MB0045

Q1. Explain the steps involved in Financial Planning

Ans- Financial Planning The Finance Manager has to estimate the financial requirements of the company. He should determine the sources from which capital can be raised and determine how effectively and judiciously these funds are put into use so that repayments can be done in time. Financial planning is deciding in advance the course of action for future. Financial planning includes: Estimation of the amount of funds to be raised, finding out the various sources of capital and the securities offered against the money so received and laying down policies to administer the usage of funds in the most appropriate way. Estimate capital requirements: This is the first step in financial planning. The following factors may be used to determine the capital: o Requirement of fixed assets. o Investment intangible assets like patents, copyrights, etc. o Amount required for current assets like stocks, cash, bank balances, etc. o Cost of set-up and likely expenses to be incurred on the new issue of shares and debentures. Determine the type of sources to be acquired and their proportion: The Finance Manager has to decide on the form in which the money is to be sourced, that is, debt, equity, preference shares, loans from banks and the proportion in which these are to be procured. Steps in Financial Planning: The financial planning process involves the following steps: 1. Projection of financial statements Financial statements are the company's profit and loss account and the balance sheet. These two statements can be prepared for a certain period of future time and they help the manager to determine the amount of fund requirements. 2. Determination of funds needed:

the delivery period or lead time for procuring the materials may fluctuate. Both these activities are essential for effective utilization of funds. 4. Maximum Level: Maximum level is that level above which stock of inventory should never rise. storing and cost. the Finance Manager can draw up a plan as to the fund requirement based on the time factor.Once the projections are drawn in terms of sales of products. production during every month is geared to sales demand of the month. Discuss the relevance and factors that influence the determination of stock level. To remove this disadvantage. marketing activities. during the slack season. To meet the pressure of sales during the peak season. thus saving on the interest payments. there will be a maximum capacity and minimum capacity. He can know whether the funds are to be procured on a short term basis or on a long term basis. however. however. Price fluctuations . Similarly. Keeping the quality of inventory intact 4. Forecast the availability of funds A company will have a steady flow of funds. Maximum level is fixed after taking in to account the following factors: 1. higher capacity may have to be sued for temporary periods. Depending upon various factors of production. there will be accumulation of finished products which will be gradually cleared as sales progressively increase. then the moneys to be borrowed can be reduced. facilities have to installed to cater to for the production required to meet the maximum demand. attempt has to be made to obtain a stabilized production programme throughout the year. Accordingly. Availability of storage space and cost of storing. Accordingly. capacity usage may have to be scaled down. Q3. etc. to avoid loss due to excessive accumulation. Establish and maintain control system: Control system is ineffective without adequate planning and the adequacy of planning can be gauged only through proper control measures. 3. a large portion of the installed facilities will remain idle with consequent uneconomic production cost. If the manager is able to forecast these amounts properly. Determination of Stock Levels Most of the industries are subject to seasonal fluctuations and sales during different months of the year are usually different. there will be maximum and minimum delivery period and the average of these two is taken as the normal delivery period. a normal capacity will be determined. 5. If. only consumption of raw material will accordingly vary depending upon the capacity usage. Develop procedures: Procedures should be developed for basic plans how they should be achieved.. During the slack season. During the slack season. Requirement and availability of capital 2. Again. the cost of production. 3.

Managerial significance of fixation of Inventory level : 1. It optimizes the investment in inventories. 3. management can avoid both overstocking and shortage of each and every essential and vital item of inventory. Safety Stock: Since it is difficult to predict in advance usage and lead time accurately. Minimum Level: Minimum level is that level below which stock of inventory should not normally fall. 2. MRC = Maximum rate of consumption MLT = Maximum lead time. Ordering Level: Ordering level is that level at which action for replenishment of inventory is initiated.5. and 6. Restrictions. Re – order Point: “When to order” is another aspect of inventory management. Minimum level = OL – (NRC x NLT) Financial Management Unit 13 Sikkim Manipal University 213 Where. Minimum level + 1 /2 of reorder quantity. Where. The re – order point is that inventory level at which an order should be placed to replenish the inventory. In this process. Financial Management Unit 13 Sikkim Manipal University 214 To arrive at the re – order point under certainty the two key required details are: 1. This brings about better coordination between materials management and production management on the one hand and between stores manager and marketing manager on the other. re – order point refers to that inventory level which will meet the consumption needs during the lead time. Risk of obsolescence. 3. Average stock level indicates the average investment in that item of inventory. This is answered by re – order point. Average stock level Average stock level can be computed in two ways 1. OL = ordering level NRC = Normal rate of consumption NLT = Normal Lead Time. It can help the management in identifying the dormant and slow moving items of inventory. minimum level + maximum level 2 2. Average usage lead time refers to the average time required to replenish the inventory after placing orders for inventory Re – order point = lead time x Average usage Under certainty. It in of quite relevant from the point of view of working capital management. provision . It ensure the smooth productions of the finished goods by making available the raw material of right quality in right quantity at the right time. OL = MRC X MLT Where. MRC = minimum rate of consumption MDP= minimum lead time. imposed by the government. Maximum Level = Ordering level – (MRC x MDP) + standard ordering quantity. Lead time 2. if any.

When safety stock is maintained. in the case of computation of the IRR. 1.000. of interest payment. The technique of determination of the explicit cost of capital is similar to the one used to ascertain IRR. This will be followed by the annual cash outflow of Rs. the cash outflows occur at the beginning followed by subsequent cash inflows while in the . The explicit cost of any source of capital is the discount rate that equates the present value of the cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outlay. Assume 250 days in a year Solution: Ö2DK Ö2 x 50000 x 20 ÖKc 0. A series of each flows are associated with a method of financing.000 units of certain product during the next year. EOQ 2.50. repayment of principal money or payment of dividends. Safety stock = (Maximum possible usage) – (Normal usage) Maximum possible usage = Maximum daily usage x Maximum lead time Normal usage = Average daily usage x Average lead time Example: A manufacturing company has an expected usage of 50. Re – order point.00.00. cash inflow occurs followed by the subsequent cash outflows in the form. there will be cash inflow to the firm of the order of 10. 10. Lead time for an order is five days and the company will keep a reserve of two days usage.is made for handling the uncertainty in consumption due to changes in usage rate and lead time. Or Safety stock when the variation in both lead time and usage rate are to be incorporated. (When Variation is only in usage rate) Re – order point = lead time x Average usage + Safety stock Safety stock = [(maximum usage rate) – (Average usage rate)] x lead time. Re cost of processing an order is Rs 20 and the carrying cost per unit per annum is Rs 0.00. the explicit cost of capital is the internal rate of return of the cash flows of financing opportunity.00. Thus. Explicit cost and Implicit cost are the two dimensions of cost.50 = 2000 units Re order point Daily usage = 50000 = 200 units 250 Safety stock = 2 x 200 400 units. What role does cost play in financial decisions Ans-Explicit Cost and Implicit Cost Cost of capital can be either explicit cost or implicit. Thus.000. The rate of discount. EOQ = = Financial Management Unit 13 Sikkim Manipal University 215 Re – order point (lead time x Average usage) + safety stock (5 x 200) + 400 = 1. Calculate 1. that equates the present value of cash inflows with the present value of cash outflows. At the time of acquisition of capital. would be the explicit cost of capital. The firm maintains a safety stock to manage the stock – out arising out of this uncertainty. if a company issues 10 per cent perpetual debentures worth Rs. with one difference.400 units Q5.

This should not tempt one to infer that the retained earnings is cost free.. or operating profits..s owners. The cost of retained earnings is the opportunity cost of earning on investment elsewhere or in the company itself. Thus. Using the cost of capital as a basis for accepting or rejecting investments is consistent with this goal. In this connection it may be mentioned that explicit costs arise when the firm raises funds for financing the project. while in the computation of explicit cost of capital.computation of the IRR. the implicit cost of capital may be defined as the rate of return associated with the best investment opportunity for the firm and its Shareholders that will be foregone if the project presently under consideration by the firm were accepted. explicit costs may also be viewed as opportunity costs. The objective of the financial manager is to maximize the wealth of the firm. the cash outflows occur at the beginning followed by subsequent cash inflows. Business risk is related to the response of the firm. It is in this sense that retained earnings has implicit cost. Cost of Capital 27 Similarly. The formula used to compute the explicit cost of capital (C) is: CI0 = CO C t t t n (1 ) 1  _ . As we shall discuss in the subsequent paragraphs.s business and financial risk are unaffected by the acceptance and financing of projects. explicit cost of retained earnings which involve no future flows to or from the firm is minus 100 per cent. Acceptance of projects with a rate of return below the cost of capital will decrease the value of the firm. It is the rate of return on other investments available to the firm or the shareholders in addition to that currently being considered. Other forms of capital also have implicit costs once they are invested. Thus in a sense. cash inflow takes place at the beginning followed by a series of cash inflow subsequently. CI0 = net cash inflow in period O.(1) Where. Risk A basic assumption of traditional cost of capital analysis is that the firm. acceptance of projects with a rate of return above the cost of capital will increase the value of the firm. COt = cash outflow in period under reference C = Explicit cost of capital The explicit cost of an interest bearing debt will be the discount rate that equates the present value of the contractual future payments of interest and principal with the net amount of cash received today.s earnings before interest and taxes. since no cash outflow will occur in future. Opportunity cost is technically termed as implicit cost of capital. The explicit cost of capital of a gift is minus 100 per cent. This implies that a project should be rejected if it has a negative present value when its cash flows are discounted by the explicit cost of capital. It is clear thus that the cost of capital is the rate of return a firm must earn on its investments for the market value of the firm to remain unchanged. retained earnings do cost the firm. When the cost of capital is used to . to changes in sales.

In short they react in much the same way as they would to increasing business risks.. l million a firm may sell either bonds.000 worth of common stock. The assumption of a constant capital structure implies that when a firm raises funds to finance a given project these funds are raised in the same proportions as the firm. Firms with high levels of long-term debt in proportion to their equity are more risky than firms maintaining lower ratios of long-term debt to equity. since the selection of a given source of financing would change the costs of alternate sources of financing..s sales revenues). As a firm. Financial risk is affected by the mixture of long-term financing. however. In the analysis of the cost of capital in this chapter. receiving the expected returns on their money.000 worth of preferred stock. but our analysis of cost of capital is based on the assumption that the firm will follow the latter strategy. The types of projects accepted by a firm can greatly affect its business risk. and Rs.s financial structure shifts toward suppliers of funds recognize a more highly levered position the increased financial risk associated with the firm. l million. 400. it may be forced into bankruptcy. The definition 28 Financial Management of the cost of capital developed in this chapter is valid only for projects that do not change the firm. The awkwardness of this assumption is obvious since in reality a firm raises funds in . It is the contractual fixed-payment obligations associated with debt financing that make a firm financially risky. This assumption eliminates the need to consider changes in the cost of specific sources of financing resulting from changes in business risk. If a firm fails to generate sufficient revenues to cover operating charges. A long-term lender will charge higher interest on loans if the probability of receiving periodic interest from the firm and ultimately regaining the principal is decreased. in order to raise Rs. preferred stock. If the firm.s capital structure were not held constant. 500. In analyzing the cost of capital it is assumed that the business risk of the firm remains unchanged (i. it does not raise a mixture of small amounts of various types of funds. Most firms will use the former strategy. or. This is because of the decreased probability of the fund suppliers.s financial structure is assumed to remain fixed. or common stock in the amount of Rs.s business risk. Rs. They compensate for this increased risk by charging higher rates of interest or requiring greater returns. and the charge for the funds will be based on the changed financial structure. If a firm accepts a project that is considerably more risky than average. the higher the operating profits required to cover these charges. Common stockholders will require the firm to increase earnings as compensation for increases in the uncertainty of receiving dividend payments or ably appreciation in the value of their stock. This assumption is necessary in order to isolate the costs of the various forms of financing. it is assumed that acceptance of the proposed projects will not affect the firm. the firm. The key factor affecting financing Costs . For example.lumps. of the firm.s existing financing. The greater the amount of interest and principal (or sinkingfund) payments a firm must make in a given period.s business risk.e. 100. it may sell Rs.s capital structure is changing rare available. More sophisticated approaches for measuring the cost of capital when a firm. or the capital structure.evaluate investment alternatives. it would be quite difficult to find its cost of capital.000 worth of bonds. suppliers of funds to the firm are quite likely to raise the cost of funds. Frequently the funds supplied to a firm by lenders will change its financial structure. that the projects accepted do not affect the variability of the firm..

. the only factor affecting their cost is the riskless cost of the particular type of financing. The cost of each type of capital to a given firm compared to the cost to another firm (i. since the riskless cost of the given type of funds remains constant. as a firm raises long-term funds at different points in time.e. f. j.s business and financial risk are assumed to be constant. of a firm. the inter firm comparison) can differ because of differences in the degree of business and financial risk associated with each firm.. the only differentiating factor is the cost of the type of financing. These premiums are a function of the business risk...e.s asset structure and its capital (financial) structure are fixed. For intra firm (i. Regardless of the type of financing used.Since the cost of capital is measured under the assumption that both the firm. j b = the business risk premium f = the financial risk premium Equation 2 indicates that the cost of each specific type of capital depends on he riskless cost of that type of funds. the business risk of the firm.(2) where kj = the specific cost of the various types of long-term financing. j. time series) comparisons. and financial risk. with different levels of business and financial risk. and the financial risk of the firm. the changing cost of each type of capital. the only factor that affects the various specific costs of financing is the supply and demand forces operating in the market for long-term funds. the following relationship should prevail: kj = rj + b + f . over time should be affected only by changes in the supply of and demand for each type of funds. j Cost of Capital 29 rj = the riskless cost of the given type of financing. Since the firm. . b. In other words. since business and financial risk are assumed to be constant An example may help to clarify these points. Different business and financial risk premiums are associated.