Financial Management

Introduction
 Why Financial Management?

 Every decision that a business makes has financial implications

– Whether in marketing activities, or
– HR activities
 Any decision which affects the finances of a business is a
corporate finance decision.
 Defined broadly, everything that a business does fits under the
rubric of corporate finance.
 Production, Marketing, Inventory – all are connected with
accounts/treasury dept.
 Financial Management is not just for the “Finance Majors”

T. P. Ghosh, IIFT
 Types of Business Firms

 Firms are entities that

– Own assets (investment)
– Use the assets to produce goods and/or services
– Plans to grow by investing in future
 Value of a firm depends on existing investment in place and the
investment to be made in future
 Investments may be made from the resources raised through
– Debt (from bank/FI or market)
– Equity (from owners)
 Firms are expected to create value for their owners
 In a way that owners cannot do on their own
– Product development and marketing
– Diversification
T. P. Ghosh, IIFT
 Corporate Financial Objective - 1

 There must be an objective, without which no evaluation is

possible
 The objective must be unique
– Pursuing two objectives, say profit maximization and increasing
market share, may lead to conflicts
– A decision may increase market share, but may reduce profits
– because higher discounts & commissions may eat into the profits
 The conventional objective is shareholder value maximization
 Classical theory of firm assumes profit maximization as the
only goal

T. P. Ghosh, IIFT
 Corporate Financial Objective - 2

 However, profit maximization does not necessarily lead to

wealth maximization
– Profit in Economics is different from profit in Finance
– Profits are accounting decision
– Some say “cash flow, and not profits, are important”
 Corporate Finance focuses on shareholder wealth/ value
maximization, or stock price maximization as the only goal
 For several reasons
– Stock prices are most frequently observed of all measures
– It reflects the future prospects as well (“market efficiency”), unlike
other measures
– Stockholders can actually realize the wealth by selling
– It embraces both risk and return
– Society, employees and stakeholders are all benefited

T. P. Ghosh, IIFT
 Corporate Financial Objective - 3

 EPS vs. Value Maximization

– While value maximization is still the goal, but EPS cannot be
ignored altogether even in the short-run of one year
 Value of a firm depends on three factors:
– Ability to utilize assets efficiently to generate max. possible cash
flows from existing assets
– Timing of the cash flows
– Riskyness of the cash flows
 Cash flow, in turn, depends on:
– Sales (value and future growth)
– After-tax operating margin, and
– Capital investment

T. P. Ghosh, IIFT
 Corporate Financial Objective - 4

 But, the problem is what should be the objective of unlisted (or

closely held firms)?
– Answer is owners’ wealth maximization
– By creating value (although market price is not observable)
 A second problem is that agency problems may mar the
objective (of shareholder value maximization)
– Principal-agent problem
– Managerial objectives may differ from owner’s objectives
 The agency problems have important implications for each of
investment decisions, financing decisions and dividend
decisions, and hence on
 Market Value
 This will be a recurrent theme in this paper
T. P. Ghosh, IIFT
 Functions of Finance

 Every firm has to make three major types of decisions

– Investment Decision:
 Selection: Make decision to ensure that firm’s investment earns a
return that is commensurate with risk
 Efficiency: Manage existing assets efficiently (e.g., management of
current assets)
 M & A is also a source growth (not just investment in new projects),
and considered as investment by the firm
– Financing Decision:
 Must choose optimal financing mix
 Financing affects value directly through tax deductibility of debt, and
indirectly through risk
– Dividend Decision:
 How much to reinvest and how much to return to the owners

T. P. Ghosh, IIFT
Forms of Business Organization
 Forms of Business Organization – 1
 Basic Forms of business organization are:
– Sole proprietorship
– Partnership
– Cooperative Society
– Company
 Private
 Public
– Limited Liability Partnership – a new form being introduced in
India
Sole Proprietorship
 Characteristics
– Owned by a single person
– No separate legal status
– Proprietor enjoys the rewards (profits) and bears all the risks and
liabilities of business
T. P. Ghosh, IIFT
 Forms of Business Organization – 2

 Advantages
– Set-up is easy & inexpensive – no formal incorporation reqd.
– Very few regulations
– No firm tax
 Disadvantages
– Life of the firm is no more than the life of the owner
– Liability of the owner is unlimited
– Raising outside funds is not possible (except for personal loan) –
growth opportunities restricted
– Applicable tax is that on personal income of owner

T. P. Ghosh, IIFT
 Forms of Business Organization – 3
Partnership
 Characteristics
– A business owned by two or more persons
– Partners bear the risks and enjoy the rewards
– A partnership agreement has to be signed & executed
 Advantages
– Set up is easy & cheap
– Very little regulation
– Expertise of partners are useful to the concern
 Disadvantages
– Withdrawal/death of one of the partners may lead to its dissolution
– Unlimited liability
– Limited ability to raise funds
– Conflict among partners a threat to business

T. P. Ghosh, IIFT
 Forms of Business Organization – 4

Co-operative Society
 Characteristics
– Minimum 10 members reqd. (no upper limit)
– Members are owners
– Objective: Promotion of economic interests of members
– Registration with Registrar of Co-operative Societies
– Management by an elected committee – “one member one vote”
– Max. dividend of 12%
– Surplus may be distributed to members according to volume of
business generated or re-invested

T. P. Ghosh, IIFT
 Forms of Business Organization – 5

 Advantages
– Set up is easy and cheap
– Limited liability of members
– State Governments provide grants & financial assistance
 Disadvantages
– Outside talent cannot be employed
– Capital scarcity due to capping of dividends
– Exploitation of co-operative structure by influential members has
been observed

T. P. Ghosh, IIFT
 Forms of Business Organization – 6

 Corporate forms – Private & Public

 Two major features:
– Distinct Legal Entity separate from its owners
 Can enter into contracts(liabilities & others), own assets, sue & be
sued in its name
 Shareholders cannot be held responsible for its action
– Limited Liability
 Liability is limited to the extent of share capital provided by the
owners
– Both have to be registered under an act – Companies Act 1956 in
India

T. P. Ghosh, IIFT
 Forms of Business Organization – 7

 Private Limited Company

 Characteristics
– A minimum paid-up capital of Rs. 1 lakh
– Right to transfer shares restricted
– A minimum of 2 persons and max. of 50 persons (excluding
employees/ ex-employees) reqd. to form private limited company
– At least 2 directors
 Advantages
– Limited liability
– Much less regulatory control than public limited companies
– Control of promoter is unchallenged (members are selected by
her/him)
– No ceiling on managerial remuneration
T. P. Ghosh, IIFT
 Forms of Business Organization – 8

 Disadvantages
– Taxation rates are higher than public companies
– Cannot issue shares/debentures to, and cannot accept fixed
deposits from, public (non-members) – growth depends mainly on
internal funds
– Transfer of ownership rights restricted

Public Limited Company

 Characteristics
– Minimum 7 members (no upper limit) reqd. to form
– Minimum paid-up share capital of Rs. 5 lakh
– Ownership rights are easily transferable under normal
circumstances
– Minimum 3 directors
T. P. Ghosh, IIFT
 Forms of Business Organization – 9

 Advantages
– Unlimited life
– Easy transferability of shares (higher value)
– Can raise external capital – theoretically no constraint on growth
(except its own performance)
 Disadvantages
– Elaborate procedure to be followed for setting up a public
company
– Subject to wide-ranging regulations – much more stringent
disclosure requirements
– Managerial remuneration capped at 11% of net profit

T. P. Ghosh, IIFT
Time Value of Money
 Time Value of Money – 1

 Rs. 100 today is more valuable than Rs. 100 next year
– Inflation
– Present consumption is preferred over future consumption
 Thus, interest rates are paid for
– Protecting the purchasing power of your savings
– Rewarding abstinence (deferring consuming)
 We encounter two situations:
– You will receive an amount after n years – what is the Present
Value (PV) of the amount today?
– You will invest an amount today for n years – what is the Future
Value (FV) of the amount (i.e., the amount you will receive after
n years)?
 Two extensions of the above situations:
– Multiple cash flows (investing or receiving)
– Frequency of compounding (monthly, quarterly, half-yearly, etc.)

T. P. Ghosh, IIFT
 Time Value of Money – 2

Discount Rate
 You are considering investment in asset A, one of many assets
(of same risk category) available in the market
 Other assets provide you a return of 7%
 You will invest in asset A if it yields a return of at least 7%
 This is the discount rate for asset A
 That is, discount rate is the return that your savings earn if
invested elsewhere
– That is, discount rate is the opportunity cost of your investable
fund
 It is also your minimum required rate of return for
considering investment in an asset (say asset A)

T. P. Ghosh, IIFT
 Time Value of Money – 3

Future Value of a Single Cash Flow

 Let
– Amount invested today: A
– Rate of interest: r
– Period of investment: n
 Then future value F is given by
F = A(1 + r)n
 The process of finding the FV is known as Compounding
 Example:
– You are investing Rs. 10,000 today in a fixed deposit (FD) with
SBI for 5 years;
– SBI pays an interest rate of 5% per annum on a 5-year FD
– What is the amount that you will get after 5 years (i.e., FV of
your investment)

T. P. Ghosh, IIFT
 Time Value of Money – 4

Present Value of a Single Cash Flow

 Similarly you may be interested to know that
– If you need Rs. 300,000 after 12 years (may be for education of
your child), what is the amount that you need to invest today if
the interest rate is 7%?
– The answer can be found using the previous relationship
– FV = A(1 + r)n, that is,
300,000 = A * (1 +0 .07)12
Or A = Rs. 300,000 / [(1.07)12] = Rs. 1,33,203.59
 The process of finding PV of a future cash flow is known as
Discounting
 Excel spreadsheet is a very powerful tool to solve time value
problems

T. P. Ghosh, IIFT
 Time Value of Money – 5

Frequency of Compounding and Effective Interest Rate

 In many situations interest rate is paid on half-yearly (e.g.,
NSC), quarterly (bank FDs) or monthly (recurring deposit of
banks)
 All these situations are tackled by computing the Effective
Interest Rate
 General formula for compounding:
r mn
F  A (1  )
m
 Where r is the annual interest rate, which is compounded m
times a year
 Example: NSC pays 8% compounded semi-annually (m=2)
 Effective interest rate is 8.16%
T. P. Ghosh, IIFT
 Time Value of Money – 6

 The formula for computing effective interest rate (re) is:

r m
re  (1  ) 1
m

Future Value of Multiple Cash Flows

 Time Line
 Annuity: A fixed cash flow (in or out) occurring every year
 End of the period - Regular Annuity
 Beginning of the period – Annuity due

T. P. Ghosh, IIFT
 Time Value of Money – 7

 General formula for Regular Annuity (end of the period):

( 1  r )n  1
F ( A , r , n )  A[ ]
r

 General formula for Annuity due (beginning of the period):

( 1  r )n  1
F ( A, r , n , due )  A( 1  r )[ ]
r

 Where symbols have usual meaning

T. P. Ghosh, IIFT
 Time Value of Money – 8

Present Value of Multiple Cash Flows

 You invest an amount today and will receive Rs. A at the end of
every year for n years
 What is the present value (that is, how much you need to invest
today), given the rate of interest (r)?
 General formula is:

( 1  r )n  1
PV ( A, r , n , End )  A[ ]
r( 1  r ) n

 Example: It helps you to find the amount of investment

required today (the PV), given r, so that you receive an income
of Rs. A at the end of every year for n years - Pension

T. P. Ghosh, IIFT
 Time Value of Money – 9

 The general formula for PV of beginning of the period cash

flows is:
( 1  r )n  1
PV ( A, r , n , Begin )  A[ n 1
]
r( 1  r )
 ( 1  r )PV ( A, r , n , End )
 Example:
 To find out the amount of investment required today (the
PV), given r, so that you receive an income of Rs. A at the
end of every year for n years
 Given the amount of investable fund available today (the PV)
and the rate of interest r, what annual income (Rs. A) you can
get at the beginning of each of n years
T. P. Ghosh, IIFT
 Time Value of Money – 10

 Car Loan case

 Excel command: Goal seek
 Perpetuities
 Perpetuities are periodic cash flows for indefinite period, i.e.,
when n   (“n tends to infinity”)
 The present value of a perpetuity can be found from
PV(A,r,n,End) by setting n   as:
PV of a Perpetuity = (A/r)
 Where r is the interest rate and A is the amount of annual cash
flow to be received indefinitely

T. P. Ghosh, IIFT