Financial Management

1. Financial Management

2. Lay out • Nature of Financial Management. • Investment & Financing Decisions. • Dividend Decisions. • Liquidity Decisions or Working Capital Management.

3. What is Finance ? • Finance stands for provision of money as and when required. • Process of raising, providing and administering all money/funds to be used in a corporate enterprise. • Is concerned with the acquisition and conservation of capital funds in meeting the financial need and overall objectives of business enterprise.

4. Approaches to finance • Providing of funds needed by a business on most suitable terms. • Cash. • Concerned with raising of funds and their effective utilisation.

5. Financial Management • The ways and means of managing money. • Planning, acquisition, allocation, and utilisation of financial resources with the aim to achieve objectives of the firm. • Is the application of planning and controlling functions to the finance function.

6. Scope of Finance Function • Estimating financial requirements. • Capital structure decisions. • Selecting source of finance. • Selecting pattern of investment. • Proper Cash management. • Implementing financial controls. • Proper use of surpluses.

7. Aims of Finance function • Acquiring sufficient funds. • Proper utilisation of funds. • Increasing profitability. • Maximising firm’s value.

8. Financial plan Is a statement estimating the amount of capital and determining its composition. Objectives: • Availability of adequate funds. • Balancing of costs and risks. • Flexibility. • Simplicity. • Long term view. • Liquidity. • Optimum use. • Economy.

9. Considerations • Nature of Industry. • Credit rating of the concern. • Future plans- Expansion and diversification. • Availability of sources. • General economic conditions. • Government control.

10. Objectives of Financial management Profit: • Profit earning. • Profitability is a barometer for measuring efficiency and economic prosperity of a business. • Economic and business conditions do not remain the same all the time. • Profits are the main sources of finance for the growth of the business. • Profitability is essential for fulfilling social goals. Wealth: Maximizes implies the market value of its shares.

11. The term profit is vague. Ignores the time value of money. Ignores Risk factor. Dividend policy. Its an prescriptive idea. Not necessarily socially desirable. Controversy objectives Maximize stockholders wealth or wealth of firm.(Agencyproblems) Ownership and management are separated. Profit Vs Wealth

12. Functions of a Finance manager • Financial forecasting and planning. • Acquisition of funds. • Investment of funds. • Helping in valuation decisions. • Maintain proper liquidity.

13. Functional areas of FM • Determining financial needs. • Selecting the source of funds. • Financial analysis and Interpretation. • C-V-P analysis. • Capital budgeting. • Working capital management. • Profit planning and control. • Dividend policy.

14. Organization of finance function • Board of directors • Managing Director/ Chairman • Director (F)/ VP (F)/ CFO Treasurer and Controller ( Financial executives)

15. Responsibilities of FE The basic responsibility of the treasurer is to provide, manage and protect the firm’s capital. The basic responsibility of the controller is to check that the funds are used efficiently.

16. Functions of FE Treasurer : Obtaining finance Banking relationship Investor relationship Short- term financing Cash management Credit administration Investments Insurance

17. Functions of FE Controller: Financial Accounting Internal audit Taxation Management accounting and control Budgeting, planning and control Economic appraisal Reporting to Government

18. FM Process FM is a dynamic decision-making process include a series of interrelated activities involving: • Financial planning • Financial decision-making • Financial analysis • Financial control

19. Concept of Time value of money • Value of the money received today is more than the value of the same amount of money received after a certain period. Reasons for Time value • Higher preference for present consumption • Purchasing power of the currency declines with time. • Money received today can be invested to earn suitable returns.

20. Reasons for Time Preference of Money • The future is always uncertain and involves risk. • People generally prefer spending than deferring for future. • Money has time value because of opportunities available to invest.

21. Timeline and Time travel • Timeline is a linear representation of the timing of the expected cash flows. Timelines are an important first step in organizing and then solving a financial problem. • A series of cash flows lasting several periods as a stream of cash flows. Rules of Time travel • Only cash flows in the same units can be compared or combined at the same point in time. • To move a cash flow forward in time, must compound it. • To move a cash flow backward in time, must use discounting.

22. Techniques of Time Value of Money • Compounding Technique Interest is compounded when the amount earned on an initial deposit becomes part of the principal at the end of the first compounding period. Principal refers to the amount of money on which interest is received. n Vn = Vo(1+i) Where Vn = Future value at the period. Vo = Value of money at time 0. i = Interest rate. Note: If calculations becomes difficult, the future value of money can be calculated with the help of Compound factor tables. Vn = Vo (CFi,n) Where CFi,n is compound factor at i percent and n periods.

23. Simple Interest vs Compound Interest Interest paid/earned on original amount or on principal borrowed is called the simple interest. Symbolically P0(i)(n) Where P0 refers to deposit today i.e., t = 0 i refers to interest rate per period n refers to number of time periods Compound Interest is the interest paid/earned on any previous interest earned as well as on the principal borrowed. n Symbolically Po(1+i) - Po

24. Multiple Compounding Periods In case the interest is payable on quarterly basis, compounding of interest twice a year say 30th June and 31st December every year. The future value of money in the above said case/cases mn Vn = Vo ( 1 + i/m) Where Vn = Future value of money after n years. Vo = Value of money at time 0 i = Interest rate m = Number of times of compounding per year

25. Multi Period Compounding The actual rate of interest realised called effective rate in case of multi period compounding is more than the apparent annual rate of interest called nominal rate. Effective rate of interest is calculated with the following formula: m ( 1 + i/m) – 1 Where i refers to nominal rate of interest m refers to frequency of compounding per year

26. Compounded value of Annuity Annuity is a series of equal payments lasting for some specified period. When cash flows occur at the end of each period the annuity is called a Regular Annuity or Deferred Annuity. If the cash flows occur at the beginning of each period instead of at the end it is called Annuity Due. Future value of Annuity: Vn = (R)(ACFi,n) Future value of Annuity Due: Vn = (R)(ACFi,n)(1 + i)

27. Sinking fund • It is a fund created out of fixed payments each period to accumulate to a future sum after a specified period. • The factor used to calculate the annuity for a given future sum is called sinking fund factor (SFF). • SFF is the reciprocal of the CVFA.

28. Problems • What will be the value of Rs.100 after two years at 10% p.a. Rate of interest if neither the principal sum of Rs.100 nor interest is withdrawn at the end of one year. • From the above calculate the value of Rs.100 @ 10% after ten years. • If you deposit Rs.1000 in an account earning 7% simple interest for two years. What is the accumulated interest at the end of the second year? • Calculate the compound value of Rs.10,000 at the end of third year @ 12% rate of interest when interest is calculated on yearly and quarterly basis.

29. 5. A company offers 12% rate of interest on deposits. What is the effective rate of interest if the compounding is done half yearly, quarterly and monthly? 6. Mr. A deposits Rs.1000 at the end of every year for four years and the deposit earns a compound interest @ 10% p.a. Determine how much money he will have at the end of four years. 7. Mr. B deposits Rs.5000 at the beginning of each year for five years in a bank and the deposit earns a compound interest @ 8% p.a. Determine how much money he will have at the end of five years?

30. 8. Yes ltd deposits Rs50,000 at the end of each year for 4 years at 6 percent rate of interest. • How much would this annuity accumulate at the end fourth year? • Calculate annuity using sinking fund factor.

31. Discounting or Present Value Technique Present value shows what the value is today of some future sum of money. The Present Value Technique is known as discounting because the present value of money to be received in future will always be less. V0 = Vn 1 + i Where Vn is future value for n period Vo is present value Note: When we use discount factors, the present value is calculated by: Present Value = Future Value x DFi,n

32. Present Value of an Annuity If the amount of payment is R, the present value of an annuity can be calculated with the help of annuity discount factor tables. Vo = (R)(ADFi,n) Present value of an annuity due: If the cash flows occur at the beginning of each year, the present value of an annuity due is calculated by using present value tables: Vo = (R)(ADFi,n)(1 + i) Present value of an Infinite Life Annuity: Vo = R/i

33. Problems • Calculate the present value of Rs.1000 to be received after one year @ 10% time preference rate. • Mr. X is to receive Rs.5000 after five years @ 10% p.a. Calculate its present value. • Calculate present value of the following five years cash flows assuming a discount rate of 10%. The cash flows for each respective year are Rs.5000, Rs.10,000, Rs.10,000, Rs.3000 and Rs.2000.

34. 4. Mr. X has to receive Rs.2000 per year for five years. Calculate the present value of annuity assuming that he can earn interest on his investment @ 10% p.a. 5. Mr. A has to receive Rs.10,000 at the beginning of each year for five years. Calculate the present value of annuity due assuming 10% rate of interest. 6. Calculate the present value of Rs.1000 received in perpetuity for an infinite period taking discount rate of 10%.

35. What is Cost of Capital? • Is the minimum rate of return expected by its investors. • Is the rate of return that a firm requires to earn from its projects. • Is the minimum rate of return which will at least maintain value of the shares.

36. Definitions • A cut-off rate for the allocation of capital to investment of projects. It is the rate of return on a project that will leave unchanged the market price of the stock. • Is the minimum required rate of earnings or the cut-off rate of capital expenditures. • The rate of return the firm requires from investment in order to increase the value of the firm in the market price.

37. Components of Cost of Capital • The expected normal rate of return at zero risk level (ro). • Premium for business risk (b). • The premium for financial risk on account of pattern of capital structure (f). Symbolically: K = ro + b + f

38. Form of Capital • Debt • Preference Capital • Retained Earnings • Equity Capital

39. Computation of Cost of Capital Debt: Cost of debt is the rate of interest payable on debt. Debt may be irredeemable or redeemable. • Cost of debt before-tax: Kdb = I/P Where ‘I’ is interest and ‘P’ is principal. • Cost of debt after-tax : Kda = Kdb(1-t) = I/NP (1-t) Where ‘NP’ refers to Net Proceeds ‘t’ refers to rate of tax

40. Debt issued at a premium or discount Net proceeds received from the issue must be considered and not the face value of securities. Kdb = I/NP 1.Compute cost of debt capital, rate of tax 50% where X ltd issues Rs.50,000 8% debentures: a) at par. b) at premium of 10%. c) at discount of 5%. 2. L&T Ltd issues Rs.1,00,000 9% debentures at a premium of 10%. The cost of floatation are 2%. The rate of tax is 60%.Compute cost of debt.

41. Redeemable debt Before Tax I + 1/n(RV-NP) Kdb = ½(RV+NP) Where ‘I’ is Annual Interest ‘n’ is number of years in which debt is to be redeemed. ‘RV’ is Redeemable value of debt ‘NP’ is Net proceeds of debentures.

42. 3. A company issues Rs.10,00,000 10% redeemable debentures at a discount 5%. The cost of floatation Rs.30,000.The debentures are redeemable after 5 years. Calculate before –tax assuming tax rate 50%. Note: calculate after-tax cost of debt.

43. After Tax I(1-t)+ 1/n(RV-NP) Kdb = ½(RV+NP)

44. Cost of Preference Capital • It is a function of dividend expected by its investors. • Perpetual Kp = D/P D refers to Annual Preference Dividend P refers to proceeds Issued at a discount or premium Kp = D/NP • Redeemable Kpr = D+MV-NP/n ½(MV+NP) MV refers to Maturity value of preference shares. NP refers to Net Proceeds of preference shares.

45. Problems • Zee ltd issues 10,000 10% Preference shares of Rs.100 each. Cost of issue is Rs.2 per share. Calculate cost of preference capital if these are issued at par, at a premium of 10% and at a discount of 5%. • Lakme ltd issues 10,000 10% preference shares of Rs.100 each redeemable after 10 years at a premium of 5%.The cost of issue is Rs.2 per share. Calculate the cost of preference capital. • Ponds India ltd issues 1,000 7% preference shares of Rs.100 each redeemable after 5years at par. Calculate the cost of preference capital.

46. Cost of Retained Earnings • It is the rate of return which the existing shareholders can obtain by investing the after-tax dividends in alternative opportunity of equal qualities. D1 Kr = + G NP or MP Where D1 is expected dividend at the end of the year G is Rate of growth

47. To make adjustment in the cost of retained earnings for tax and cost of purchasing new securities the following formula is adopted. Kr = (D/NP + G) (1-t)(1-b) or Kr = Ke(1-t)(1-b) Where Ke is rate of return available to shareholders. ‘b’ is cost of purchasing new securities or brokerage costs. A firm’s return available to shareholders is 15%, the average tax rate of shareholders is 40% and it is expected that 2% is brokerage costs. What is the cost of retained earnings.

48. Cost of Equity It refers to the maximum rate of return that the company must earn on equity finance in order to maintain the present market price of the stock. Dividend yield method: Ke = D/NP or MP Dividend yield plus growth method: Ke = (D1/NP + G) = Do(1+g)/NP+G

49. Problems • A company issues 1000 equity shares for Rs.100 each at a premium of 10%. A company has been paying 20% dividend for the past five years and expects the same in near future. Compute the cost of equity capital. Will it make any difference if the market price of equity share is Rs.160? • A company plans to wish you 1000 new shares of Rs.100 each at par. The flotation costs are expected to be 5% of the share price. The company pays dividend of Rs.10 per share initially and growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares. If the current price of an equity share is Rs.150. Calculate the cost of existing equity share capital.

50. Weighted average cost of capital • Is the average cost of the costs of various sources of financing. • It lies between the least and most expensive funds. • It enables the maximization of profits and the wealth of the equity shareholders by investing the funds in projects earning excess of the overall cost of capital. • Composite cost of capital or Overall cost of capital or average cost of capital.