Financial Management (2)
January 7, 2017 | Author: Madhurjya Boruah | Category: N/A
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Financial Management
Unit 1
Unit 1
Financial Management
Structure
1.1 Introduction 1.2
Meaning And Definitions
1.3
Goals Of Financial Management 1.3.1 Profit Maximization 1.3.2 Wealth Maximization
1.4 Finance Functions 1.4.1 Investment Decisions: 1.4.2 Financing Decisions: 1.4.3 Dividend Decisions 1.4.4 Liquidity Decision 1.5 Organization Of Finance Function 1.5.1 Interface Between Finance And Other Business Functions 1.5.2 Finance And Accounting 1.5.3 Finance And Marketing 1.5.4 Finance And Production (Operations) 1.5.5 Finance And HR 1.6
Summary Terminal Questions Answers to SAQs and TQs
1.1
Introduction
To establish any business, a person must find answers to the following questions: a) Capital investments are required to be made. Capital investments are made to acquire the real assets, required for establishing and running the business smoothly. Real assets are land and buildings, plant and equipments etc. b) Decision to be taken on the sources from which the funds required for the capital investments mentioned above could be obtained, to be taken. c) Therefore, there are two sources of funds viz. debt and equity. In what proportion the funds are to be obtained from these sources is to be decided for formulating the financing plan.
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d) Decision on the routine aspects of day to day management of collecting money due from the firms’ customers and making payments to the suppliers of various resources to the firm. These are the core elements of financial management of a firm.
Financial Management of a firm is concerned with procurement and effective utilization of funds for the benefit of its stakeholders. The most admired Indian companies are Reliance, Infosys. They have been rated well by the financial analyst on many crucial aspects that enabled them to create value for its share holders. They employ the best technology, produce quality goods or render services at the least cost and continuously contribute to the share holders’ wealth. All corporate decisions have financial implications. Therefore, financial management embraces all those managerial activities that are required to procure funds at the least cost and their effective deployment. Finance is the life blood of all organizations. It occupies a pivotal role in corporate management. Any business which ignores the role of finance in its functioning cannot grow competitively in today’s complex business world. Value maximization is the cardinal rule of efficient financial managers today.
Learning Objectives: After studying this unit, you should be able to understand the following.
1. The meaning of Business Finance. 2. The objectives of Financial Management. 3. The various interfaces between finance and other managerial functions of a firm. 1.2Meaning And Definitions The branch of knowledge that deals with the art and science of managing money is called financial management. With liberalization and globalization of Indian economy, regulatory and economic environments have undergone drastic changes. This has changed the profile of Indian finance managers today. Indian financial managers have transformed themselves from licensed raj managers to well informed dynamic proactive managers capable of taking decisions of complex nature in the present global scenario. Traditionally, financial management was considered a branch of knowledge with focus on the procurement of funds. Instruments of financing, formation, merger & restructuring of firms, legal and institutional frame work involved therein occupied the prime place in this traditional approach.
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The modern approach transformed the field of study from the traditional narrow approach to the most analytical nature. The core of modern approach evolved around, procurement of the least cost funds and its effective utilization for maximization of share holders’ wealth. Globalization of business and impact of information technology on financial management have added new dimensions to the scope of financial management.
Self Assessment Question 1 1. Financial Management deals with procurement of funds at the least cost and ______ funds.
1.3Goals Of Financial Management Goals mean financial objective of a firm. Experts in financial management have endorsed the view that the goal of Financial Management of a firm is maximization of economic welfare of its shareholders. Maximization of economic welfare means maximization of wealth of its shareholders. Shareholders’ wealth maximization is reflected in the market value of the firms’ shares. A firm’s contribution to the society is maximized when it maximizes its value. There are two versions of the goals of financial management of the firm:
1.3.1 Profit Maximization: In a competitive economy, profit maximization has been considered as the legitimate objective of a firm because profit maximization is based on the cardinal rule of efficiency. Under perfect competition allocation of resources shall be based on the goal of profit maximization. A firm’s performance is evaluated in terms of profitability. Investor’s perception of company’s performance can be traced to the goal of profit maximization. But, the goal of profit maximization has been criticized on many accounts: 1. The concept of profit lacks clarity. What does the profit mean? a) Is it profit after tax or before tax? b) Is it operating profit or net profit available to share holders?
Differences in interpretation on the concept of profit expose the weakness of the goal of profit maximization 2. Profit maximization ignores time value of money because it does not differentiate between profits of current year with the profit to be earned in later years.
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3. The concept of profit maximization fails to consider the fluctuation in the profits earned from year to year. Fluctuations may be attributable to the business risk of the firm but the concept fails to throw light on this aspect. 4. Profit maximization does not make clear the concept of profit as to whether it is accounting profit or economic normal profit or economic supernormal profits. 5. Because of these deficiencies, profit maximization fails to meet the standards stipulated in an operationally feasible criterion for maximizing shareholders wealth.
1.3.2
Wealth Maximization
Wealth Maximization has, been accepted by the finance managers, because it overcomes the limitations of profit maximisation. Wealth maximisation means maximizing the net wealth of the Company’s share holders. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. Following arguments are in support of the superiority of wealth maximisation over profit maximisation: 1. Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand there are many subjective elements in the concept of profit maximisation. 2. It considers time value of money. Time value of money translates cash flows occurring at different periods into a comparable value at zero period. In this process, the quality of cash flows is considered critically in all decisions as it incorporates the risk associated with the cash flow stream. It finally crystallizes into the rate of return that will motivate investors to part with their hard earned savings. It is called required rate of return or hurdle rate which is employed in evaluating all capital projects undertaken by the firm. Maximizing the wealth of shareholders means positive net present value of the decisions implemented. Positive net present value can be defined as the excess of present value of cash inflows of any decision implemented over the present value of cash out flows associated with the process of implementation of the decisions taken. To compute net present value we employ time value factor. Time value factor is known as time preference rate i.e. the sum of risk free rate and risk premium. Risk free rate is the rate that an investor can earn on any government security for the duration under consideration. Risk premium is the consideration for the risk perceived by the investor in investing in that asset or security. X Ltd is a listed company engaged in the business of FMCG (Fast Moving Consumer goods). Listed means the company’s shares are allowed to be traded officially on the portals of the stock
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exchange. The Board of Directors of X Ltd took a decision in one of its Board meeting, to enter into the business of power generation. When the company informs the stock exchange at the conclusion of the meeting of the decision taken, the stock market reacts unfavourably with the result that the next days’ closing of quotation was 30 % less than that of the previous day. The question now is, why the market reacted in this manner. Investors in this FMCG Company might have thought that the risk profile of the new business (power) that the company wants to take up is higher compared to the risk profile of the existing FMCG business of the X Ltd. When they want a higher return, market value of company’s share declines. Therefore the risk profile of the company gets translated
into a time value factor. The time value factor so translated
becomes the required rate of return. Required rate of return is the return that the investors want for making investment in that sector. Any project which generates positive net present value creates wealth to the company. When a company creates wealth from a course of action it has initiated the share holders benefit because such a course of action will increase the market value of the company’s shares.
Superiority of Wealth Maximisation over Profit Maximisation
1. It is based on cash flow, not based on accounting profit. 2. Through the process of discounting it takes care of the quality of cash flows. Distant cash flows are uncertain. Converting distant uncertain cash flows into comparable values at base period facilitates better comparison of projects. There are various ways of dealing with risk associated with cash flows. These risks are adequately considered when present values of cash flows are taken to arrive at the net present value of any project. 3. In today’s competitive business scenario corporates play a key role. In company form of organization, shareholders own the company but the management of the company rests with the board of directors. Directors are elected by shareholders and hence agents of the shareholders. Company management procures funds for expansion and diversification from Capital Markets. In the liberalized set up, the society expects corporates to tap the capital markets effectively for their capital requirements. Therefore to keep the investors happy through the performance of value of shares in the market, management of the company must meet the wealth maximisation criterion. 4. When a firm follows wealth maximisation goal, it achieves maximization of market value of share. When a firm practices wealth maximisation goal, it is possible only when it produces quality goods at low cost. On this account society gains because of the societal welfare.
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5. Maximization of wealth demands on the part of corporates to develop new products or render new services in the most effective and efficient manner. This helps the consumers as it will bring to the market the products and services that consumers need. 6. Another notable features of the firms committed to the maximisation of wealth is that to achieve this goal they are forced to render efficient service to their customers with courtesy. This enhances consumer welfare and hence the benefit to the society. 7. From the point of evaluation of performance of listed firms, the most remarkable measure is that of performance of the company in the share market. Every corporate action finds its reflection on the market value of shares of the company. Therefore, shareholders wealth maximization could be considered a superior goal compared to profit maximisation. 8. Since listing ensures liquidity to the shares held by the investors, shareholders can reap the benefits arising from the performance of company only when they sell their shares. Therefore, it is clear that maximization of market value of shares will lead to maximisation of the net wealth of shareholders. Therefore, we can conclude that maximization of wealth is the appropriate of goal of financial management in today’s context.
Self Assessment Questions 2 1. Under perfect competition, allocation of resources shall be based on the goal of _______. 2. _____________ is based on cash flows. 3. __________________ consider time value of money.
1.4
Finance Functions
Finance functions are closely related to financial decisions. The functions performed by a finance manager are known as finance functions. In the course of performing these functions finance manager takes the following decisions: 1. Financing decision 2. Investment Decision 3. Dividend decision 4. Liquidity decision.
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1.4.1
Unit 1
Investment Decisions:
To survive and grow, all organizations must be innovative. Innovation demands managerial proactive actions. Proactive organizations continuously search for innovative ways of performing the activities of the organization. Innovation is wider in nature. It could be expansion through entering into new markets, adding new products to its product mix, performing value added activities to enhance the customer satisfaction, or adopting new technology that would drastically reduce the cost of production or rendering services or mass production at low cost or restructuring the organization to improve productivity. All these will change the profile of an organization. These decisions are strategic because, they are risky but if executed successfully with a clear plan of action, they generate super normal growth to the organization. If the management errs in any phase of taking these decisions and executing them, the firm may become bankrupt. Therefore, such decisions will have to be taken after taking into account all facts affecting the decisions and their execution. Two critical issues to be considered in these decisions are: 1. Evaluation of expected profitability of the new investments. 2. Rate of return required on the project. The rate of return required by investor is normally known by hurdle rate or cutoff rate or opportunity cost of capital. After a firm takes a decision to enter into any business or expand it’s existing business, plans to invest in buildings, machineries etc. are conceived and executed. The process involved is called Capital Budgeting. Capital Budgeting decisions demand considerable time, attention and energy of the management. They are strategic in nature as the success or failure of an organization is directly attributable to the execution of capital budgeting decisions taken. Investment decisions are also known as Capital Budgeting Decisions. Capital Budgeting decisions lead to investment in real assets Dividends are payouts to shareholders. Dividends are paid to keep the shareholders happy. Dividend policy formulation requires the decision of the management as to how much of the profits earned will be paid as dividend. A growing firm may retain a large portion of profits as retained earnings to meet its needs of financing capital projects. Here, the finance manager has to strike a balance between the expectation of shareholders on dividend payment and the need to provide for funds out of the profits to meet the organization’s growth.
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1.4.2
Unit 1
Financing Decisions:
Financing decisions relate to the acquisition of funds at the least cost. Here cost has two dimensions viz explicit cost and implicit cost. Explicit cost refers to the cost in the form of coupon rate, cost of floating and issuing the securities etc. Implicit cost is not a visible cost but it may seriously affect the company’s operations especially when it is exposed to business and financial risk. For example, implicit cost is the failure of the organization to pay to its lenders or debenture holders loan installments on due date on account of fluctuations in cash flow attributable to the firms business risk. In India if the company is unable to pay its debts, creditors of the company may use legal means to sue the company for winding up. This risk is normally known as risk of insolvency. A company which employs debt as a means of financing normally faces this risk especially when its operations are exposed to high degree of business risk. In all financing decisions a firm has to determine the proportion of equity and debt. The composition of debt and equity is called the capital structure of the firm. Debt is cheap because interest payable on loan is allowed as deductions in computing taxable income on which the company is liable to pay income tax to the Government of India. For example, if the interest rate on loan taken is 12 %, tax rate applicable to the company is 50 %, then when the company pays Rs.12 as interest to the lender, taxable income of the company will be reduced by Rs.12. In other words when actual cost is 12% with the tax rate of 50 % the effective cost becomes 6% therefore, debt is cheap. But, every installment of debt brings along with it corresponding insolvency risk. Another thing notable in this connection is that the firm cannot avoid its obligation to pay interest and loan installments to its lenders and debentures. On the other hand, a company does not have any obligation to pay dividend to its shareholders. A company enjoys absolute freedom not to declare dividend even if its profitability and cash positions are comfortable. However, shareholders are one of the stakeholders of the company. They are in reality the owners of the company. Therefore well managed companies cannot ignore the claim of shareholders for dividend. Dividend yield is an important determinant for stock prices. Dividend yield refers to dividend paid with reference to the market price of the shares of the company. An investor in company’s shares has two objectives for investing: 1. Income from Capital appreciation (i.e. Capital gains on sale of shares at market price) 2. Income from dividends.
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It is the ability of the company to give both these incomes to its shareholders that determines the market price of the company’s shares. The most important goal of financial management is maximisation of net wealth of the shareholders. Therefore, management of every company should strive hard to ensure that its shareholders enjoy both dividend income and capital gains as per the expectation of the market. But, dividend is declared out of the profit earned by the company after paying income tax to the Govt of India. For example, let us assume the following facts: Dividend = 12 % on paid up value Tax rate applicable to the company = 30 % Dividend tax = 10 % When a Company pays Rs.12 on paid up Capital of Rs.100 as dividend, the profit that the company must earn before tax is: Since payment of dividend by an Indian Company attracts dividend tax, the company when it pays Rs.12 to shareholders, must pay to the Govt of India 10 % of Rs.12 = Rs.1.2 as dividend tax. Therefore dividend and dividend tax sum up to 12 + 1.2 = Rs.13.2 Since this is paid out of the post tax profit, in this question, the company must earn: Post – tax dividend paid 1 – Tax rate applicable to the company = pre tax profit required to declare and pay the dividend 13.2
= 1 – 0.3
13.2
=
0.7
= Rs 19 approximate
Therefore, to declare a dividend of 12 % Company has to earn a pre tax profit of 19 %. On the other hand, to pay an interest of 12 % Company has to earn only 8.4 %. This leads to the conclusion that for every Rs.100 procured through debt, it costs 8.4 % where as the same amount procured in the form of equity (share capital) costs 19 %. This confirms the established theory that equity is costly but debt is a cheap but risky source of funds to the corporates. The challenge before the finance manager is to arrive at a combination of debt and equity for financing decisions which would attain an optimal structure of capital. An optimal structure is one that arrives at the least cost structure, keeping in mind the financial risk involved and the ability of the company to manage the business risk. Besides, financing decision involves the consideration of managerial control, flexibility and legal aspects. As such it involves quite a lot of regulatory and managerial elements in financing decisions.
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1.4.3
Unit 1
Dividend Decisions
Dividend yield is an important determinant of an investor’s attitude towards the security (stock) in his portfolio management decisions. But dividend yield is the result of dividend decision. Dividend decision is a major decision made by a finance manager. It is the decision on formulation of dividend policy. Since the goal of financial management is maximisation of wealth of shareholders, dividend policy formulation demands the managerial attention on the impact of its policy on dividend on the market value of the shares. Optimum dividend policy requires decision on dividend payment rates so as to maximize the market value of shares. The payout ratio means what portion of earnings per share is given to the shareholders in the form of cash dividend. In the formulation of dividend policy, management of a company must consider the relevance of its policy on bonus shares. Dividend policy influences the dividend yield on shares. Since company’s ratings in the Capital market have a major impact on its ability to procure funds by issuing securities in the capital markets, dividend policy, a determinant of dividend yield has to be formulated having regard to all the crucial elements in building up the corporate image. The following need adequate consideration in deciding on dividend policy: 1. Preferences of share holders Do they want cash dividend or Capital gains? 2. Current financial requirements of the company 3. Legal constraints on paying dividends. 4. Striking an optimum balance between desires of share holders and the company’s funds requirements.
1.4.4 Liquidity Decision Liquidity decisions are concerned with Working Capital Management. It is concerned with the day to –day financial operations that involve current assets and current liabilities. The important element of liquidity decisions are: 1) Formulation of inventory policy 2) Policies on receivable management. 3) Formulation of cash management strategies 4) Policies on utilization of spontaneous finance effectively.
1.4.5
Organization Of Finance Function
Financial decisions are strategic in character and therefore, an efficient organizational structure is required to administer the same. Finance is like blood that flows through out the organization.
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In all organizations CFOs play an important role in ensuring proper reporting based on substance to the stake holders of the company. Because of the crucial role these functions play, finance functions are organized directly under the control of Board of Directors. For the survival of the firm, there is a need to ensure both long term and short term financial solvency. Failure to achieve this will have its impact on all other activities of the firm. Weak functional performance by financial department will weaken production, marketing and HR activities of the company. The result would be the organization becoming anemic. Once anemic, unless crucial and effective remedial measures are taken up it will pave way for corporate bankruptcy. CFO reports to the Board of Directors. Under CFO, normally two senior officers manage the treasurer and controller functions. A Treasurer performs the following function : 1. Obtaining finance. 2. Liasoning with term lending and other financial institutions. 3. Managing working capital. 4. Managing investment in real assets.
A Controller performs: 1. Accounting and Auditing 2. Management control systems 3. Taxation and insurance 4. Budgeting and performance evaluation 5. Maintaining assets intact to ensure higher productivity of operating capital employed in the organization. In India CFOs have a legal obligation under various regulatory provisions to certify the correctness of various financial statements information reported to the stake holders in the annual reports. Listing norms, regulations on corporate governance and other notifications of Govt of India have adequately recognized the role of finance function in the corporate set up in India.
Self Assessment Questions 3 1. ____________ lead to investment in real assets. 2. _______________ relate to the acquisition of funds at the least cost. 3. Formulation of inventory policy is an important element of ___________. 4. Obtaining finance is an important function of _________.
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1.5 Interface Between Finance And Other Business Functions
1.5.1 Finance And Accounting Looking at the hierarchy of the finance function of an organization, the controller reports to CFO. Accounting is one of the functions that a controller discharges. Accounting and finance are closely related. For computation of Return on Investment, earnings per share and of various ratios for financial analysis the data base will be accounting information. Without a proper accounting system, an organization cannot administer effectively function of financial management. The purpose of accounting is to report the financial performance of the business for the period under consideration. It is historical in character. But financial management uses the historical accounting information for decision making. All the financial decisions are futuristic based on cash flow analysis. All the financial decisions consider quality of cash flows as an important element of decisions. Since financial decisions are futuristic, it is taken and put into effect under conditions of uncertainty. Assuming the degree of uncertainty and incorporating their effect on decision making involve use of various statistical models. In the selection of these models, element of subjectivity creeps in.
1.5.2 Finance And Marketing Many marketing decisions have financial implications. Selections of channels of distribution, deciding on advertisement policy, remunerating the salesmen etc have financial implications. In fact, the recent behaviour of rupee against us $ (appreciation of rupee against US dollar), affected the cash flow positions of export oriented textile units and BPO’s and other software companies. It is generally believed that the currency in which marketing manager invoices the exports decides the cash flow consequences of the organization if the company is mainly dependent on exports. Marketing cost analysis, a function of finance managers is the best example of application of principles of finance on the performance of marketing functions by a business unit. Formulation of policy on credit management cannot be done unless the integration of marketing with finance is achieved. Deciding on credit terms to achieve a particular level of sales has financial implication because sanctioning liberal credit may result in huge bad debt, on the other hand a conservative credit terms may depress the sales. Credit terms also affect the investment in receivable, an area of working capital management. There is a close relation between inventory and sales. Co ordination of stores administration with that of marketing management is required to ensure customer satisfaction and good will. But investment in inventory requires the financial clearance because funds are locked in and the funds so blocked have opportunity cost of capital.
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1.5.3 Finance And Productions (Operations) Finance and operations management are closely related. Decisions on plant layout, technology selection, productions / operations, process plant size, removing imbalance in the flow of input material in the production / operation process and batch size are all operations management decisions but their formulation and execution cannot be done unless evaluated from the financial angle. The capital budgeting decisions are closely related to production and operations management. These decisions make or mar a business unit. We have examples to substantiate this. Failure to understand the implications of the latest technological trend on capacity expansions has cost even blue chip companies. Many textile units in India became sick because they did not provide sufficient finance for modernization of plant and machinery. Inventory management is crucial to successful operation management. But management of inventory involves quite a lot of financial variables.
1.5.4 Finance And HR Attracting and retaining the best man power in the industry cannot be done unless they are paid salary at competitive rates. If an organization formulates & implements a policy for attracting the competent man power it has to pay the most competitive salary packages to them. But it improves organizational capital and productivity. Infosys does not have physical assets similar to that of Indian Railways. But if both were to come to capital market with a public issue of equity, Infosys would command better investor’s acceptance than the Indian Railways. This is because the value of human resources plays an important role in valuing a firm. The better the quality of man power in an organization, the higher the value of the human capital and consequently the higher the productivity of the organization. Indian Software and IT enabled services have been globally acclaimed only because of the man power they possess. But it has a cost factor i.e. the best remuneration to the staff.
1.6 Summary Financial Management is concerned with the procurement of the least cost funds and its’ effective utilization for maximization of the net wealth of the firm. There exists a close relation between the maximization of net wealth of shareholders and the maximization of the net wealth of the company. The broad areas of decision are capital budgeting, financing, dividend and working capital. Dividend decision demands the managerial attention to strike a balance between the investor’s expectation and the organizations’ growth.
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Terminal Questions 1. What are the objectives of financial management? 2. How does a finance manager arrive at an optimal capital structure? 3. Examine the relationship of financial management with other functional areas of a firm.
Answers To Self Assessment Questions’s Self Assessment Questions 1: 1. Effective utilization
Self Assessment Questions 2
1. Profit maximisation. 2. Wealth maximisation 3. Wealth maximisation
Self Assessment Questions 3 1. Investment decisions. 2. Financing decisions 3. Liquidity 4. Treasures
Answer for Terminal Questions 1. Refer 1.3 2. Refer 1.4.1 3. Refer 1.5
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Unit 2
Unit 2 Financial Planning Structure
2.1.
Introduction
2.2.
Steps in financial planning
2.3.
Factors affecting financial plan
2.4.
Estimation of financial requirements of a firm.
2.5.
Capitalizations 2.1.1 Cost Theory 2.1.2 Earnings theory: 2.1.3 Overcapitalization 2.1.4 Undercapitalization
2.6
Summary Terminal Questions Answer to SAQs and TQs
2.1
Introduction
Liberalization and globalization policies initiated by the Government have changed the dimension of business environment. It has changed the dimension of competition that a firm faces today. Therefore for survival and growth a firm has to execute planned strategy systematically. To execute any strategic plan, resources are required. Resources may be manpower, plant and machinery, building, technology or any intangible asset. To acquire all these assets financial resources are essentially required. Therefore, finance manager of a company must have both longrange and shortrange financial plans. Integration of both these plans is required for the effective utilization of all the resources of the firm. The longrange plan must consider (1) Funds required to execute the planned course of action. (2) Funds available at the disposal of the company. (3) Determination of funds to be procured from outside sources.
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Learning Objectives: After studying this unit you should
1. Explain the steps involved in financial planning. 2. Explain the factors affecting the financial planning. 3. List out the causes of over capitation 4. Explain the effects of under capitation. Objectives of Financial Planning Financial Planning is a process by which funds required for each course of action is decided. It must consider expected business Scenario and develop appropriate courses of action. A financial plan has to consider Capital Structure, Capital expenditure and cash flow. In this connection decisions on the composition of debt and equity must be taken. Financial planning generates financial plan. Financial plan indicates: 1. The quantum of funds required to execute business plans. 2. Composition of debt and equity, keeping in view the risk profile of the existing business, new business to be taken up and the dynamics of capital market conditions. 3. Formulation of policies for giving effect to the financial plans under consideration. A financial plan is at the core of value creation process. A successful value creation process can effectively meet the bench marks of investor’s expectations.
Benefits that accrue to a firm out of the financial planning 1. Effective utilization of funds: Shortage is managed by a plan that ensures flow of cash at the least cost. Surplus is deployed through well planned treasury management. Ultimately the productivity of assets is enhanced. 2. Flexibility in capital structure is given adequate consideration. Here flexibility means the firms ability to change the composition of funds that constitute its capital structure in accordance with the changing conditions of capital market. Flexibility refers to the ability of a firm to obtain funds at the right time, in the right quantity and at the least cost as per requirements to finance emerging opportunities. 3. Formulation of policies and instituting procedures for elimination of all types of wastages in the process of execution of strategic plans. 4. Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for plant and machinery and other fixed assets. This will help the firm in reducing its
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operating capital. Operating capital refers to the ratio of capital employed to sales generated. A perusal of annual reports of Dell computers will throw light on how Dell strategically minimized the operating capital required to support sales. Such companies are admired by investing community. 5. Integration of long range plans with the shortage plans.
Guidelines for financial planning 1. Never ignore the coordinal principle that fixed asset requirements be met from the long term sources. 2. Make maximum use of spontaneous source of finance to achieve highest productivity of resources. 3. Maintain the operating capital intact by providing adequately out of the current periods earnings. Due attention to be given to physical capital maintenance or operating capability. 4. Never ignore the need for financial capital maintenance in units of constant purchasing power. 5. Employ current cost principle wherever required. 6. Give due weightage to cost and risk in using debt and equity. 7. Keeping the need for finance for expansion of business, formulate plough back policy of earnings. 8. Exercise thorough control over overheads. 9. Seasonal peak requirements to be met from short term borrowings from banks.
2.2 Steps In Financial Planning 1. Establish Corporate Objectives: Corporate objectives could be grouped into qualitative and quantitative. For example, a company’s mission statement may specify “create economic – value added.” But this qualitative statement has to be stated in quantitative terms such as a 25 % ROE or a 12 % earnings growth rates. Since business enterprises operate in a dynamic environment, there is a need to formulate both short run and long run objectives. 2. Next stage is formulation of strategies for attaining the objectives set. In this connection corporates develop operating plans. Operating plans are framed with a time horizon. It could be a five year plan or a ten year plan. 3. Once the plans are formulated, responsibility for achieving sales target, operating targets, cost management bench marks, profit targets etc is fixed on respective executives. 4. Forecast the various financial variables such as sales, assets required, flow of funds, cost to be incurred and then translate the same into financial statements. Such forecasts help the
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finance manager to monitor the deviations of actual from the forecasts and take effective remedial measures to ensure that targets set are achieved without any time overrun and cost overrun. 5. Develop a detailed plan for funds required for the plan period under various heads of expenditure. 6. From the funds required plan, develop a forecast of funds that can be obtained from internal as well as external sources during the time horizon for which plans are developed. In this connection legal constrains in obtaining funds on the basis of covenants of borrowings should be given due weightage. There is also a need to collaborate the firm’s business risk with risk implications of a particular source of funds. 7. Develop a control mechanism for allocation of funds and their effective use. 8. At the time of formulating the plans certain assumptions need to be made about the economic environment. But when plans are implemented economic environment may change. To manage such situations, there is a need to incorporate an inbuilt mechanism which would scale up or scale down the operations accordingly.
Forecast of Income Statement and Balance Sheet There are three methods of preparing income statement: 1. Percent of sales method or constant ratio method 2. Expense method 3. Combination of both these two
Percent of Sales method: This approach is based on the assumptions that each element of cost bears some constant relationship with the sales revenue. For example, Raw material cost is 40 % of sales revenue of the year ended 31.03.2007. But this method assumes that the ratio of raw material cost to sales will continue to be the same in 2008 also. Such an assumption may not hold good in most of the situations. For example, Raw material cost increases by 10 % in 2008 but selling price of finished goods increases only by 5 %. In this case raw material cost will be 44 / 105 of the sales revenue in 2008. This can be solved to some extent by taking average for same representative years. However, inflation, change in Govt policies, wage agreements, technological innovation totally invalidate this approach on a long run basis.
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2. Budgeted Expense Method: Expenses for the planning period are budgeted on the basis of anticipated behaviour of various items of cost and revenue. This demands effective data base for reasonable budgeting of expenses. 3. Combination of both these methods is used because some expenses can be budgeted by the management taking into account the expected business environment and some other expenses could be based on their relationship with the sales revenue expected to be earned.
Forecast of Balance Sheet 1. Items of certain assets and liabilities which have a close relationship with the sales revenue could be computed based on the forecast of sales and the historical data base of their relationship with the sales. 2. Determine the equity and debt mix on the basis of funds requirements and the company’s policy on Capital structure.
Example : The following details have been extracted from the books of X Ltd Income Statement (Rs. In millions) 2006
2007
Sales less returns
1000
1300
Gross Profit
300
520
Selling Expenses
100
120
Administration
40
45
Deprecation
60
75
Operating Profit
100
280
Non operating income
20
40
EBIT (Earnings before interest & Tax
120
320
Interest
15
18
Profit before tax
105
302
Tax
30
100
Profit after tax
75
202
Dividend
38
100
Retained earnings
37
102
Balance Sheet (Rs. In million)
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Financial Management
Liabilities
Unit 2
2006
2007
Assets
2006
2007
Share holders fund
Fixed Assets
400
510
Share Capital
Less: Depreciation
100
120
300
390
50
50
Cash at Bank
10
12
Receivables
80
128
Inventories
200
300
Loans & Advances
50
80
10
24
700
984
Equity
120
120
Preference
50
50
Reserves & Surplus
122
224
Secured Loans
100
120
Unsecured loans
50
60
Current Liabilities Trade Crs
210
250
Investments
Current Assets, loans & Advances
Miscellaneous
Provisions
expenditure
Tax
10
60
Proposed Dividend
38
100
760
984
Forecast the income statement and balance sheet for the year 2008 based on the following assumptions. 1. Sales for the year 2008 will increase by 30% over the sales value for 2007. 2. Use percent of sales method to forecast the values for various items of income statement using the percentage for the year 2007. 3. Depreciation is to charged at 25 % of fixed assets. 4. Fixed assets will increase by Rs.100 million. 5. Investments will increase by Rs.100 million. 6. Current assets and Current liabilities are to be decided based on their relationship to sales in the year 2007. 7. Miscellaneous expenditure will increase by Rs.19 million. 8. Secured loans in 2008 will be based on its relationship to sales in the year 2007. 9. Additional funds required, if any, will be met by bank borrowings. 10. Tax rates will be 30 %.
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11. Dividends will be 50 % of profit after tax. 12. Non operating income will increase by 10%. 13. There will be no change in the total amount of administration expenses to be spent in the year 2008 14. There is no change in equity and preference capital in 2008. 15. Interest for 2008 will maintain the same ratio as it has in 2007 with the sales of 2007.
Income Statement for the Year 2008 (Rs. In million) (Forecast) Particulars
Basis
Working
Amount (Rs.)
a. Sales
Increase by 30 %
1300 x 1.3
1690
b. Cost of Sales
Increase by 30 %
780 x 1.3
1014
c. Gross profit
Sales–Cost of sales
1690 1014
676
d. Selling expenses
30 % increase
120 x 1.3
156
e. Administration
No change
f. Depreciation
% given
45 390 + 100
123 (Rounded off)
4 g. Operating Profit
C (D + E + F)
h. Non operating Income
Increase by 10 %
352 1.1 x 40
44
i. Earnings Before
396
Interest & Taxes (EBIT) j. Interest
18 of sales
18 x 1690
1300
1300
23 (Decimal ignored)
k. Profit before tax
373
l. Tax
112
m. Profit after tax
261
n. Dividends
130
o. Retained earnings
131
Balance Sheet for the year 2008 (Rs. In million) (Forecast)
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Financial Management
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Particulars
Basis
Working
Amount (Rs.)
Assets Fixed Assets
Given
510
Add: Addition
100 610
Depreciation
120 + 123
243
1. Net fixed assets
367
2. Investments
150
3. Current Assets & Loans & advances Cash at bank
Receivables
Inventories
Loans & Advances
12
12 x 1690
1300
1300
128
128 x 1690
1300
1300
300
300 x 1690
1300
1300
80
80 x 1690
1300
1300
4. Miscellaneous
Given
Expenditure
24 + 19
Total
16 (Rounded off)
166
390
104
43 1236
Liabilities 1. Share Capital Equity
120
Preference
50
2. Reserves & Surplus
Increase by current year’s retained
355
earnings 3. Secured Loan
Bank borrowings
60
60 x 1690
1300
1300
78 40 (Difference – Balancing figure)
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Financial Management
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4. Unsecured Loan
60
60
5. Current Liabilities & Provision Trade creditors
Provision for tax
Proposed Dividend
250
250 x 1690
1300
1300
60
60 x 1690
1300
1300
325
78
Current year given
130
Total Liabilities
1236
Computerised Financial Planning Systems All corporate forecasts use Computerised forecasting models. Additional funds required to finance the increase in sales could be ascertained using a mathematical relationship based on the following:
Additional funds Required
= Required increase
in assets
Spontaneous
Increase in
increase in liabilities
retained earnings
(This formula has been recommended by Engene.F.Brighaom and Michael C Ehrharte in their book financial management – Theory and Practice, 10 th edition.
Prof. Prasanna Chandra, in his book Financial Management, has given a comprehensive formula for ascertaining the external financing requirements: EFR = A (Ds) – L (Ds) – ms (1d) – (D1m + SR) S
S
Here A
= Expected increase in assets, both fixed and current required for the
X Ds
S expected increase in sales in the next year. L = Expected Spontaneous financing available for the expected increase in
X Ds S sales MS1 (1d) = It is the product of Profit margin x Expected sales for the next year x Retention Ratio
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Financial Management
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Here, retention ratio is 1 – payout ratio. Payout ratio refers to the ratio of dividend paid to earnings per share D1m = Expected change in the level of investments and miscellaneous expenditure SR = It is the firm’s repayment liability on term loans and debenture for the next year. This formula has certain features: 1. Ratios of assets and spontaneous liabilities to sales remain constant over the planning period. 2. Dividend payout and profit margin for the next year can be reasonably planned in advance. 3. Since external funds requirements involve borrowings from financial institution, the formula rightly incorporates the management’s liability on repayments. Example A Ltd has given the following forecasts: “Sales in 2008 will increase to Rs.2000 from Rs.1000 in 2007” The balance sheet of the company as on December 31, 2007 gives the following details: Liabilities
Rs
Share Capital
Assets
Rs
Net Fixed Assets
500
Equity (Shares of Rs.10 each)
100
Inventories
200
Reserves & Surplus
250
Cash
100
Long term loan
400
Bills Receivable
200
Crs for expenses outstanding
50
Trade creditors
50
Bills Payable
150 1000
1000
Ascertain the external funds requirements for the year 2008, taking into account the following information: 1. The Company’s utilization of fixed assets in 2007 was 50 % of capacity but its current assets were at their proper levels. 2. Current assets increase at the same rate as sales. 3. Company’s aftertax profit margin is expected to be 5%, and its payout ratio will be 60 %. 4. Creditors for expenses are closely related to sales ( Adapted from IGNOU MBA)
Answers Preliminary workings A = Current assets = Cash + Bills Receivables + Inventories
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Financial Management
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= 100 + 200 +200 = 500 A = 500 = Rs.500
X Ds
S 1000
X 1000
L = Trade creditors + Bills payable + Expenses outstanding = 50 + 150 + 50 = Rs.250 L
= 250 = Rs.250
X Ds S
1000
X 1000
M (Profit Margin)= 5 / 100 = 0.05 S1 = Rs.200 1d = 1 – 0.6 = 0.4 or 40 % D1m = NIL SR = NIL Therefore:
EFR =
A ( Ds ) L - x DS - mS 1 ( 1 - d ) - ( D1 m + SR ) S S
= 500 – 250 – (0.05 x 200 x 0.4) – (0 + 0) = 500 – 250 – 40 (0 + 0) = Rs.210 Therefore, external funds requirements (additional funds required) for 2008 will be Rs.210. This additional funds requirements will be procured by the firm based on its policy on capital structure.
Self Assessment Questions 1 1. Corporate objectives could be group into ________ and ________. 2. Control mechanism is developed for _____________ and their effective use. 3. Seasonal peak requirements to be met from ___________________ from banks. 4. Exercise through _________ over overheads.
2.3 Factors Affecting Financial Plan
1. Nature of the industry: Here, we must consider whether it is a capital intensive or labour intensive industry. This will have a major impact on the total assets that the firm owns. 2. Size of the Company: The size of the company greatly influences the availability of funds from different sources. A small company normally finds it difficult to raise funds from long
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Financial Management
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term sources at competitive terms. On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short term and long term at attractive rates. 3. Status of the company in the industry: A well established company enjoying a good market share, for its products normally commands investors’ confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment. 4. Sources of finance available: Sources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with a diversified product mix may manage higher quantum of debt because the firm may manage higher financial risk with a lower business risk. Selection of sources of finance is closely linked to the firm’s capacity to manage the risk exposure. 5. The Capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing preference shares and debentures to outsiders. 6. Matching the sources with utilization: The prudent policy of any good financial plan is to match the term of the source with the term of investment. To finance fluctuating working capital needs the firm resorts to short terms finance. All fixed assets financed investments are to be financial by long term sources. It is a cardinal principle of financial planning. 7. Flexibility: The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure when ever need arises. If the capital structure of a company is flexible, it will not face any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalization of capital market. 8. Government Policy: SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and Department of corporate affairs (Govt of India) influence the financial plans of corporates today. Management of public issues of shares demands the compliances with many statues in India. They are to be complied with a time constraint.
Self Assessment Questions 2: 1. ___________ has a major impact on the total assets that the firm owns. 2. Sources of finance could be grouped into __ and _______________.
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3. ___________ of any good financial plan is to match the term of the source with the term of the source with the term of the investment. 4. ________________ refers the ability to ______________________ whenever need arises.
2.4
Estimation Of Financial Requirements Of a Firm.
The estimation of capital requirements of a firm involves a complex process. Even with expertise, managements of successful firms could not arrive at the optimum capital composition in terms of the quantum and the sources. Capital requirements of a firm could be grouped into fixed capital and working capital. The long term requirements such as investment in fixed assets will have to be met out of funds obtained on long term basis. Variable working capital requirements which fluctuate from season to season will have to be financed only by short term sources. Any departure from this well accepted norm causes negative impacts on firm’s finances.
Self Assessment Question 3: 1. Capital requirement of a firm could be grouped into ________ and __________. 2. Variable working capital will have to be financed only by _______________.
2.5 Capitalizations Meaning: Capitalization of a firm refers the composition of its longterm funds. It refers to the capital structure of the firm. It has two components viz debt and equity. After estimating the financial requirements of a firm, then the next decision that the management has to take is to arrive at the value at which the company has to be capitalized. There are two theories of Capitalization for new companies: 1. Cost theory and
2. Earnings theory
2.5.1 Cost Theory: Under this approach, the total amount of capitalization for a new company is the sum of the following: 1. Cost of fixed assets. 2. Cost of establishing the business. 3. Amount of working capital required
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Merits of cost approach: 1. It helps promoters to estimate the amount of capital required for incorporation of company conducting market surveys, preparing detailed project report, procuring funds, procuring assets both fixed and current, trial production run and successfully producing, positioning and marketing of its products or rendering of services. 2. If done systematically it will lay foundation for successful initiation of the working of the firm. Demerits 1. If the firm establishes its production facilities at inflated prices, productivity of the firm will be less than that of the industry. 2. Net worth of a company is decided by the investors by the earnings of a company. Earnings capacity based net worth helps a firm to arrive at the total capital in terms of industry specified yardstick ( i,e, operating capital based on bench marks in that industry) cost theory fails in this respect.
2.5.2
Earnings Theory:
Earnings are forecast and capitalized at a rate of return which is representative of the industry. It involves two steps. 1. Estimation of the average annual future earnings. 2. Normal earning rate of the industry to which the company belongs.
Merits 1. It is superior to cost theory because there are, the least chances of neither under not over capitalization. 2. Comparison of earnings approach with that of cost approach will make the management to be cautious in negotiating the technology and cost of procuring and establishing the new business.
Demerits 1. The major challenge that a new firm faces is in deciding on capitalization and its division thereof into various procurement sources. 2. Arriving at capitalization rate is equally a formidable task because the investors’ perception of established companies cannot be really representative of what investors perceive of the earning power of new company.
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Financial Management
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Because of the problem, most of the new companies are forced to adopt the cost theory of capitalization. Ideally every company should have normal capitalization. But it is an utopian way of thinking. Changing business environment, role of international forces and dynamics of capital market conditions force us to think in terms of what is optimal today need not be so tomorrow. Even with these constraints, management of every firm should continuously monitor the firms capital structure to ensure to avoid the bad consequences of over and under capitalization.
2.5.3
Overcapitalization
A company is said to be overcapitalized, when its total capital (both equity and debt) exceeds the true value of its assets. It is wrong to identify overcapitalization with excess of capital because most of the overcapitalized firms suffer from the problems of liquidity. The correct indicator of overcapitalization is the earnings capacity of the firm. If the earnings of the firm are less then that of the market expectation, it will not be in a position to pay dividends to its shareholders as per their expectations. It is a sign of overcapitalization. It is also possible that a company has more funds than its requirements based on current operation levels, and yet have low earnings. Overcapitalization may be on account of any of the following: 1. Acquiring assets at inflated rates 2. Acquiring unproductive assets. 3. High initial cost of establishing the firm 4. Companies which establish their new business during boom condition are forced to pay more for acquiring assets, causing a situation of overcapitalization once the boom conditions subside. 5. Total funds requirements have been over estimated. 6. Unpredictable circumstances (like change in import –export policy, change in market rates of interest, changes in international economic and political environment) reduce substantially the earning capacity of the firm. For example, rupee appreciation against U.S.dollar has affected earning capacity of firms engaged mainly in export business because they invoice their sales in US dollar. 7. Inadequate provision for depreciation adversely affects the earning capacity of a company , leading to overcapitalization of the firm. 8. Existence of idle funds.
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Effects of over capitalization 1. Decline in the earnings of the company. 2. Fall in dividend rates. 3. Market value of company’s share falls, and company loses investors confidence. 4. Company may collapse at any time because of anemic financial conditions – it will affect its employees, society, consumers and its shareholders. Employees will lose jobs. If the company is engaged in the production and marketing of certain essential goods and services to the society, the collapse of the company will cause social damage.
Remedies for Overcapitalization: Restructuring the firm is to be executed to avoid the situation of company becoming sick. It involves 1. Reduction of debt burden. 2. Negotiation with term lending institutions for reduction in interest obligation. 3. Redemption of preference shares through a scheme of capital reduction. 4. Reducing the face value and paidup value of equity shares. 5. Initiating merger with well managed profit making companies interested in taking over ailing company.
2.5.4 Undercapitalization Undercapitalization is just the reverse of overcapitalization. A company is considered to be undercapitalized when its actual capitalization is lower than its proper capitalization as warranted by its earning capacity.
Symptoms of undercapitalization 1. Actual capitalization is less than that warranted by its earning capacity. 2. Its rate of earnings is exceptionally high in relation to the return enjoyed by similar situated companies in the same industry.
Causes of undercapitalization 1. Under estimation of future earnings at the time of promotion of the company. 2. Abnormal increase in earnings from new economic and business environment. 3. Under estimation of total funds requirements.
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Financial Management
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4. Maintaining very high efficiency through improved means of production of goods or rendering of services. 5. Companies which are set up during recession start making higher earning capacity as soon as the recession is over. 6. Use of low capitalization rate. 7. Companies which follow conservative dividend policy will achieve a process of gradually rising profits. 8. Purchase of assets at exceptionally low prices during recession.
Effects of undercapitalization 1. Encouragement to competition: undercapitalization encourages competition by creating a feeling that the line of business is lucrative. 2. It encourages the management of the company to manipulate the company’s share prices. 3. High profits will attract higher amount of taxes. 4. High profits will make the workers demand higher wages. Such a feeling on the part of employees leads to labour unrest. 5. High margin of profit may create among consumers an impression that the company is charging high prices for its products. 6. High margin of profits and the consequent dissatisfaction among its employees and consumer, may invite governmental enquiry into the pricing mechanism of the company.
Remedies 1. Splitting up of the shares – This will reduce the dividend per share. 2. Issue of bonus shares: This will reduce both the dividend per share and earnings per share. Both overcapitalization and undercapitalization are detrimental to the interests of the society.
Self Assessment Question 4 1. ______________ of a firm refers to the composition of its long –term funds. 2. Two theories of capitalization for new companies are ________ and earnings theory. 3. A company is said to be ___________, when its total capital exceeds the true value of its assets. 4. A company is considered to be ________________ when its actual capitalization is lower than its proper capitalization as warranted by its earning capacity.
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Financial Management
2.6
Unit 2
Summary
Financial planning deals with the planning, execution and monitoring of the procurement and utilization of funds. Financial planning process gives birth to financial plan. It could be thought of a blueprint explaining the proposed strategy and its execution. There are many financial planning models. All these models forecast the future operations and then translate them into income statements and balance sheets. It will also help the finance managers to ascertain the funds to be procured from outside sources. The essence of all these is to achieve a least cost capital structure which would match with the risk exposure of the company. Failure to follow the principle of financial planning may lead a new firm to over or undercapitalization when the economic environment undergoes a change. Ideally every firm should aim at optimum capitalization. Other wise it may face a situation of over or undercapitalization. Both are detrimental to the interests of the society. There are two theories of capitalization viz cost theory and earnings theory.
Terminal Questions 1. Explain the steps involved in Financial Planning. 2. Explain the factors affecting Financial Plan 3. List out the causes of Over – Capitalization. 4. Explain the effects of Under – Capitalization.
Answers To Self Assessment Questions Self Assessment Questions 1 1. Qualitative, Quantitative. 2. Allocation of funds 3. Short term borrowings
Self Assessment Question 2 1. Nature of the industry 2. Debt, Equity 3. The product policy 4. Flexibility in capital structure, effect changes in the composites of capital structure
Self Assessment Question 3
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Financial Management
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1. Fixed capital, working capital. 2. Short term sources
Self Assessment Question 4 1. Capitalization 2. Cost theory 3. Over Capitalized 4. Under capitalized
Answer to Terminal Questions 1. Refer to unit 2.2 2. Refer to unit 2.3 3. Refer to unit 2.5.3 4. Refer to unit 2.5.4
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Financial Management
Unit 3
Unit 3
Time Value of Money
Structure
3.1 Introduction 3.2 Time Preference Rate and Required Rate of Return 3.2.1 Compounding Technique 3.2.2 Discounting Technique 3.2.3 Future Value of a Single Flow (Lump sum): 3.2.4 Future Value of Series of Cash Flows 3.2.5 Future Value of an Annuity 3.2.5.1 Sinking Fund 3.3 Present Value 3.3.1 Discounting or Present Value of a Single Flow 3.3.2 Present Value of a Series of Cash Flows 3.3.2.1 Present Value of Perpetuity 3.3.2.2 Capital Recovery Factor 3.4 Summary Solved Problems Terminal Questions Answer to SAQs and TQs 3.1 Introduction The main objective of this unit is to enable you to learn the time value of money. In the previous unit, we have learnt that wealth maximization is the primary objective of financial management and that is more important than profit maximization for its superiority in the sense that it is futureoriented. A decision taken today will have farfetching implications. For example, a firm investing in fixed assets will reap the benefits of such investment for a number of years. If such assets are procured through bank borrowings or term loans from financial institutions, these involve an obligation to pay interest and return of principal. Decisions are made by comparing the cash inflows (benefits/returns) and cash outflows (outlays). Since these two components occur at different time periods, there should be
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Financial Management
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a comparison. In order to have a logical and meaningful comparison between cash flows that accrue over different intervals of time, it is necessary to convert the amounts to a common point of time. This unit is devoted for a discussion of the techniques of doing so.
Learning Objectives: After studying this unit, you should be able to understand the following.
1. Explain the time value of money. 2. Understand the valuation concepts. 3. Calculate the present and future values of lump sum and annuity flows. Rationale: “Time Value of Money” is the value of a unit of money at different time intervals. The value of money received today is more than its value received at a later date. In other words, the value of money changes over a period of time. Since a rupee received today has more value, rational investors would prefer current receipts to future receipts. That is why this phenomenon is also referred to as “Time Preference of Money”. Some important factors contributing to this are:
Investment opportunities: Preference for consumption Risk These factors remind us of the famous English saying “A bird in hand is worth two in the bush”. Why should money have time value? Some of the reasons are: Money can be employed productively to generate real returns. For example, if we spend Rs. 500 on materials and Rs. 300 on labour and Rs. 200 on other expenses and the finished product is sold for Rs. 1100, we can say that the investment of Rs. 1000 has fetched us a return of 10%. Secondly, during periods of inflation, a rupee has a higher purchasing power than a rupee in future. Thirdly, we all live under conditions of risk and uncertainty. As future is characterized by uncertainty, individuals prefer current consumption to future consumption. Most people have
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Financial Management
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subjective preference for present consumption either because of their current preferences or because of inflationary pressures. 3.2 Future Value: Time Preference Rate and Required Rate of Return The time preference for money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk. It is called the riskfree rate. For example, if an individual’s time preference is 8%, it implies that he is willing to forego Rs. 100 today to receive Rs. 108 after a period of one year. Thus he considers Rs. 100 and Rs. 108 are equivalent in value. But in reality this is not the only factor he considers. There is an amount of risk involved in such investment. He therefore requires another rate for compensating him with this which is called the risk premium. Required rate of return=Risk free rate + Risk Premium There are two methods by which time value of money can be calculated – compounding and discounting. 3.2.1 Compounding Technique: Under this method of compounding, the future values of all cash inflows at the end of the time horizon at a particular rate of interest are found. Interest is compounded when the amount earned on an initial deposit becomes part of the principal at the end of the first compounding period. If Mr. A invests Rs. 1000 in a bank which offers him 5% interest compounded annually, he has Rs. 1050 in his account at the end of the first year. The total of the interest and principal Rs. 1050 constitutes the principal for the next year. He thus earns Rs. 1102.50 for the second year. This becomes the principal for the third year. This compounding procedure will continue for an indefinite number of years. The compounding of interest can be calculated by the following equation: A=P (1+i ) n Where A = Amount at the end of the period P = Principal at the end of the period i =rate of interest n = number of years The amount of money in the account at the end of various years is calculated as under, using the equation:
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Financial Management
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Amount at the end of year 1=Rs. 1000 (1+0.05)==Rs. 1050 Amount at the end of year 2=Rs. 1050 (1+0.05)==Rs. 1102.50 Amount at the end of year 3=Rs. 1102.50 (1+0.05)==Rs. 1157.63 Year Beginning amount Interest rate Amount of interest Beginning principal Ending principal
1 Rs. 1000
2
3
Rs. 1050 Rs. 1102.50
5%
5%
5%
50
52.50
55.13
1000
Rs. 1050 Rs. 1102.50
Rs. 1050 Rs. 1102.50 Rs. 1157.63
The amount at the end of year 2 can be ascertained by substituting Rs. 1000 (1+0.05) for R. 1050, that is, Rs. 1000(1+0.05) (1+0.05)= Rs. 1102.50. Similarly, the amount at the end of year 3 can be ascertained by substituting Rs. Rs. 1000(1+0.05) (1+0.05) (1+0.05) =Rs. 1157.63. Thus by substituting the actual figures for the investment or Rs. 1000 in the formula A=P (1+i ) n , we arrive at the result shown above in Table. 3.2.2 Discounting Technique: Under the method of discounting, we find the time value of money now, that is, at time 0 on the time line. It is concerned with determining the present value of a future amount. This is in contrast to the compounding approach where we convert present amounts into future amounts; in discounting approach we convert the future value to present sums. For example, if Mr. A requires to have Rs. 1050 at the end of year 1, given the rate of interest as 5%, he would like to know how much he should invest today to earn this amount. If P is the unknown amount and using the equation we get P (1+0.5)=1050. Solving the equation, we get P=Rs. 1050/1.05=Rs. 1000. Thus Rs. 1000 would be the required principal investment to have Rs. 1050 at the end of year 1 at 5% interest rate. In other words, the present value of Rs. 1050 received one year from now, rate of interest 5%, is Rs. 1000. The present value of money is the reciprocal of the compounding value. Mathematically, we have P=A {1/(1+i) n } in which P is the present value for the future sum to be received, A is the sum to be received in future, i is the interest rate and n is the number of years.
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Financial Management
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3.2.3 Future Value of a Single Flow (lump sum): The process of calculating future value will become very cumbersome if they have to be calculated over long maturity periods of 10 or 20 years. A generalized procedure for calculating the future value of a single cash flow compounded annually is as follows: FVn = PV(1+i) n Where FVn = Future value of the initial flow in n years hence PV = Initial cash flow I = Annual rate of interest N = Life of investment The expression (1+i) n represents the future value of the initial investment of Re. 1 at the end of n number of years at the interest rate i, referred to as the Future Value Interest Factor (FVIF). To help ease in calculations, the various combinations of “I” and “n” can be referred to in the table. To calculate the future value of any investment, the corresponding value of (1+i) n from the table is multiplied with the initial investment. Example: The fixed deposit scheme of a bank offers the following interest rates: Period of deposit
Rate per annum
coupon rate, then value of bond Zero = accept 2. NPV k, the firm’s earnings can be retained as the firm has better and profitable investment opportunities and the firm can earn more than what the shareholders could by reinvesting, if earnings are distributed. Firms which have r>k are called ‘growth firms’ and such firms should have a zero payout ratio. If return on investment r is less than cost of capital k, the firm should have a 100% payout ratio as the investors have better investment opportunities than the firm. Such a policy will maximize the firm value.
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Financial Management
Unit 15
If a firm has a ROI r equal to its cost of capital k, the firm’s dividend policy will have no impact on the firm’s value. The dividend payouts can range between zero and 100% and the firm value will remain constant in all cases. Such firms are called ‘normal firms’. Walter’s Model is based on certain assumptions: ·
Financing: All financing is done through retained earnings.Retained earnings is the only source of finance available and the firm does not use any external source of funds like debt or new equity.
·
Constant rate of return and cost of capital: The firm’s r and k remain constant and it follows that any additional investment made by the firm will not change the risk and return profile.
·
100% payout or retention: All earnings are either completely distributed or reinvested entirely immediately.
·
Constant EPS and DPS: The earnings and dividends do not change and are assumed to be constant forever.
·
Life: The firm has a perpetual life.
Walter’s formula to determine the market price is as follows: P =
D [ r ( E - D ) / Ke ] + Ke Ke
Where P is the market price per share, D is the dividend per share, Ke is the cost of capital, g is the growth rate of earnings, E is Earnings per share, r is IRR. Example: The following information relates to Alpha Ltd. Show the effect of the dividend policy on the market price of its shares using the Walter’s Model Equity capitalization rate Ke 11% Earnings per share
Rs. 10
ROI (r) may be assumed as follows: 15%, 11% and 8% Show the effect of the dividend policies on the share value of the firm for three different levels of r, taking the DP ratios as zero, 25%, 50%, 75% and 100%
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Solution Ke 11%, EPS 10, r 15%, DPS=0 P =
D [ r / Ke ( E - D )] + Ke Ke
Case I r>k (r=15%, K=11%)
a. DP = 0
0 + [ 0 . 15 / 0 . 11 ( 10 - 0 )] = 13.64/0.11 = Rs. 123.97 0 . 11
b. DP = 25%
2. 5 + [ 0 . 15 / 0 . 11 ( 10 - 2 . 5 )] = 12.73/0.11 = Rs. 115.73 0 . 11
c. DP = 50%
5 + [ 0 . 15 / 0 . 11 ( 10 - 5 )] = 11.82/0.11 = Rs. 107.44 0 . 11
d. DP = 75%
7. 5 + [ 0 . 15 / 0 . 11 ( 10 - 7 . 5 )] = 10.91/0.11 = Rs. 99.17 0 . 11
e. DP = 100%
10 + [ 0 . 15 / 0 . 11 ( 10 - 10 )] = 10/0.11 = Rs. 90.91 0 . 11
Case II r = k (r = 11%, K = 11%) a. DP = 0
0 + [ 0 . 11 / 0 . 11 ( 10 - 0 )] = 10/0.11 = Rs. 90.91 0 . 11
b. DP = 25%
2. 5 + [ 0 . 11 / 0 . 11 ( 10 - 2 . 5 )] = 10/0.11 = Rs. 90.91 0 . 11
c. DP = 50%
5 + [ 0 . 11 / 0 . 11 ( 10 - 5 )] = 10/0.11 = Rs. 90.91 0 . 11
d. DP = 75%
7. 5 + [ 0 . 11 / 0 . 11 ( 10 - 7 . 5 )] = 10/0.11 = Rs. 90.91 0 . 11
e. DP = 100%
10 + [ 0 . 11 / 0 . 11 ( 10 - 10 )] = 10/0.11 = Rs. 90.91 0 . 11
Case III rk, that is, in growth firms, the value of shares is inversely related to DP ratio, as the DP increases, market value of shares decline. Market value of share is highest when DP is zero and least when DP is 100%. 2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected whether the firm retains the profits or distributes them. 3. In the third situation, when rbr
·
Gordon’s model assumes investors are rational and riskaverse. They prefer certain returns to uncertain returns and therefore give a premium to the constant returns and discount uncertain returns. The shareholders therefore prefer current dividends to avoid risk. In other words, they discount future dividends. Retained earnings are evaluated by the shareholders as risky and therefore the market price of the shares would be adversely affected. Gordon explains his theory with preference for current income. Investors prefer to pay higher price for stocks which fetch them current dividend income. Gordon’s model can be symbolically expressed as: P=
E ( 1 - b ) Ke - br
Where P is the price of the share, E is Earnings Per Share, b is Retention raio, (1 – b) is dividend payout ratio, Ke is cost of equity capital, br is growth rate in the rate of return on investment. Example: Given Ke as 11%, E is Rs. 10, calculate the stock value of Mahindra Tech. for (a) r=12%, (b) r=11% and (c) r=10% for various levels of DP ratios given under: DP ratio (1 – b) Retention ratio A
10%
90%
B
20%
80%
C
30%
70%
D
40%
60%
E
50%
50%
Solution Case I r>k ( r=12%, K=11%) P = E(1—b) Ke—br
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Financial Management
Unit 15
a. DP 10%, b 90% 10(1—0.9)
equals 1/.002 = Rs. 500
0.11(0.9*0.12) b. DP 20%, b 80% 10(1—0.8)
equals 2/.014 = Rs. 142.86
0.11(0.8*0.12) c. DP 30%, b 70% 10(1—0.7)
equals 3/.026 = Rs. 115.38
0.11(0.7*0.12) d. DP 40%, b 60% 10(1—0.6)
equals 4/.038 = Rs. 105.26
0.11(0.6*0.12) e. DP 50%, b 50% 10(1—0.5)
equals 5/.05 = Rs. 100
0.11(0.5*0.12) Case II r=k ( r=11%, K=11%) P = E(1—b) Ke—br a. DP 10%, b 90% 10(1—0.9)
equals 1/.011 = Rs. 90.91
0.11(0.9*0.11) b. DP 20%, b 80% 10(1—0.8)
equals 2/.022 = Rs. 90.91
0.11(0.8*0.11) c. DP 30%, b 70% 10(1—0.7)
equals 3/.033 = Rs. 90.91
0.11(0.7*0.11) d. DP 40%, b 60% 10(1—0.6)
equals 4/.044 = Rs. 90.91
0.11(0.6*0.11)
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Financial Management
Unit 15
e. DP 50%, b 50% 10(1—0.5)
equals 5/.55 = Rs. 90.91
0.11(0.5*0.11) Case III rk, the firm’s value decreases with an increase in payout ratio. Market value of share is highest when DP is least and retention highest. 2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected whether the firm retains the profits or distributes them. 3. When r
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