year for 7 years. Calculate the payback period of the project.

Solution

Payback Period = Initial Investment / Annual Cash Flow = $105M /$25M

= 4.2 years
 Traditional Method
When cash inflows are uneven, we use the following formula for payback
period:
Payback Period = A + (B/C)

In the above formula,

A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the
period A;
C is the total cash flow during the period after A
 Traditional Method
▪ Company C is planning to undertake another project requiring initial
investment of $50 million and is expected to generate $10 million in
Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year
4 and $22 million in Year 5. Calculate the payback value of the project.

Solution: (cash flows in millions) Cumulative

years
Payback Period Cash flow Cash flow
= 3 + ($11M ÷ $19M) 0 (50) (50)
=3 + 0.58 1 10 (40)
=3.58 years 2 13 (27)
3 16 (11)
4 19 8
5 22 30
 Traditional Method

Accounting rate of return method

▪ This method of ARR is not commonly accepted in assessing the
profitability of capital expenditure

Formula
▪ Accounting Rate of Return is calculated using the following formula:
▪ ARR = Average Accounting Profit/Average Investment
Example 1: An initial investment of $130,000 is expected to generate
annual cash inflow of $32,000 for 6 years. Depreciation is allowed on
the straight-line basis. It is estimated that the project will generate
scrap value of $10,500 at end of the 6th year. Calculate its accounting
rate of return assuming that there are no other expenses on the
project.

Solution

Annual Depreciation = (Initial Investment - Scrap Value) /Useful Life in

Years

Annual Depreciation = ($130,000 - $10,500) /6 ~ $19,917

Average Accounting Income = $32,000 - $19,917 = $12 083

Accounting Rate of Return = $12,083 / $130,000 ~ 9.3%

 Discounted cash flow Method
Net present value method
▪ It recognizes the impact of time value of money

Formula:
NPV = R x 1 - (1 + i)-n - Initial Investment
i
▪ In the above formula,
• R is the net cash inflow expected to be received in each period;
• i is the required rate of return per period;
• n are the number of periods during which the project is expected to
operate and generate cash inflows.
 Discounted cash flow Method
▪ Calculate the net present value of a project which requires an initial
investment of $243,000 and it is expected to generate a cash inflow of
$50,000 each month for 12 months. Assume that the salvage value of
the project is zero. The target rate of return is 12% per annum.
Solution
We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% / 12 = 1%
Net Present Value
= $50,000 x (1 - (1 + 1%)^-12) ÷1% - $243,000
= $50,000 x (1 - 1.01^-12) ÷ 0.01 - $243,000
~ $50,000 x (1 - 0.887449) ÷ 0.01 - $243,000
~ $50,000 x 0.112551 ÷ 0.01 - $243,000
~ $50,000 x 11.2551 - $243,000
~ $562,754 - $243,000
~ $319,754
 Discounted cash flow Method
▪ Profitability Index (PI)
Profitability Index = Present Value of Future Cash Flows Initial
Investment Required

▪ Note: PI should always be expressed as a positive number.

▪ If PI > 1, then accept the real investment project; otherwise,

reject it.
 Discounted cash flow Method

Example
Company C is undertaking a project at a cost of $50 million which is
expected to generate future net cash flows with a present value of
$65 million. Calculate the profitability index.

Solution
Profitability Index =
PV of Future Net Cash Flows I ÷ Initial Investment Required
Profitability Index = $65M / $50M = 1.3
Functions of Chief Financial Officer
1.Formation of Financial Policies and Forecasting

2.Managing Fund

3.Appropriate Disposal of Profits

4.Report to the top management

5.Keeping an Eye on Market

6.Making Relations with Financial resources

7.Discharge his Duty Towards Various Parties

8.Maximization of shareholders wealth

 Investment Decision
▪ Following is a five-step process decision-making process that guides
investors:

1.Analyze Financial Position

2.Define Investment Objective

3.Asset Allocation

4.Select Investment Products

5.Monitor and Due Diligence

 Factors Affecting Investment Decision
▪ An investment is a planned decision, and some of the factors that are
responsible for these decisions are as follows:

• Investment Objective
• Return on Investment
• Return Frequency
• Risk Involved
• Maturity Period or Investment Tenure
• Tax Benefit
• Safety
• Volatility
• Liquidity
• Inflation Rate
 Financial Decisions
▪ Financial decisions are the decisions that managers take regarding the

finances of a company.

▪ These are crucial decisions for the financial well-being of the company.

▪ These decisions can be in terms of acquisition of assets, financing and

raising funds, day-to-day capital and expenditure management, etc.

▪ Financial decisions, therefore, affect both the assets and liabilities of a

company.

▪ They can lead to profits, revenue generation, and receipt of funds and

assets for the company.

▪ They can also be in terms of expenditure, the creation of liabilities, and

an exodus of funds for a company.

 Dividend Decision
▪ Dividend is defined as the distribution of a portion of a company’s
earnings, decided by the board of directors, to a class of its
shareholders.

▪ The dividend is most often quoted in terms of the dollar amount each
share receives (dividends per share).

▪ It can also be quoted in terms of a percent of the current market

price, referred to as dividend yield.
 Types of Dividend

▪ Interim Dividend: It is the dividend which is paid to the

shareholders before the preparation of final accounts.

▪ Final Dividend: After the determination of divisible profit at the

end of the financial year, the dividend declared as per provisions of

the articles of association of the company is known as final dividend.

 Factors Influencing a Firm’s Dividend
Decision
▪ There are certain issues that are considered by the directors while
making the dividend decisions:

• Free-cash flow

• Dividend clienteles

• Information signaling