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FinancialManagement Unit1
1
Unit1 FinancialManagement
Structure
1.1 Introduction
1.2 MeaningAndDefinitions
1.3 GoalsOfFinancialManagement
1.3.1 ProfitMaximization
1.3.2 WealthMaximization
1.4FinanceFunctions
1.4.1 InvestmentDecisions:
1.4.2 FinancingDecisions:
1.4.3 DividendDecisions
1.4.4 LiquidityDecision
1.5OrganizationOfFinanceFunction
1.5.1 InterfaceBetweenFinanceAndOtherBusinessFunctions
1.5.2 FinanceAndAccounting
1.5.3 FinanceAndMarketing
1.5.4 FinanceAndProduction(Operations)
1.5.5 FinanceAndHR
1.6 Summary
TerminalQuestions
AnswerstoSAQsandTQs
1.1 Introduction
Toestablishanybusiness,apersonmustfindanswerstothefollowingquestions:
a) Capital investments are required tobemade.Capital investments aremade to acquire the
realassets,requiredforestablishingandrunningthebusinesssmoothly.Realassetsareland
andbuildings,plantandequipmentsetc.
b) Decisiontobetakenonthesourcesfromwhichthefundsrequiredforthecapitalinvestments
mentionedabovecouldbeobtained,tobetaken.
c) Therefore, thereare twosourcesoffundsviz.debtandequity. Inwhatproportionthefunds
aretobeobtainedfromthesesourcesistobedecidedforformulatingthefinancingplan.
suryaStamp
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d) Decisionontheroutineaspectsofdaytodaymanagementofcollectingmoneyduefromthe
firmscustomersandmakingpaymentstothesuppliersofvariousresourcestothefirm.
Thesearethecoreelementsoffinancialmanagementofafirm.
FinancialManagementofafirmisconcernedwithprocurementandeffectiveutilizationoffunds
for thebenefitof its stakeholders. Themostadmired Indian companiesareReliance, Infosys.
Theyhavebeenratedwellbythefinancialanalystonmanycrucialaspectsthatenabledthemto
createvalue for itsshareholders. Theyemploy thebest technology,producequalitygoodsor
renderservicesattheleastcostandcontinuouslycontributetotheshareholderswealth.
Allcorporatedecisionshavefinancialimplications.Therefore,financialmanagementembracesall
thosemanagerialactivitiesthatarerequiredtoprocurefundsattheleastcostandtheireffective
deployment.Financeisthelifebloodofallorganizations.Itoccupiesapivotalroleincorporate
management. Any business which ignores the role of finance in its functioning cannot grow
competitively in todays complex business world. Value maximization is the cardinal rule of
efficientfinancialmanagerstoday.
LearningObjectives:
Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.
1. ThemeaningofBusinessFinance.
2. TheobjectivesofFinancialManagement.
3. Thevarious interfacesbetweenfinanceandothermanagerial functions ofafirm.
1.2MeaningAndDefinitions
The branch of knowledge that deals with the art and science of managing money is called
financialmanagement. With liberalization and globalization of Indian economy, regulatory and
economicenvironmentshaveundergonedrasticchanges.ThishaschangedtheprofileofIndian
financemanagerstoday.Indianfinancialmanagershavetransformedthemselvesfromlicensed
raj managers to well informed dynamic proactive managers capable of taking decisions of
complexnatureinthepresentglobalscenario.
Traditionally, financial management was considered a branch of knowledge with focus on the
procurementoffunds.Instrumentsoffinancing,formation,merger&restructuringoffirms,legal
andinstitutionalframeworkinvolvedthereinoccupiedtheprimeplaceinthistraditionalapproach.
suryaTypewritten Text 2008-2012 GreeneStep Technologies. All rights reserved. All trademarks are property of respective owners.
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Themodernapproachtransformedthefieldofstudyfromthetraditionalnarrowapproachto the
mostanalyticalnature.Thecoreofmodernapproachevolvedaround,procurementoftheleast
costfundsanditseffectiveutilizationformaximizationofshareholderswealth.Globalizationof
business and impact of information technology on financial management have added new
dimensionstothescopeoffinancialmanagement.
SelfAssessmentQuestion1
1. FinancialManagementdealswithprocurementoffundsattheleastcostand______funds.
1.3GoalsOfFinancialManagement
Goalsmean financialobjectiveofafirm. Experts in financialmanagement haveendorsed the
viewthatthegoalofFinancialManagementofafirmismaximizationofeconomicwelfareofits
shareholders. Maximization of economic welfare means maximization of wealth of its
shareholders. Shareholders wealthmaximization is reflected in themarket value of the firms
shares.Afirmscontributiontothesociety ismaximizedwhenitmaximizes itsvalue.Thereare
twoversionsofthegoalsoffinancialmanagementofthefirm:
1.3.1 ProfitMaximization:
Inacompetitiveeconomy,profitmaximizationhasbeenconsideredasthelegitimateobjectiveof
a firm because profit maximization is based on the cardinal rule of efficiency. Under perfect
competition allocationof resourcesshall bebasedon thegoalof profitmaximization. A firms
performance is evaluated in terms of profitability. Investors perception of companys
performancecanbetracedtothegoalofprofitmaximization.But,thegoalofprofitmaximization
hasbeencriticizedonmanyaccounts:
1. Theconceptofprofitlacksclarity.Whatdoestheprofitmean?
a) Isitprofitaftertaxorbeforetax?
b) Isitoperatingprofitornetprofitavailabletoshareholders?
Differences in interpretationon the concept of profit expose theweaknessof the goalof profit
maximization
2. Profitmaximization ignores time value ofmoneybecause it does not differentiate between
profitsofcurrentyearwiththeprofittobeearnedinlateryears.
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3. Theconceptofprofitmaximizationfails toconsiderthefluctuationintheprofitsearnedfrom
yeartoyear.Fluctuationsmaybeattributabletothebusiness riskofthefirmbuttheconcept
failstothrowlightonthisaspect.
4. Profitmaximizationdoesnotmakeclear theconceptofprofitas towhether itisaccounting
profitoreconomicnormalprofitoreconomicsupernormalprofits.
5.Becauseofthesedeficiencies,profitmaximizationfailstomeetthestandardsstipulatedinan
operationallyfeasiblecriterionformaximizingshareholderswealth.
1.3.2 WealthMaximization
WealthMaximization has, beenacceptedby the financemanagers, because it overcomes the
limitationsofprofitmaximisation. Wealthmaximisationmeansmaximizingthenetwealthofthe
Companys share holders. Wealth maximisation is possible only when the company pursues
policiesthatwouldincreasethemarketvalueofsharesofthecompany.
Following arguments are in support of the superiority of wealth maximisation over profit
maximisation:
1. Wealthmaximisationisbasedontheconceptofcashflows.Cashflowsarearealityandnot
based on any subjective interpretation. On the other hand there are many subjective
elementsintheconceptofprofitmaximisation.
2. It considers timevalue ofmoney. Time value ofmoneytranslatescash flowsoccurringat
differentperiodsintoacomparablevalueatzeroperiod.In thisprocess,thequalityofcash
flowsisconsideredcriticallyinalldecisionsasitincorporatestheriskassociatedwiththecash
flowstream.Itfinallycrystallizesintotherateofreturnthatwillmotivateinvestorstopartwith
theirhardearnedsavings.Itiscalledrequiredrateofreturnorhurdleratewhichisemployed
in evaluating all capital projects undertaken by the firm. Maximizing the wealth of
shareholdersmeanspositive net presentvalueof the decisions implemented. Positive net
presentvaluecanbedefinedastheexcessofpresentvalueofcashinflowsofanydecision
implemented over the present value of cash out flows associated with the process of
implementationofthedecisionstaken.Tocomputenetpresentvalueweemploytimevalue
factor. Timevaluefactorisknownastimepreferenceratei.e. thesumofriskfreerateand
riskpremium.Riskfreerateistheratethataninvestorcanearnonanygovernmentsecurity
forthedurationunderconsideration.Riskpremiumistheconsiderationfortheriskperceived
bytheinvestorininvestinginthatassetorsecurity.
XLtd isa listedcompanyengaged in thebusinessofFMCG(FastMovingConsumergoods).
Listedmeansthecompanyssharesareallowedtobetradedofficiallyontheportalsofthestock
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exchange.TheBoardofDirectorsofXLtdtookadecisioninoneofitsBoardmeeting,toenter
into thebusinessof power generation.When the company informs the stockexchangeat the
conclusionof themeetingof the decision taken, thestockmarket reactsunfavourably with the
resultthatthenextdaysclosingofquotationwas30%lessthanthatofthepreviousday.
Thequestionnow is,whythemarket reacted in thismanner. Investors in thisFMCGCompany
mighthavethought that theriskprofileof thenewbusiness(power) that thecompanywantsto
takeupishighercomparedtotheriskprofileoftheexistingFMCGbusinessoftheXLtd.When
theywantahigherreturn,marketvalueofcompanyssharedeclines.Thereforetheriskprofileof
the company gets translated into a timevalue factor. The time value factor so translated
becomestherequiredrateofreturn. Requiredrateofreturnisthereturnthattheinvestorswant
formakinginvestmentinthatsector.
Anyprojectwhichgeneratespositivenetpresentvaluecreateswealthtothecompany.Whena
companycreateswealthfromacourseofactionithasinitiatedtheshareholdersbenefitbecause
suchacourseofactionwillincreasethemarketvalueofthecompanysshares.
SuperiorityofWealthMaximisationoverProfitMaximisation
1. Itisbasedoncashflow,notbasedonaccountingprofit.
2. Through the processof discounting it takes care of the quality of cash flows. Distant cash
flowsareuncertain.Convertingdistantuncertaincashflowsintocomparablevaluesatbase
periodfacilitatesbettercomparisonofprojects. Therearevariouswaysofdealingwith risk
associatedwithcashflows. Theserisksareadequatelyconsideredwhenpresentvaluesof
cashflowsaretakentoarriveatthenetpresentvalueofanyproject.
3. In todays competitive business scenario corporates play a key role. In company form of
organization,shareholdersownthecompanybutthemanagementofthecompanyrestswith
the board of directors. Directors are elected by shareholders and hence agents of the
shareholders. Companymanagementprocuresfundsforexpansionanddiversificationfrom
CapitalMarkets. In the liberalized set up, the society expectscorporatesto tap the capital
markets effectively for their capital requirements. Therefore to keep the investors happy
throughtheperformanceofvalueofsharesinthemarket,managementofthecompanymust
meetthewealthmaximisationcriterion.
4. Whena firm follows wealthmaximisationgoal, itachievesmaximizationofmarket valueof
share.Whenafirmpracticeswealthmaximisationgoal,itispossibleonlywhenitproduces
qualitygoodsatlowcost.Onthisaccountsocietygainsbecauseofthesocietalwelfare.
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5. Maximizationofwealthdemandsonthepartofcorporatestodevelopnewproductsorrender
newservicesinthemosteffectiveandefficientmanner.Thishelpstheconsumersas itwill
bringtothemarkettheproductsandservicesthatconsumersneed.
6. Another notable features of the firms committed to the maximisation of wealth is that to
achievethisgoaltheyareforcedtorenderefficientservicetotheircustomerswithcourtesy.
Thisenhancesconsumerwelfareandhencethebenefittothesociety.
7. Fromthepointofevaluationofperformanceoflistedfirms, themostremarkablemeasureis
that of performance of the company in the sharemarket. Every corporateaction finds its
reflection on themarket valueof shares of the company. Therefore, shareholders wealth
maximizationcouldbeconsideredasuperiorgoalcomparedtoprofitmaximisation.
8. Sincelistingensures liquidity tothesharesheldbythe investors,shareholderscanreapthe
benefits arising from the performance of company only when they sell their shares.
Therefore,itisclearthatmaximizationofmarketvalueofshareswillleadtomaximisationof
thenetwealthofshareholders.
Therefore,wecanconcludethatmaximizationofwealthistheappropriateofgoaloffinancial
managementintodayscontext.
SelfAssessmentQuestions2
1.Underperfectcompetition,allocationofresourcesshallbebasedonthegoalof_______.
2._____________isbasedoncashflows.
3.__________________considertimevalueofmoney.
1.4 FinanceFunctions
Financefunctionsarecloselyrelatedtofinancialdecisions.Thefunctionsperformedbyafinance
manager are known as finance functions. In the course of performing these functions finance
managertakesthefollowingdecisions:
1.Financingdecision 2.InvestmentDecision 3.Dividenddecision 4.Liquiditydecision.
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1.4.1 InvestmentDecisions:
To survive and grow, all organizations must be innovative. Innovation demands managerial
proactiveactions.Proactiveorganization continuouslysearchforinnovativewaysofperforming
the activities of the organization. Innovation iswider in nature. It couldbe expansion through
entering into new markets, adding new products to its product mix, performing value added
activitiestoenhancethecustomersatisfaction,oradoptingnewtechnologythatwoulddrastically
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.Thesedecisionsarestrategicbecause,theyareriskybutifexecutedsuccessfully
withaclearplanofaction,theygeneratesupernormalgrowthtotheorganization.
If themanagementerrsinanyphaseoftakingthesedecisionsandexecutingthem,thefirmmay
becomebankrupt. Therefore,suchdecisionswillhavetobe takenafter taking intoaccountall
factsaffectingthedecisionsandtheirexecution.
Twocriticalissuestobeconsideredinthesedecisionsare:
1. Evaluationofexpectedprofitabilityofthenewinvestments.
2. Rateofreturnrequiredontheproject.
The rate of return required by investor is normally known by hurdle rate or cutoff rate or
opportunitycostofcapital.
Afterafirmtakesadecisiontoenterintoanybusinessorexpanditsexistingbusiness,plansto
investinbuildings,machineriesetc.areconceivedandexecuted.Theprocessinvolvediscalled
CapitalBudgeting.CapitalBudgetingdecisionsdemandconsiderabletime,attentionandenergy
of themanagement.Theyarestrategicinnatureasthesuccessorfailureofanorganization is
directlyattributabletotheexecutionofcapitalbudgetingdecisionstaken.
Investment decisions are also known as Capital Budgeting Decisions. Capital Budgeting
decisionsleadtoinvestmentinrealassets
Dividendsarepayoutstoshareholders.Dividendsarepaidtokeeptheshareholdershappy.
Dividendpolicyformulationrequiresthedecisionofthemanagementastohowmuchofthe
profitsearnedwillbepaidasdividend.Agrowingfirmmayretainalargeportionofprofitsas
retainedearningstomeetitsneedsoffinancingcapitalprojects.Here,thefinancemanagerhas
tostrikeabalancebetweentheexpectationofshareholdersondividendpaymentandtheneedto
provideforfundsoutoftheprofitstomeettheorganizationsgrowth.
s
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1.4.2 FinancingDecisions:
Financing decisions relate to the acquisition of funds at the least cost. Here cost has two
dimensionsvizexplicitcostandimplicitcost.
Explicitcostreferstothecostintheformofcouponrate,costoffloatingandissuingthesecurities
etc.
Implicitcostisnotavisiblecostbutitmayseriouslyaffect thecompanysoperationsespecially
when itisexposedtobusinessandfinancialrisk.Forexample,implicitcostisthefailureofthe
organizationtopaytoitslendersordebentureholdersloaninstallmentsonduedateonaccount
of fluctuations in cash flow attributable to the firms business risk. In India if the company is
unabletopay itsdebts,creditorsof thecompanymayuse legalmeanstosuethecompanyfor
windingup.Thisriskisnormallyknownasriskofinsolvency.Acompanywhichemploysdebtas
ameansoffinancingnormallyfacesthisriskespeciallywhenitsoperationsareexposedtohigh
degreeofbusinessrisk.
In all financing decisions a firm has to determine the proportion of equity and debt. The
compositionofdebtandequityiscalledthecapitalstructureofthefirm.
Debtischeapbecause interestpayableon loan isallowedasdeductions incomputingtaxable
income on which the company is liable to pay income tax to the Government of India. For
example,if the interestrateon loantaken is12%, taxrateapplicableto thecompanyis50%,
thenwhenthecompanypaysRs.12asinteresttothelender,taxableincomeofthecompanywill
bereducedbyRs.12.
Inotherwordswhenactualcostis12%withthetaxrateof50%theeffectivecostbecomes6%
therefore, debt is cheap. But, every installment of debt brings along with it corresponding
insolvencyrisk.
Anotherthingnotableinthisconnectionisthatthefirmcannotavoiditsobligationtopayinterest
andloaninstallmentstoitslendersanddebentures.
Ontheotherhand,acompanydoesnothaveanyobligationtopaydividendtoitsshareholders.
A company enjoys absolute freedom not to declare dividend even if its profitability and cash
positionsarecomfortable. However,shareholdersareoneofthestakeholdersof thecompany.
Theyareinrealitytheownersofthecompany.Thereforewellmanagedcompaniescannotignore
the claim of shareholders for dividend. Dividend yield is an important determinant for stock
prices.Dividendyieldreferstodividendpaidwithreferencetothemarketpriceofthesharesof
thecompany.Aninvestorincompanysshareshastwoobjectivesforinvesting:
1. IncomefromCapitalappreciation(i.e.Capitalgainsonsaleofsharesatmarketprice)
2. Incomefromdividends.
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Itistheabilityofthecompanytogiveboththeseincomestoitsshareholdersthatdeterminesthe
marketpriceofthecompanysshares.
The most important goal of financial management is maximisation of net wealth of the
shareholders. Therefore,management of everycompany should strive hard to ensure that its
shareholdersenjoybothdividendincomeandcapitalgainsaspertheexpectationofthemarket.
But,dividendisdeclaredoutoftheprofitearnedbythecompanyafterpayingincometaxtothe
GovtofIndia.
Forexample,letusassumethefollowingfacts:
Dividend=12%onpaidupvalue
Taxrateapplicabletothecompany=30%
Dividendtax=10%
When a Company pays Rs.12 on paid up Capital of Rs.100 as dividend, the profit that the
companymustearnbeforetaxis:
Since payment of dividend by an Indian Company attracts dividend tax, the companywhen it
paysRs.12toshareholders,mustpaytotheGovtofIndia
10%ofRs.12=Rs.1.2asdividendtax.Thereforedividendanddividendtaxsumupto12+1.2
=Rs.13.2
Sincethisispaidoutoftheposttaxprofit,inthis question,thecompanymustearn:
Posttaxdividendpaid
1Taxrateapplicabletothecompany=pretaxprofitrequiredtodeclareandpaythedividend
13.2 13.2
10.3 0.7
Therefore, todeclareadividendof12%Companyhastoearnapretaxprofitof19%.Onthe
other hand, to payan interest of 12% Company has to earn only 8.4%. This leads to the
conclusionthatforeveryRs.100procuredthroughdebt,itcosts8.4%whereasthesameamount
procuredintheformofequity(sharecapital)costs
19%. This confirms the established theory that equity is costly but debt is a cheap but risky
sourceoffundstothecorporates.
The challenge before the financemanager is toarriveat acombinationof debt and equity for
financingdecisionswhichwouldattainanoptimalstructureofcapital.Anoptimalstructureisone
thatarrivesattheleastcoststructure,keepinginmindthefinancialriskinvolvedandtheabilityof
thecompanytomanagethebusinessrisk.Besides,financingdecisioninvolvestheconsideration
ofmanagerialcontrol,flexibilityandlegalaspects.Assuchitinvolves quitealotofregulatoryand
managerialelementsinfinancingdecisions.
== = Rs19approximate
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1.4.3 DividendDecisions
Dividendyieldisanimportantdeterminantofaninvestorsattitudetowardsthesecurity(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
formulationofdividendpolicy.Sincethegoaloffinancialmanagementismaximisationofwealth
ofshareholders,dividendpolicyformulationdemandsthemanagerialattentionontheimpactof
its policy on dividend on the market value of the shares. Optimum dividend policy requires
decisionondividendpaymentratessoastomaximizethemarketvalueofshares. Thepayout
ratiomeanswhatportionofearningspershare isgiventotheshareholdersintheformofcash
dividend. In the formulationof dividendpolicy,management of a companymust consider the
relevanceofitspolicyonbonusshares.
Dividendpolicy influencesthedividendyieldonshares. SincecompanysratingsintheCapital
market have amajor impact on its ability to procure fundsby issuing securities in the capital
markets,dividendpolicy,adeterminantofdividendyieldhastobeformulatedhavingregardtoall
the crucial elements in building up the corporate image. The following need adequate
considerationindecidingondividendpolicy:
1. PreferencesofshareholdersDotheywantcashdividendorCapitalgains?
2. Currentfinancialrequirementsofthecompany
3. Legalconstraintsonpayingdividends.
4. Striking an optimum balance between desires of share holders and the companys funds
requirements.
1.4.4 LiquidityDecision
LiquiditydecisionsareconcernedwithWorkingCapitalManagement. It isconcernedwith the
daytodayfinancialoperationsthatinvolvecurrentassetsandcurrentliabilities.
Theimportantelementofliquiditydecisionsare:
1) Formulationofinventorypolicy
2) Policiesonreceivablemanagement.
3) Formulationofcashmanagementstrategies
4) Policiesonutilizationofspontaneousfinanceeffectively.
1.4.5 OrganizationOfFinanceFunction
Financialdecisionsarestrategicincharacterandtherefore,anefficientorganizationalstructure
isrequiredtoadministerthesame.Financeislikebloodthatflowsthroughouttheorganization.
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InallorganizationsCFOsplayanimportantroleinensuringproperreportingbasedon
substancetothestakeholdersofthecompany.Becauseofthecrucialrolethesefunctionsplay,
financefunctionsareorganizeddirectlyunderthecontrolofBoardofDirectors.Forthesurvival
ofthefirm,thereisaneedtoensurebothlongtermandshorttermfinancialsolvency. Failureto
achievethiswillhaveitsimpactonallotheractivitiesofthefirm.
Weakfunctionalperformancebyfinancialdepartmentwillweakenproduction,marketingandHR
activitiesofthecompany.Theresultwouldbetheorganizationbecominganemic.Once
anemic,unlesscrucialandeffectiveremedialmeasuresaretakenupitwillpavewayfor
corporatebankruptcy.
CFOreportstotheBoardofDirectors. UnderCFO,normallytwoseniorofficersmanagethe
treasurerandcontrollerfunctions.
ATreasurerperformsthefollowingfunction:
1. Obtainingfinance.
2. Liasoningwithtermlendingandotherfinancialinstitutions.
3. Managingworkingcapital.
4. Managinginvestmentinrealassets.
AControllerperforms:
1. AccountingandAuditing
2. Managementcontrolsystems
3. Taxationandinsurance
4. Budgetingandperformanceevaluation
5. Maintaining assets intact to ensurehigher productivity of operating capital employed in the
organization.
In India CFOs have a legal obligation under various regulatory provisions to certify the
correctnessofvariousfinancialstatementsinformationreportedtothestakeholdersintheannual
reports. Listing norms, regulationson corporate governanceand other notificationsofGovtof
IndiahaveadequatelyrecognizedtheroleoffinancefunctioninthecorporatesetupinIndia.
SelfAssessmentQuestions3
1.____________leadtoinvestmentinrealassets.
2._______________relatetotheacquisitionoffundsattheleastcost.
3.Formulationofinventorypolicyisanimportantelementof___________.
4.Obtainingfinanceisanimportantfunctionof_________.
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1.5 InterfaceBetweenFinanceAndOtherBusinessFunctions
1.5.1 FinanceAndAccounting
Lookingatthehierarchyofthefinancefunctionofanorganization,thecontrollerreportstoCFO.
Accountingisoneofthefunctionsthatacontrollerdischarges.Accountingandfinanceareclosely
related. ForcomputationofReturnon Investment,earningspershareandofvarious ratiosfor
financial analysis the data base will be accounting information. Without a proper accounting
system, an organization cannot administer effectively function of financial management. The
purposeofaccountingistoreportthefinancialperformanceofthebusinessfortheperiodunder
consideration. It is historical in character. But financial management uses the historical
accounting information for decisionmaking. All the financial decisions are futuristic based on
cash flow analysis. All the financial decisions consider quality of cash flows as an important
elementofdecisions.Sincefinancialdecisionsarefuturistic,itistakenandputintoeffectunder
conditionsofuncertainty.
Assumingthedegreeofuncertaintyandincorporatingtheireffectondecisionmakinginvolveuse
ofvariousstatisticalmodels.Intheselectionofthesemodels,elementofsubjectivitycreepsin.
1.5.2 FinanceAndMarketing
Manymarketing decisions have financial implications. Selections of channels of distribution,
decidingonadvertisementpolicy,remuneratingthesalesmenetchavefinancialimplications.In
fact,therecentbehaviourofrupeeagainstus$(appreciationofrupeeagainstUSdollar),affected
thecashflowpositionsofexportorientedtextileunitsandBPOsandothersoftwarecompanies.
Itisgenerallybelievedthatthecurrencyinwhichmarketingmanagerinvoicestheexportsdecides
thecashflowconsequencesoftheorganizationifthecompanyismainlydependentonexports.
Marketing cost analysis, a function of finance managers is thebest example of application of
principlesoffinanceontheperformanceofmarketingfunctionsbyabusinessunit. Formulation
ofpolicyoncreditmanagementcannotbedoneunlesstheintegrationofmarketingwithfinanceis
achieved.Decidingoncredittermstoachieveaparticularlevelofsaleshasfinancialimplication
becausesanctioningliberalcreditmayresultinhugebaddebt,ontheotherhandaconservative
credittermsmaydepressthesales.Credittermsalsoaffecttheinvestmentinreceivable,anarea
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
customersatisfactionandgoodwill.Butinvestmentininventoryrequiresthefinancialclearance
becausefundsarelockedinandthefundssoblockedhaveopportunitycostofcapital.
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1.5.3FinanceAndProductions(Operations)
Financeandoperationsmanagementarecloselyrelated.Decisionsonplantlayout,technology
selection,productions / operations,processplant size, removing imbalance inthe flowof input
material in the production / operation process and batch size are all operations management
decisionsbuttheirformulationandexecutioncannotbedoneunlessevaluatedfromthefinancial
angle. The capital budgeting decisions are closely related to production and operations
management.Thesedecisionsmakeormarabusinessunit.Wehaveexamplestosubstantiate
this. Failure to understand the implications of the latest technological trend on capacity
expansionshascostevenbluechipcompanies.ManytextileunitsinIndiabecamesickbecause
they did not provide sufficient finance for modernization of plant and machinery. Inventory
management is crucial to successful operation management. But management of inventory
involvesquitealotoffinancialvariables.
1.5.4 FinanceAndHR
Attractingandretainingthebestmanpowerintheindustrycannotbedoneunlesstheyarepaid
salaryatcompetitiverates. Ifanorganizationformulates&implementsapolicyforattractingthe
competent man power it has to pay the most competitive salary packages to them. But it
improvesorganizationalcapitalandproductivity.Infosysdoesnothavephysicalassetssimilarto
thatofIndianRailways.Butifbothweretocometocapitalmarketwithapublicissueofequity,
InfosyswouldcommandbetterinvestorsacceptancethantheIndianRailways.Thisisbecause
thevalueofhumanresourcesplaysanimportantroleinvaluingafirm.Thebetterthequalityof
manpower inanorganization, thehigher thevalueof thehumancapitalandconsequently the
highertheproductivityoftheorganization.
IndianSoftwareandITenabledserviceshavebeengloballyacclaimedonlybecauseoftheman
powertheypossess.Butithasacostfactori.e.thebestremunerationtothestaff.
1.6Summary
Financial Management is concerned with the procurement of the least cost funds and its
effectiveutilizationformaximizationof thenetwealthof thefirm.Thereexistsacloserelation
betweenthemaximizationofnetwealthofshareholdersandthemaximizationofthenetwealth
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
betweentheinvestorsexpectationandtheorganizationsgrowth.
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TerminalQuestions
1. Whataretheobjectivesoffinancialmanagement?
2. Howdoesafinancemanagerarriveatanoptimalcapitalstructure?
3. Examinetherelationshipoffinancialmanagementwithotherfunctionalareasofafirm.
AnswersToSelfAssessmentQuestionss
SelfAssessmentQuestions1:
1. Effectiveutilization
SelfAssessmentQuestions2
1. Profitmaximisation.
2. Wealth maximisation
3. Wealthmaximisation
SelfAssessmentQuestions3
1. Investmentdecisions.
2. Financingdecisions
3. Liquidity
4. Treasures
AnswerforTerminalQuestions
1. Refer1.3
2. Refer1.4.1
3. Refer1.5
FinancialManagement Unit2
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Unit2FinancialPlanning
Structure
2.1. Introduction
2.2. Stepsinfinancialplanning
2.3. Factorsaffectingfinancialplan
2.4. Estimationoffinancialrequirementsofafirm.
2.5. Capitalizations
2.1.1 CostTheory
2.1.2 Earningstheory:
2.1.3 Overcapitalization
2.1.4 Undercapitalization
2.6 Summary
TerminalQuestions
AnswertoSAQsandTQs
2.1 Introduction
LiberalizationandglobalizationpoliciesinitiatedbytheGovernmenthavechangedthedimension
of businessenvironment. It has changed thedimension of competitionthat a firm faces today.
Thereforeforsurvivalandgrowthafirmhastoexecuteplannedstrategysystematically.
Toexecuteanystrategicplan,resourcesarerequired.Resourcesmaybemanpower,plantand
machinery,building,technologyoranyintangibleasset.
To acquire all these assets financial resources are essentially required. Therefore, finance
managerofacompanymusthavebothlongrangeandshortrangefinancialplans.Integrationof
boththeseplansisrequiredfortheeffectiveutilizationofalltheresourcesofthefirm.
Thelongrangeplanmustconsider(1)Fundsrequiredtoexecutetheplannedcourseofaction.
(2)Fundsavailableat thedisposalof thecompany. (3)Determinationof funds tobeprocured
fromoutsidesources.
FinancialManagement Unit2
16
LearningObjectives:
Afterstudyingthisunityoushould
1. Explainthestepsinvolvedinfinancialplanning.
2. Explainthefactorsaffectingthefinancialplanning.
3. Listoutthecausesofovercapitation
4. Explaintheeffectsofundercapitation.
ObjectivesofFinancialPlanning
FinancialPlanningisaprocessbywhichfundsrequiredforeachcourseofactionisdecided.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
connectiondecisionsonthecompositionofdebtandequitymustbetaken.
Financialplanninggeneratesfinancialplan.Financialplanindicates:
1. Thequantumoffundsrequiredtoexecutebusinessplans.
2. Compositionofdebtandequity,keepinginviewtheriskprofileoftheexistingbusiness,new
businesstobetakenupandthedynamicsofcapitalmarketconditions.
3. Formulationofpoliciesforgivingeffecttothefinancialplansunderconsideration.
Afinancialplanisatthecoreofvaluecreationprocess. Asuccessfulvaluecreationprocesscan
effectivelymeetthebenchmarksofinvestorsexpectations.
Benefitsthataccruetoafirmoutofthefinancialplanning
1. Effectiveutilizationoffunds:Shortageismanagedbyaplanthatensuresflowofcashatthe
leastcost. Surplus isdeployed throughwellplannedtreasurymanagement. Ultimately the
productivityofassetsisenhanced.
2. Flexibilityincapitalstructureisgivenadequateconsideration.Hereflexibilitymeansthefirms
ability tochange the compositionof funds thatconstitute itscapitalstructure in accordance
withthechangingconditionsofcapitalmarket.Flexibilityreferstotheabilityofafirmtoobtain
funds at the right time, in the right quantity and at the least cost as per requirements to
financeemergingopportunities.
3. Formulationof policiesand institutingprocedures foreliminationof all typesofwastages in
theprocessofexecutionofstrategicplans.
4. Maintainingtheoperatingcapabilityofthefirmthroughtheevolutionofscientificreplacement
schemesforplantandmachineryandotherfixedassets.Thiswillhelpthefirminreducingits
FinancialManagement Unit2
17
operatingcapital.Operatingcapitalreferstotheratioofcapitalemployedtosalesgenerated.
A perusal of annual reports of Dell computers will throw light on how Dell strategically
minimized theoperatingcapital required tosupportsales. Suchcompaniesareadmiredby
investingcommunity.
5. Integrationoflongrangeplanswiththeshortageplans.
Guidelinesforfinancialplanning
1. Neverignorethecoordinalprinciplethatfixedassetrequirementsbemetfromthelongterm
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.Dueattentiontobegiventophysicalcapitalmaintenanceoroperatingcapability.
4. Neverignoretheneedforfinancialcapitalmaintenanceinunitsofconstantpurchasingpower.
5. Employcurrentcostprinciplewhereverrequired.
6. Givedueweightagetocostandriskinusingdebtandequity.
7. Keeping the need for finance for expansion of business, formulate plough back policy of
earnings.
8. Exercisethoroughcontroloveroverheads.
9. Seasonalpeakrequirementstobemetfromshorttermborrowingsfrombanks.
2.2 StepsInFinancialPlanning
1. EstablishCorporateObjectives: Corporateobjectivescouldbegroupedintoqualitativeand
quantitative. Forexample,acompanysmissionstatementmayspecify createeconomic
valueadded.Butthisqualitativestatementhastobestatedinquantitativetermssuchasa
25%ROEora12%earningsgrowthrates.Sincebusinessenterprisesoperateinadynamic
environment,thereisaneedtoformulatebothshortrunandlongrunobjectives.
2. Next stage is formulation of strategies for attaining the objectives set. In this connection
corporatesdevelopoperatingplans.Operatingplansareframedwithatimehorizon.Itcould
beafiveyearplanoratenyearplan.
3. Once the plans are formulated, responsibility for achieving sales target, operating targets,
costmanagementbenchmarks,profittargetsetcisfixedonrespectiveexecutives.
4. Forecastthevariousfinancialvariablessuchassales,assetsrequired,flowoffunds,costto
be incurredand then translate thesame into financialstatements. Suchforecastshelpthe
FinancialManagement Unit2
18
finance manager to monitor the deviations of actual from the forecasts and take effective
remedialmeasurestoensurethattargetssetareachievedwithoutanytimeoverrunandcost
overrun.
5. Develop a detailed plan for funds required for the plan period under various heads of
expenditure.
6. Fromthefundsrequiredplan,developaforecastoffundsthatcanbeobtainedfrominternal
aswellas external sourcesduring the timehorizon forwhichplansaredeveloped. In this
connectionlegalconstrainsinobtainingfundsonthebasisofcovenantsofborrowingsshould
begivendueweightage.Thereisalsoaneedtocollaboratethefirmsbusinessriskwithrisk
implicationsofaparticularsourceoffunds.
7. Developacontrolmechanismforallocationoffundsandtheireffectiveuse.
8. Atthetimeofformulatingtheplanscertainassumptionsneedtobemadeabouttheeconomic
environment. But when plans are implemented economic environment may change. To
manage such situations, there is a need to incorporate an inbuiltmechanismwhichwould
scaleuporscaledowntheoperationsaccordingly.
ForecastofIncomeStatementandBalanceSheet
Therearethreemethodsofpreparingincomestatement:
1. Percentofsalesmethodorconstantratiomethod
2. Expensemethod
3. Combinationofboththesetwo
PercentofSalesmethod:Thisapproachisbasedontheassumptionsthateachelementofcost
bearssomeconstantrelationshipwiththesalesrevenue.
Forexample,Rawmaterialcostis40%ofsalesrevenueoftheyearended31.03.2007.Butthis
methodassumesthattheratioofrawmaterialcosttosaleswillcontinuetobethesamein2008
also. Such an assumption may not hold good in most of the situations. For example, Raw
materialcostincreasesby10%in2008butsellingpriceoffinishedgoodsincreasesonlyby5%.
Inthiscaserawmaterialcostwillbe44/105ofthesalesrevenuein2008.Thiscanbesolvedto
someextentbytakingaverageforsamerepresentativeyears.However,inflation,changeinGovt
policies,wageagreements,technologicalinnovationtotallyinvalidatethisapproachonalongrun
basis.
FinancialManagement Unit2
19
2. BudgetedExpenseMethod:Expensesfor theplanningperiodarebudgetedonthebasisof
anticipated behaviour of various items of cost and revenue. This demands effective data
baseforreasonablebudgetingofexpenses.
3. Combinationofboththesemethodsisusedbecausesomeexpensescanbebudgetedbythe
management taking into account the expected business environment and some other
expensescouldbebasedontheirrelationshipwiththesalesrevenueexpectedtobeearned.
ForecastofBalanceSheet
1. Itemsofcertainassetsandliabilitieswhichhaveacloserelationshipwith thesalesrevenue
could be computed based on the forecast of sales and the historical data base of their
relationshipwiththesales.
2. Determine the equityand debtmix on the basis of funds requirements and the companys
policyonCapitalstructure.
Example:ThefollowingdetailshavebeenextractedfromthebooksofXLtd
IncomeStatement(Rs.Inmillions)
2006 2007
Saleslessreturns 1000 1300
GrossProfit 300 520
SellingExpenses 100 120
Administration 40 45
Deprecation 60 75
OperatingProfit 100 280
Nonoperatingincome 20 40
EBIT(Earningsbeforeinterest&Tax 120 320
Interest 15 18
Profitbeforetax 105 302
Tax 30 100
Profitaftertax 75 202
Dividend 38 100
Retainedearnings 37 102
BalanceSheet (Rs.Inmillion)
FinancialManagement Unit2
20
Liabilities 2006 2007 Assets 2006 2007
Shareholdersfund FixedAssets 400 510
ShareCapital Less:Depreciation 100 120
Equity 120 120 300 390
Preference 50 50 Investments 50 50
Reserves&Surplus 122 224
SecuredLoans 100 120CurrentAssets,loans
&Advances
Unsecuredloans 50 60 CashatBank 10 12
Receivables 80 128
CurrentLiabilities Inventories 200 300
TradeCrs 210 250 Loans&Advances 50 80
ProvisionsMiscellaneous
expenditure10 24
Tax 10 60
ProposedDividend 38 100
760 984 700 984
Forecast the income statement and balance sheet for the year 2008 based on the following
assumptions.
1. Salesfortheyear2008willincreaseby30%overthesalesvaluefor2007.
2. Usepercent of salesmethod to forecast the values for various itemsof income statement
usingthepercentagefortheyear2007.
3. Depreciationistochargedat25%offixedassets.
4. FixedassetswillincreasebyRs.100million.
5. InvestmentswillincreasebyRs.100million.
6. CurrentassetsandCurrentliabilitiesaretobedecidedbasedontheirrelationshiptosalesin
theyear2007.
7. MiscellaneousexpenditurewillincreasebyRs.19million.
8. Securedloansin2008willbebasedonitsrelationshiptosalesintheyear2007.
9. Additionalfundsrequired,ifany,willbemetbybankborrowings.
10. Taxrateswillbe30%.
FinancialManagement Unit2
21
11. Dividendswillbe50%ofprofitaftertax.
12. Nonoperatingincomewillincreaseby10%.
13. Therewillbenochangeinthetotalamountofadministrationexpensestobespentintheyear
2008
14. Thereisnochangeinequityandpreferencecapitalin2008.
15. Interestfor2008willmaintainthesameratioasithasin2007withthesalesof2007.
IncomeStatementfortheYear2008 (Rs.Inmillion)
(Forecast)
Particulars Basis Working Amount(Rs.)
a.Sales Increaseby30% 1300x1.3 1690
b.CostofSales Increaseby30% 780x1.3 1014
c.Grossprofit SalesCostofsales 16901014 676
d.Sellingexpenses 30%increase 120x1.3 156
e.Administration Nochange 45
f.Depreciation %given 390+100
4
123(Roundedoff)
g.OperatingProfit C(D+E+F) 352
h.NonoperatingIncome Increaseby10% 1.1x40 44
i.EarningsBefore
Interest&Taxes(EBIT)
396
j.Interest 18ofsales
1300
18x1690
1300
23(Decimalignored)
k.Profitbeforetax 373
l.Tax 112
m.Profitaftertax 261
n.Dividends 130
o.Retainedearnings 131
BalanceSheetfortheyear2008(Rs.Inmillion)
(Forecast)
FinancialManagement Unit2
22
Particulars Basis Working Amount(Rs.)
Assets
FixedAssets Given 510
Add:Addition 100
610
Depreciation 120+123 243
1.Netfixedassets 367
2.Investments 150
3.CurrentAssets&Loans
&advances
Cashatbank 12
1300
12x1690
130016(Roundedoff)
Receivables 128
1300
128x1690
1300166
Inventories 300
1300
300x1690
1300390
Loans&Advances 80
1300
80x1690
1300104
4.Miscellaneous
ExpenditureGiven 24+19 43
Total 1236
Liabilities
1. ShareCapital
Equity 120
Preference 50
2.Reserves&Surplus Increasebycurrent
yearsretained
earnings
355
3.SecuredLoan 60
1300
60x1690
130078
Bankborrowings 40(Difference
Balancingfigure)
FinancialManagement Unit2
23
4. UnsecuredLoan 60 60
5. CurrentLiabilities&
Provision
Tradecreditors 250
1300
250x1690
1300325
Provisionfortax 60
1300
60x1690
130078
ProposedDividend Currentyeargiven 130
TotalLiabilities 1236
ComputerisedFinancialPlanningSystems
AllcorporateforecastsuseComputerisedforecastingmodels.
Additional funds required to finance the increase in sales could be ascertained using a
mathematicalrelationshipbasedonthefollowing:
Additionalfunds =Requiredincrease Spontaneous Increasein
Required inassets increasein retained
liabilities earnings
(This formulahas been recommended by Engene.F.BrighaomandMichael CEhrharte in their
bookfinancialmanagementTheoryandPractice,10thedition.
Prof.PrasannaChandra,inhisbookFinancialManagement,hasgivenacomprehensiveformula
forascertainingtheexternalfinancingrequirements:
EFR=A(Ds)L(Ds)ms(1d)(D1m+SR)
S S
Here
A =Expectedincreaseinassets,bothfixedandcurrentrequiredforthe
Sexpectedincreaseinsalesinthenextyear.
L=ExpectedSpontaneousfinancingavailablefortheexpectedincreasein
Ssales
MS1 (1d)=Itistheproductof
ProfitmarginxExpectedsalesforthenextyearxRetentionRatio
X Ds
X Ds
FinancialManagement Unit2
24
Here, retention ratio is 1 payout ratio. Payout ratio refers to the ratio of dividendpaid to
earningspershare
D1m=Expectedchangeinthelevelofinvestmentsandmiscellaneousexpenditure
SR=Itisthefirmsrepaymentliabilityontermloansanddebentureforthenextyear.
Thisformulahascertainfeatures:
1. Ratiosofassetsandspontaneousliabilitiestosalesremainconstantovertheplanningperiod.
2. Dividendpayoutandprofitmarginforthenextyearcanbereasonablyplannedinadvance.
3. Sinceexternal funds requirements involve borrowings from financial institution, the formula
rightlyincorporatesthemanagementsliabilityonrepayments.
Example
ALtdhasgiventhefollowingforecasts:
Salesin2008willincreasetoRs.2000fromRs.1000in2007
ThebalancesheetofthecompanyasonDecember31,2007givesthefollowingdetails:
Liabilities Rs Assets Rs
ShareCapital NetFixedAssets 500
Equity(SharesofRs.10each) 100 Inventories 200
Reserves&Surplus 250 Cash 100
Longtermloan 400 BillsReceivable 200
Crsforexpensesoutstanding 50
Tradecreditors 50
BillsPayable 150
1000 1000
Ascertain theexternal funds requirements for the year 2008, taking into account the following
information:
1. TheCompanysutilizationoffixedassetsin2007was50%ofcapacitybutitscurrentassets
wereattheirproperlevels.
2. Currentassetsincreaseatthesamerateassales.
3. Companysaftertaxprofitmarginisexpectedtobe5%,anditspayoutratiowillbe60%.
4. Creditorsforexpensesarecloselyrelatedtosales(AdaptedfromIGNOUMBA)
Answers
Preliminaryworkings
A=Currentassets=Cash+BillsReceivables+Inventories
FinancialManagement Unit2
25
=100+200+200=500
A=500=Rs.500
S1000
L=Tradecreditors+Billspayable+Expensesoutstanding
=50+150+50=Rs.250
L =250=Rs.250
S 1000
M(ProfitMargin)=5/100=0.05
S1=Rs.200
1d=10.6=0.4or40%
D1m=NIL
SR=NIL
Therefore:
)1()1()(
1 SRmdmSSxSL
SsA
EFR + D - - - D - D
=
=500250(0.05x200x0.4)(0+0)
=50025040(0+0)
=Rs.210
Therefore, external funds requirements (additional funds required) for 2008 will be Rs.210.
This additional funds requirementswill be procured by the firm based on its policy on capital
structure.
SelfAssessmentQuestions1
1. Corporateobjectivescouldbegroupinto________and________.
2. Controlmechanismisdevelopedfor_____________andtheireffectiveuse.
3. Seasonalpeakrequirementstobemetfrom___________________frombanks.
4. Exercisethrough_________overoverheads.
2.3FactorsAffectingFinancialPlan
1. Natureof the industry: Here,wemustconsiderwhether it isacapital intensiveor labour
intensiveindustry.Thiswillhaveamajorimpactonthetotalassetsthatthefirmowns.
2. Sizeof theCompany: Thesizeof thecompanygreatly influences theavailabilityof funds
fromdifferent sources. A smallcompanynormally finds it difficult to raise funds from long
X Ds X1000
X Ds X1000
FinancialManagement Unit2
26
termsourcesatcompetitiveterms. Ontheotherhand,largecompanies likeRelianceenjoy
theprivilegeofobtainingfundsbothshorttermandlongtermatattractiverates.
3. Status of the company in the industry: A well established company enjoying a good
market share, for its productsnormally commandsinvestors confidence. Sucha company
cantapthecapitalmarketforraisingfundsincompetitivetermsforimplementingnewprojects
toexploitthenewopportunitiesemergingfromchangingbusinessenvironment.
4. Sourcesof financeavailable: Sourcesof finance couldbe grouped into debtandequity.
Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital
structure thatwould achieve the least cost capital structure. A large firmwith adiversified
product mix may manage higher quantum of debt because the firm may manage higher
financialriskwithalowerbusinessrisk.Selectionofsourcesoffinanceiscloselylinkedtothe
firmscapacitytomanagetheriskexposure.
5. TheCapitalstructureofacompany is influencedby thedesireof theexistingmanagement
(promoters)ofthecompanytoretaincontrolovertheaffairsofthecompany.Thepromoters
whodonotliketolosetheirgripovertheaffairsofthecompanynormallyobtainextrafunds
forgrowthbyissuingpreferencesharesanddebenturestooutsiders.
6. Matching thesourceswithutilization:Theprudentpolicyofanygoodfinancialplan is to
match the term of the source with the term of investment. To finance fluctuating working
capitalneedsthefirmresortstoshorttermsfinance.Allfixedassetsfinancedinvestmentsare
tobefinancialbylongtermsources.Itisacardinalprincipleoffinancialplanning.
7. Flexibility:Thefinancialplanofacompanyshouldpossessflexibilitysoastoeffectchanges
in the compositionof capital structurewhen ever needarises. If the capital structure of a
companyisflexible,itwillnotfaceanydifficultyinchangingthesourcesoffunds.Thisfactor
hasbecomeasignificantonetodaybecauseoftheglobalizationofcapitalmarket.
8. GovernmentPolicy:SEBIguidelines,financeministrycirculars,variousclausesofStandard
Listing Agreement and regulatory mechanism imposed by FEMA and Department of
corporate affairs (Govt of India) influence the financial plans of corporates today.
ManagementofpublicissuesofsharesdemandsthecomplianceswithmanystatuesinIndia.
Theyaretobecompliedwithatimeconstraint.
SelfAssessmentQuestions2:
1. ___________hasamajorimpactonthetotalassetsthatthefirmowns.
2. Sourcesoffinancecouldbegroupedinto__and_______________.
FinancialManagement Unit2
27
3. ___________ofanygoodfinancialplanis tomatchthetermofthesourcewiththetermof
thesourcewiththetermoftheinvestment.
4. ________________referstheabilityto______________________wheneverneedarises.
2.4 EstimationOfFinancialRequirementsOfaFirm.
Theestimationofcapitalrequirementsofafirminvolvesacomplexprocess.Evenwithexpertise,
managementsofsuccessfulfirmscouldnotarriveattheoptimumcapitalcompositionintermsof
thequantumandthesources.Capitalrequirementsofafirmcouldbegroupedintofixedcapital
andworkingcapital.Thelongtermrequirementssuchasinvestmentinfixedassetswillhaveto
bemetoutof fundsobtainedon long termbasis. Variableworkingcapital requirementswhich
fluctuate from season to season will have to be financed only by short term sources. Any
departurefromthiswellacceptednormcausesnegativeimpactsonfirmsfinances.
SelfAssessmentQuestion3:
1.Capitalrequirementofafirmcouldbegroupedinto________and__________.
2.Variableworkingcapitalwillhavetobefinancedonlyby_______________.
2.5Capitalizations
Meaning: Capitalizationofafirmrefersthecompositionofits longtermfunds. It referstothe
capitalstructureofthefirm.Ithastwocomponentsvizdebtandequity.
Afterestimatingthefinancialrequirementsofafirm,thenthenextdecisionthatthemanagement
hastotakeistoarriveatthevalueatwhichthecompanyhastobecapitalized.
TherearetwotheoriesofCapitalizationfornewcompanies:
1.Costtheoryand 2.Earningstheory
2.5.1CostTheory:
Under this approach, the total amount of capitalization for a new company is the sum of the
following:
1. Costoffixedassets.
2. Costofestablishingthebusiness.
3. Amountofworkingcapitalrequired
FinancialManagement Unit2
28
Meritsofcostapproach:
1. It helps promoters to estimate theamount of capital required for incorporationof company
conducting market surveys, preparing detailed project report, procuring funds, procuring
assetsbothfixedandcurrent,trialproductionrunandsuccessfullyproducing,positioningand
marketingofitsproductsorrenderingofservices.
2. Ifdonesystematicallyitwilllayfoundationforsuccessfulinitiationoftheworkingofthefirm.
Demerits
1. Ifthefirmestablishesitsproductionfacilitiesatinflatedprices,productivityofthefirmwillbe
lessthanthatoftheindustry.
2. Networthofacompanyisdecidedbytheinvestorsbytheearningsofacompany.Earnings
capacitybasednetworthhelpsafirmtoarriveatthetotalcapitalintermsofindustryspecified
yardstick ( i,e,operatingcapitalbasedonbenchmarks in that industry) cost theoryfails in
thisrespect.
2.5.2 EarningsTheory:
Earningsareforecastandcapitalizedatarateofreturnwhichisrepresentativeoftheindustry.It
involvestwosteps.
1. Estimationoftheaverageannualfutureearnings.
2. Normalearningrateoftheindustrytowhichthecompanybelongs.
Merits
1. It is superior to cost theorybecause thereare, the least chancesof neitherundernotover
capitalization.
2. Comparisonofearningsapproachwiththatofcostapproachwillmakethemanagementtobe
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
thereofintovariousprocurementsources.
2. Arrivingatcapitalizationrateisequallyaformidabletaskbecausetheinvestorsperceptionof
established companies cannot be really representative of what investors perceive of the
earningpowerofnewcompany.
FinancialManagement Unit2
29
Because of the problem, most of the new companies are forced to adopt the cost theory of
capitalization.
Ideallyeverycompanyshouldhavenormalcapitalization.Butitisanutopianwayofthinking.
Changing business environment, role of international forces and dynamics of capital market
conditionsforceustothinkintermsofwhatisoptimaltodayneednotbesotomorrow.Evenwith
these constraints, management of every firm should continuously monitor the firms capital
structuretoensuretoavoidthebadconsequencesofoverandundercapitalization.
2.5.3 Overcapitalization
Acompanyissaidtobeovercapitalized,whenitstotalcapital(bothequityanddebt)exceedsthe
truevalueofitsassets. Itiswrongtoidentifyovercapitalizationwithexcessofcapitalbecause
most of theovercapitalized firms suffer from theproblemsof liquidity. Thecorrect indicatorof
overcapitalizationistheearningscapacityofthefirm.Iftheearningsofthefirmarelessthenthat
of themarketexpectation,itwillnotbe inapositiontopaydividendstoitsshareholdersasper
theirexpectations.Itisasignofovercapitalization.Itisalsopossiblethatacompanyhasmore
fundsthanitsrequirementsbasedoncurrentoperationlevels,andyethavelowearnings.
Overcapitalizationmaybeonaccountofanyofthefollowing:
1. Acquiringassetsatinflatedrates
2. Acquiringunproductiveassets.
3. Highinitialcostofestablishingthefirm
4. Companieswhichestablishtheirnewbusinessduringboomconditionareforcedtopaymore
for acquiring assets, causing a situation of overcapitalization once the boom conditions
subside.
5. Totalfundsrequirementshavebeenoverestimated.
6. Unpredictablecircumstances(likechangeinimportexportpolicy,changeinmarketratesof
interest,changesininternationaleconomicandpoliticalenvironment)reducesubstantiallythe
earningcapacityofthefirm.Forexample,rupeeappreciationagainstU.S.dollarhasaffected
earningcapacityoffirmsengagedmainlyinexportbusinessbecausetheyinvoicetheirsales
inUSdollar.
7. Inadequateprovisionfordepreciationadverselyaffects theearningcapacityofacompany ,
leadingtoovercapitalizationofthefirm.
8. Existenceofidlefunds.
FinancialManagement Unit2
30
Effectsofovercapitalization
1. Declineintheearningsofthecompany.
2. Fallindividendrates.
3. Marketvalueofcompanyssharefalls,andcompanylosesinvestorsconfidence.
4. Companymaycollapseatanytimebecauseofanemicfinancialconditions itwillaffectits
employees, society, consumers and its shareholders. Employees will lose jobs. If the
companyisengagedintheproductionandmarketingofcertainessentialgoodsandservices
tothesociety,thecollapseofthecompanywillcausesocialdamage.
RemediesforOvercapitalization:
Restructuringthefirmistobeexecutedtoavoidthesituationofcompanybecomingsick.
Itinvolves
1. Reductionofdebtburden.
2. Negotiationwithtermlendinginstitutionsforreductionininterestobligation.
3. Redemptionofpreferencesharesthroughaschemeofcapitalreduction.
4. Reducingthefacevalueandpaidupvalueofequityshares.
5. Initiatingmergerwithwellmanagedprofitmakingcompanies interested in takingoverailing
company.
2.5.4 Undercapitalization
Undercapitalization is just the reverse of overcapitalization. A company is considered to be
undercapitalizedwhenitsactualcapitalizationislowerthanitspropercapitalizationaswarranted
byitsearningcapacity.
Symptomsofundercapitalization
1. Actualcapitalizationislessthanthatwarrantedbyitsearningcapacity.
2. Its rateofearnings isexceptionallyhigh in relation to the returnenjoyedbysimilarsituated
companiesinthesameindustry.
Causesofundercapitalization
1. Underestimationoffutureearningsatthetimeofpromotionofthecompany.
2. Abnormalincreaseinearningsfromneweconomicandbusinessenvironment.
3. Underestimationoftotalfundsrequirements.
FinancialManagement Unit2
31
4. Maintainingveryhighefficiencythroughimprovedmeansofproductionofgoodsorrendering
ofservices.
5. Companieswhicharesetupduringrecessionstartmakinghigherearningcapacityassoon
astherecessionisover.
6. Useoflowcapitalizationrate.
7. Companieswhichfollowconservativedividendpolicywillachieveaprocessofgraduallyrising
profits.
8. Purchaseofassetsatexceptionallylow pricesduringrecession.
Effectsofundercapitalization
1. Encouragement to competition: undercapitalization encourages competition by creating a
feelingthatthelineofbusinessislucrative.
2. Itencouragesthemanagementofthecompanytomanipulatethecompanysshareprices.
3. Highprofitswillattracthigheramountoftaxes.
4. High profits will make the workers demand higher wages. Such a feeling on the part of
employeesleadstolabourunrest.
5. High margin of profit may create among consumers an impression that the company is
charginghighpricesforitsproducts.
6. High margin of profits and the consequent dissatisfaction among its employees and
consumer,mayinvitegovernmentalenquiryintothepricingmechanismofthecompany.
Remedies
1. SplittingupofthesharesThiswillreducethedividendpershare.
2. Issueofbonusshares:Thiswillreduceboththedividendpershareandearningspershare.
Bothovercapitalizationandundercapitalizationaredetrimentaltotheinterestsofthesociety.
SelfAssessmentQuestion4
1.______________ofafirmreferstothecompositionofitslongtermfunds.
2.Twotheoriesofcapitalizationfornewcompaniesare________andearningstheory.
3.Acompanyissaidtobe___________,whenitstotalcapitalexceedsthetruevalueofits
assets.
4.Acompanyisconsideredtobe________________whenitsactualcapitalizationislowerthan
itspropercapitalizationaswarrantedbyitsearningcapacity.
FinancialManagement Unit2
32
2.6 Summary
Financial planning deals with the planning, execution and monitoring of theprocurement and
utilizationoffunds.Financialplanningprocessgivesbirthtofinancialplan.Itcouldbethoughtof
ablueprintexplainingtheproposedstrategyanditsexecution.Therearemanyfinancialplanning
models. All these models forecast the future operations and then translate them into income
statementsandbalancesheets.Itwillalsohelpthefinancemanagerstoascertainthefundsto
be procured fromoutside sources. Theessenceofall these is toachievea least cost capital
structurewhichwouldmatchwiththeriskexposureofthecompany. Failuretofollowtheprinciple
of financial planning may lead a new firm to over or undercapitalization when the economic
environmentundergoesachange. Ideallyeveryfirmshouldaimatoptimumcapitalization.Other
wiseitmayfaceasituationofoverorundercapitalization.Botharedetrimentaltotheinterestsof
thesociety.Therearetwotheoriesofcapitalizationvizcosttheoryandearningstheory.
TerminalQuestions
1. ExplainthestepsinvolvedinFinancialPlanning.
2. ExplainthefactorsaffectingFinancialPlan
3. ListoutthecausesofOverCapitalization.
4. ExplaintheeffectsofUnderCapitalization.
AnswersToSelfAssessmentQuestions
SelfAssessmentQuestions1
1. Qualitative,Quantitative.
2. Allocationoffunds
3. Shorttermborrowings
SelfAssessmentQuestion2
1. Natureoftheindustry
2. Debt,Equity
3. Theproductpolicy
4. Flexibilityincapitalstructure,effectchangesinthecompositesofcapitalstructure
SelfAssessmentQuestion3
FinancialManagement Unit2
33
1. Fixedcapital,workingcapital.
2. Shorttermsources
SelfAssessmentQuestion4
1. Capitalization
2. Costtheory
3. OverCapitalized
4. Undercapitalized
AnswertoTerminalQuestions
1. Refertounit2.2
2. Refertounit 2.3
3. Refertounit 2.5.3
4. Refer tounit 2.5.4
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Unit3 TimeValueofMoney
Structure
3.1 Introduction
3.2 TimePreferenceRateandRequiredRateofReturn
3.2.1 CompoundingTechnique
3.2.2 DiscountingTechnique
3.2.3 FutureValueofaSingleFlow(Lumpsum):
3.2.4 FutureValueofSeriesofCashFlows
3.2.5 FutureValueofanAnnuity
3.2.5.1SinkingFund
3.3 PresentValue
3.3.1 DiscountingorPresentValueofaSingleFlow
3.3.2 PresentValueofaSeriesofCashFlows
3.3.2.1 PresentValueofPerpetuity
3.3.2.2 CapitalRecoveryFactor
3.4 Summary
SolvedProblems
TerminalQuestions
AnswertoSAQsandTQs
3.1 Introduction
Themainobjectiveofthisunitistoenableyoutolearnthetimevalueofmoney.Inthepreviousunit,
wehavelearntthatwealthmaximizationistheprimaryobjectiveoffinancialmanagementandthatis
more important thanprofitmaximization for its superiority in the sense that it is futureoriented.A
decisiontakentodaywillhavefarfetchingimplications.Forexample,afirminvestinginfixedassets
willreapthebenefitsofsuchinvestmentforanumberofyears.Ifsuchassetsareprocuredthrough
bankborrowingsortermloansfromfinancial institutions, theseinvolveanobligationtopayinterest
and return of principal. Decisions aremade by comparing the cash inflows (benefits/returns) and
cashoutflows(outlays).Sincethesetwocomponentsoccuratdifferenttimeperiods,thereshouldbe
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acomparison.Inordertohavealogicalandmeaningfulcomparisonbetweencashflowsthataccrue
overdifferentintervalsoftime,itisnecessarytoconverttheamountstoacommonpointoftime.This
unitisdevotedforadiscussionofthetechniquesofdoingso.
LearningObjectives:
Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.
1. Explainthetimevalueofmoney.
2. Understandthevaluationconcepts.
3. Calculatethepresentandfuturevaluesoflumpsumandannuityflows.
Rationale: TimeValue ofMoney is the valueof a unit ofmoneyat different time intervals. The
valueofmoney received today ismore than itsvalue receivedata laterdate. Inotherwords, the
valueofmoneychangesoveraperiodoftime.Sincearupeereceivedtodayhasmorevalue,rational
investors would prefer current receipts to future receipts. That is why this phenomenon is also
referredtoasTimePreferenceofMoney.Someimportantfactorscontributingtothisare:
Investmentopportunities:
Preferenceforconsumption
Risk
ThesefactorsremindusofthefamousEnglishsayingAbirdinhandisworthtwointhebush.
Whyshouldmoneyhavetimevalue?
Someofthereasonsare:
Moneycanbeemployedproductivelytogeneraterealreturns.Forexample,ifwespendRs.500on
materialsandRs.300onlabourandRs.200onotherexpensesandthefinishedproductissoldfor
Rs.1100,wecansaythattheinvestmentofRs.1000hasfetchedusareturnof10%.
Secondly,duringperiodsofinflation,arupeehasahigherpurchasingpowerthanarupeeinfuture.
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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subjective preference for present consumption either because of their current preferences or
becauseofinflationarypressures.
3.2 FutureValue:
TimePreferenceRateandRequiredRateofReturn
Thetimepreferenceformoneyisgenerallyexpressedbyaninterestrate.Thisratewillbepositive
even in theabsenceof any risk. It is called the riskfree rate. Forexample, if an individuals time
preferenceis8%,itimpliesthatheiswillingtoforegoRs.100todaytoreceiveRs.108afteraperiod
ofoneyear.ThusheconsidersRs.100andRs.108areequivalentinvalue.Butinrealitythisisnot
theonlyfactorheconsiders.There isanamountof risk involved insuch investment.He therefore
requiresanotherrateforcompensatinghimwiththiswhichiscalledtheriskpremium.
Requiredrateofreturn=Riskfreerate+RiskPremium
There are two methods by which time value of money can be calculated compounding and
discounting.
3.2.1CompoundingTechnique:Underthismethodofcompounding,thefuturevaluesofallcash
inflowsattheendofthetimehorizonataparticularrateofinterestarefound.Interestiscompounded
when theamountearnedonan initial depositbecomespartof theprincipalat theendof the first
compoundingperiod.IfMr.AinvestsRs.1000inabankwhichoffershim5%interestcompounded
annually,hehasRs.1050 inhisaccountat theendof thefirstyear.The totalof the interestand
principal Rs. 1050 constitutes the principal for the next year. He thus earns Rs. 1102.50 for the
secondyear.Thisbecomestheprincipalforthethirdyear.Thiscompoundingprocedurewillcontinue
for an indefinitenumberof years.Thecompoundingof interest canbe calculatedby the following
equation:
A=P(1+i)n
WhereA=Amountattheendoftheperiod
P=Principalattheendoftheperiod
i=rateofinterest
n=numberofyears
Theamountofmoney in theaccountat theendofvariousyears iscalculatedasunder,using the
equation:
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Amountattheendofyear1=Rs.1000(1+0.05)==Rs.1050
Amountattheendofyear2=Rs.1050(1+0.05)==Rs.1102.50
Amountattheendofyear3=Rs.1102.50(1+0.05)==Rs.1157.63
Year 1 2 3
Beginningamount Rs.1000 Rs.1050 Rs.1102.50
Interestrate 5% 5% 5%
Amountofinterest 50 52.50 55.13
Beginningprincipal
1000 Rs.1050 Rs.1102.50
Endingprincipal Rs.1050 Rs.1102.50 Rs.1157.63
Theamountattheendofyear2canbeascertainedbysubstitutingRs.1000(1+0.05)forR.
1050,thatis,Rs.1000(1+0.05)(1+0.05)=Rs.1102.50.
Similarly, theamountat theendofyear3canbeascertainedbysubstitutingRs.Rs.1000(1+0.05)
(1+0.05)(1+0.05)=Rs.1157.63.
ThusbysubstitutingtheactualfiguresfortheinvestmentorRs.1000intheformulaA=P(1+i)n,we
arriveattheresultshownaboveinTable.
3.2.2DiscountingTechnique:Underthemethodofdiscounting,wefindthetimevalueofmoney
now,thatis,attime0onthetimeline.Itisconcernedwithdeterminingthepresentvalueofafuture
amount.This is in contrast to the compoundingapproachwhereweconvert presentamounts into
futureamountsindiscountingapproachweconvertthefuturevaluetopresentsums.Forexample,if
Mr.ArequirestohaveRs.1050attheendofyear1,giventherateofinterestas5%,hewouldlike
toknowhowmuchheshouldinvesttodaytoearnthisamount.IfPistheunknownamountandusing
theequationwegetP(1+0.5)=1050.Solvingtheequation,wegetP=Rs.1050/1.05=Rs.1000.
ThusRs.1000wouldbetherequiredprincipalinvestmenttohaveRs.1050attheendofyear1at
5%interestrate.Inotherwords,thepresentvalueofRs.1050receivedoneyearfromnow,rateof
interest5%, isRs.1000.Thepresentvalueofmoney is the reciprocalof thecompoundingvalue.
Mathematically, we have P=A {1/(1+i)n} in which P is the present value for the future sum to be
received,Aisthesumtobereceivedinfuture,iistheinterestrateandnisthenumberofyears.
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3.2.3FutureValueofaSingleFlow (lump sum): Theprocessof calculating futurevaluewill
becomeverycumbersomeiftheyhavetobecalculatedoverlongmaturityperiodsof10or20years.
Ageneralizedprocedureforcalculatingthefuturevalueofasinglecashflowcompoundedannually
isasfollows:
FVn=PV(1+i)n
WhereFVn=Futurevalueoftheinitialflowinnyearshence
PV=Initialcashflow
I=Annualrateofinterest
N=Lifeofinvestment
Theexpression (1+i)n represents thefuturevalueof the initial investmentofRe.1at theendofn
numberofyearsattheinterestratei,referredtoastheFutureValueInterestFactor(FVIF).Tohelp
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
multipliedwiththeinitialinvestment.
Example:Thefixeddepositschemeofabankoffersthefollowinginterestrates:
Periodofdeposit Rateperannum
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A much accurate way of calculating doubling period is the rule of 69, which is expressed as
0.35+69/interestrate.Goingbythesameexamplegivenabove,wegetthenumberofyearsas7.25
years{0.35+69/10(0.35+6.9)}.
Increasedfrequencyofcompounding
It has been assumed that the compounding is done annually. If a scheme is offered where
compounding isdonemore frequently, let us see its effecton interestearned.Forexample, ifwe
have deposited Rs. 10000 in a bank which offers 10% interest per annum compounded semi
annually,theinterestearnedwillbeasfollows:
Amountinvested Rs. 10000
Interestearnedforfirst6months
10000*10%*1/2(for6months) Rs. 500
Amountattheendof6months Rs. 10500
Interestearnedforsecond6months
10500*10%*1/2 Rs. 525
Amountattheendoftheyear Rs. 11025
If in theabovecasecompoundingisdoneonlyonceayearthe interestearnedwillbe10000*10%
whichisequaltoRs.1000andwewillhaveRs.11000attheendoffirstyear.Wefindthatweget
moreinterestifcompoundingisdoneonamorefrequentbasis.Thegeneralizedformulaforshorter
compoundingperiodsis:
FVn=PV(1+i/m)m*n
Where,FVn=Futurevalueafternyears
PV=Cashflowtoday
i=Nominalinterestrateperannum
m=No.oftimescompoundingisdoneduringayear
n=No.ofyearsforwhichcompoundingisdone.
Example: Under the Andhra Banks Cash Multiplier Scheme, deposits can be made for periods
rangingfrom3months to5years.Everyquarter, interest isadded to theprincipal.Theapplicable
rateof interest is9%fordeposits lessthan23monthsand10%forperiodsmorethan24months.
WhatwilltheamountofRs.1000todaybeafter2years?
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Solution:
FVn=PV(1+i/m)m*n
1000(1+0.10/4)4*2
1000(1+0.10/4)8
Rs.1218
Effectivevs.nominal rateof interest:Wehave just learnt that interestaccumulationbyfrequent
compoundingismuchmorethantheannualcompounding.Thismeansthattherateofinterestgiven
to us, that is, 10% is the nominal rate of interest per annum. If the compounding is done more
frequently,saysemiannually,theprincipalamountgrowsat10.25%perannum.0.25%isknownas
theEffectiveRateofInterest.Thegeneralrelationshipbetweentheeffectiveandnominalratesof
interestisasfollows:
r={(1+i/m)m}1
Where,
r=Effectiverateofinterest
i=Nominalrateofinterest
m=Frequencyofcompoundingperyear.
Example:Calculatetheeffectiverateofinterestifthenominalrateofinterestis12%andinterestis
compoundedquarterly.
Solution:
r={(1+i/m)m}1
r={(1+0.12/4)4}1
r=0.126or12.6%p.a.
3.2.4 FutureValueOfSeriesOfCashFlows
Wehaveconsideredonlysinglepaymentmadeonceanditsaccumulationeffect.Aninvestormaybe
interestedininvestingmoneyininstallmentsandwishtoknowthevalueofhissavingsafternyears.
Forexample,Mr.MadaninvestsRs.500,Rs.1000,Rs.1500,Rs.2000andRs.2500attheendof
eachyearfor5years.Calculatethevalueattheendof5yearscompoundedannuallyiftherateof
interestis5%p.a.
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Solution:
Endofyear
Amountinvested
Numberofyears
compounded
Compoundedinterestfactorfromtables
FVinRs.
1 Rs.500 4 1.216 608
2 Rs.1000
3 1.158 1158
3 Rs.1500
2 1.103 1654
4 Rs.2000 1 1.050 2100
5 Rs.2500
0 1.000 2500
Amountattheendof5thYear Rs.8020
3.2.5 FutureValueOfAnAnnuity
Annuityreferstotheperiodicflowsofequalamounts.Theseflowscanbeeithertermedasreceipts
or payments. For example, if you have subscribed to the Recurring Deposit Scheme of a bank
requiring you to pay Rs. 5000 annually for 10 years, this stream of payouts can be called
Annuities.Annuities require calculationsbasedon regular periodic contributionofa fixed sumof
money.
Thefuturevalueofaregularannuityforaperiodofnyearsatirateofinterestcanbesummedupas
under:
FVAn=A{(1+i)n1}/i
WhereFVAn=Accumulationattheendofnyears
i=Rateofinterest
n=Timehorizonorno.ofyears
A=Amountdeposit/investedattheendofeveryyearfornyears.
Theexpression {(1+i)n1}/ i iscalled theFutureValue InterestFactor forAnnuity (FVIFA).This
representstheaccumulationofRe.1investedattheendofeveryyearfornnumberofyearsatirate
ofinterest.Thetablesattheendofthisbookgiveusthecalculationsfordifferentcombinationsofi
andn.We justhave tomultiply the relevantvaluewithAandget theaccumulation in theformula
givenabove.
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Example:M.RamKumardepositsRs.3000attheendofeveryyearfor5yearsintohisaccountfor
5years,interestbeing5%compoundedannually.Determinetheamountofmoneyhewillhaveatthe
endofthe5thyear.
Endofyear
Amountinvested
Numberofyears
compounded
Compoundedinterest
factorfromtables
FVinRs.
1 Rs.2000
4 1.216 2432
2 Rs.2000
3 1.158 2316
3 Rs.2000
2 1.103 2206
4 Rs.2000 1 1.050 2100
5 Rs.2000
0 1.000 2000
Amountattheendof5thYear Rs.11054
ORUsingformulaandthetableswecanfindthat:
=2000FVIFA(5%,5y)
=2000*5.526
=Rs.11052
Wenoticethatwecangettheaccumulationsattheendofnperiodusingthetables.Calculationsfor
alongtimehorizonareeasilydonewiththehelpofreferencetables.Annuitytablesarewidelyused
inthefieldofinvestmentbankingasreadyreckoners.
Example:Calculate the valueof anannuity flowofRs.5000doneona yearlybasis for 5 years,
yieldinganinterestof8%p.a.
Solution:
=5000FVIFA(8%,5y)
=5000*5.867
=Rs.29335
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3.2.5.1SinkingFund
Sinkingfundisafundwhichiscreatedoutoffixedpaymentseachperiodtoaccumulatetoafuture
sumafteraspecifiedperiod.Thesinkingfundfactorisusefulindeterminingtheannualamounttobe
putinafundtorepaybondsordebenturesortopurchaseafixedassetorapropertyattheendofa
specifiedperiod.
A=FVA*i/{(1+i)n1}
i/{(1+i)n1}iscalledtheSinkingFundFactor.
SelfAssessmentQuestions1
1. Theimportantfactorscontributingtotimevalueofmoneyare__________,________________
and_______.
2. Duringperiodsofinflation,arupeehasa___________thanarupeeinfuture.
3. As future is characterized by uncertainty, individuals prefer _________consumption to
__________consumption.
4. There are twomethods by which time value of money can be calculated by _________ and
_________techniques.
3.3 PresentValue
Wehavesofarseenhowthecompoundingtechniquecanbeused.Theycanbeusedtocompare
thecashflowsseparatedbymorethanonetimeperiod,giventheinterestrate.Withthistechnique,
theamountofpresentcashcanbeconvertedintoanamountofcashofequivalentvalueinfuture.
Likewise, wemaybe interested in converting the future cash flows into their present values. The
PresentValuePVofafuturecashflow is theamountof thecurrentcash that isequivalent to the
investor. The process of determining present value of a future payment or a series of future
paymentsisknownasdiscounting.
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3.3.1DiscountingorPresentValueofaSingleFlow:
WecandeterminethePVofafuturecashfloworastreamoffuturecashflowsusingtheformula:
PV=FVn/(1+i)n
WherePV=PresentValue
FVn=Amount
i=Interestrate
n=Numberofyears
Example: IfMs.SapnaexpectstohaveanamountofRs.1000afteroneyearwhatshouldbethe
amountshehastoinvesttodayifthebankisoffering10%interestrate?
Solution:
PV=FVn/(1+i)n
=1000/(1+0.10)1
=Rs.909.09
Thesamecanbecalculatedwiththehelpoftables.
=1000*PVIF(10%,1y)
=1000*0.909
=Rs.909
Example:AninvestorwantstofindoutthevalueofanamountofRs.100000tobereceivedafter15
years.Theinterestofferedbybankis9%.CalculatethePVofthisamount.
Solution:
PV=FVn/(1+i)nor100000PVIF(9%,15y)
=100000*0.275
=Rs.27500
3.3.2PresentValueofaSeriesofCashFlows
Inabusinessscenario,thebusinessmanwillreceiveperiodicamounts(annuity)foracertainnumber
ofyears.Aninvestmentdonetodaywillfetchhimreturnsspreadoveraperiodoftime.Hewouldlike
toknow if it isworthwhile to investacertainsumnow inanticipationof returnsheexpectsovera
certainnumberofyears.Heshouldthereforeequatetheanticipatedfuturereturnstothepresentsum
heiswillingtoforego.ThePVofaseriesofcashflowscanberepresentedbythefollowingformula:
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PV=Ct/(1=i)1+Ct/(1=i)2+Ct/(1=i)3 Ct/(1=i)4+..+Ct/(1=i)n
Whichreducesto:
PVAn=A{1+i)n1/i(1+i)n}
The expression {1+i)n1 / i(1+i)n} is known as Present Value Interest Factor Annuity (PVIFA). It
representsthePVIFAofRe.1forthegivenvaluesofiandn.ThevaluesofPVIFA(I,n)canbefound
outusingthetablesattheendofthebook.Itshouldbenotedthatthesevaluesaretrueonlyifthe
cashflowsareequalandtheflowsoccurattheendofeveryyear.
Example:
Calculate thePVofanannuityofRs.500 receivedannuallyfor4year,whendiscountingfactor is
10%.
Endofyear Cashinflows
PVfactor PVinRs.
1 Rs.500 0.909 454
2 Rs.500 0.827 413
3 Rs.500 0.751 375
4 Rs.500 0.683 341
PresentValueofanannuityRs.1585.
ORbydirectlylookingatthetablewecancalculate:
=500*PVIFA(10%,4y)
=500*3.170
=Rs.1585
Example:Findout thepresentvalueofanannuityofRs.10000over3yearswhendiscountedat
5%.
Solution:
=10000*PVIFA(5%,3y)
=10000*2.773
=Rs.27730
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3.3.2.1PresentValueofPerpetuity
Anannuityforaninfinitetimeperiodisperpetuity.Itoccursindefinitely.Apersonmayliketofindout
thepresentvalueofhis investmentassuminghewill receiveaconstantreturnyearafteryear.The
PVofperpetuityiscalculatedasP=A/i
Example: If theprincipalofacollegewants to instituteascholarshipofRs.5000 toameritorious
studentinfinanceeveryyear,findoutthePVofinvestmentwhichwouldyieldRs.5000inperpetuity,
discountedat10%.
Solution:
P=A/i
=5000/0.10
=Rs.50000
ThismeansheshouldinvestRs.50000togetanannualreturnofRs.5000.
Presentvalueofanunevenperiodicsum:Insomeinvestmentdecisionsofafirm,thereturnsmay
notbeconstant.Insuchcases,thePViscalculatedasfollows:
P=A1/(1+i)+A2/(1+i)2+A3/(1+i)3+A4/(1+i)4++An/(1+i)n
OR
PV=A1PVIF(i,1)+A2PVIF(i,2)+A3PVIF(i,3)+A4PVIF(i,4)+.+AnPVIF(i,n)
Example: An investor will receive Rs. 10000, Rs. 15000, Rs. 8000, Rs. 11000 and R. 4000
respectivelyattheendofeachof5years.Findoutthepresentvalueofthisstreamofunevencash
flows,iftheinvestorsinterestrateis8%.
PV=10000/(1+0.08)+15000/(1+0.08)2+8000/(1+0.08)3+11000/(1+0.08)4+4000/(1+0.08)5
=Rs.39276
Or
PV=10000PVIF(8,1)+15000PVIF(8,2)+8000PVIF(8,3)+11000PVIF(8,4)+
4000PVIF(8,5)
=10000*0.926+15000*0.857+8000*0.794+11000*0.735+4000*0.681
=Rs.39276
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3.3.2.2CapitalRecoveryFactor
Capitalrecovery istheannuityofan investmentforaspecifiedtimeatagivenrateof interest.The
reciprocalofthepresentvalueannuityfactoriscalledCapitalRecoveryFactor.
A=PVAn{i(1+i)n}/(1+i)n1}
{i(1+i)n}/(1+i)n1}isknownastheCapitalRecoveryFactor.
Example:A loanofRs.100000istoberepaid in5equalannual installments. Ifthe loancarriesa
rateof14%p.a,whatistheamountofeachinstallment?
Solution:
Installment*PVIFA(14%,5)=100000
Installment=100000/3.433=Rs.29129
SelfAssessmentQuestions2
1. _________________iscreatedoutoffixedpaymentseachperiodtoaccumulatetoafuturesum
afteraspecifiedperiod.
2. The________________ofafuturecashflowistheamountofthecurrentcashthatisequivalent
totheinvestor.
3. Anannuityforaninfinitetimeperiodiscalled______________.
4. Thereciprocalofthepresentvalueannuityfactoriscalled_____________.
3.4 Summary
Money has time preference. A rupee in hand today is more valuable than a rupee a year later.
Individualspreferpossessionofcashnowratherthanatafuturepointoftime.Thereforecashflows
occurring at different points in time cannot be compared. Interest rategivesmoney its value and
facilitates comparison of cash flows occurring at different periods of time. Compounding and
discountingaretwomethodsusedtocalculatethetimevalueofmoney.
SolvedProblemsTimeValueofMoney
1. WhatisthefuturevalueofaregularannuityofRe.1.00earningarateof12%interestp.a.for5
years?
Solution:1*FVIFA(12%,5y)=1*6.353=Rs.6.353
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2. IfaborrowerpromisestopayRs.20000eightyearsfromnowinreturnforaloanofRs.12550
today,whatistheannualinterestbeingoffered?
Solution:20000*PVIF(k%,8y)=Rs.12550Kisapproximately6%.
3. AloanofRs.500000istoberepaidin10equalinstallments.Iftheloancarries12%interestp.a.
whatisthevalueofoneinstallment?
Solution:A*PVIFA(12%,10y)=500000SoA=500000/5.650=Rs.88492
4. ApersondepositsRs.25000inabankthatpays6%interesthalfyearly.Calculatetheamountat
theendof3years.
Solution:25000*(1+0.06)3*2=25000*1.194=Rs.29850
5. FindthepresentvalueofRs.100000receivableafter10yearsif10%isthetimepreferencefor
money.
Solution:100000*(0.386)=Rs.38600
TerminalQuestions
1. If you deposit Rs. 10000 today in a bank that offers 8% interest, in howmany yearswill this
amountdouble?
2. AnemployeeofabankdepositsRs.30000intohisPFA/cattheendofeachyearfor20years.
What is theamounthewillaccumulate inhisPFat theendof20 years, if the rateof interest
givenbyPFauthoritiesis9%?
3. Apersoncansave_____________annuallytoaccumulateRs.400000bytheendof10years,
ifthesavingearns12%.
4. Mr. Vinod has to receive Rs. 20000 per year for 5 years. Calculate the present value of the
annuityassuminghecanearninterestonhisinvestmentat10%p.a.
5. AparnainvestsRs.5000attheendofeachyearat10%interestp.a.Whatistheamountshe
willreceiveafter4years?
AnswerstoSelfAssessmentQuestions
SelfAssessmentQuestions1
1. Investmentopportunities,preferenceforconsumption,risk.
2. Higherpurchasingpower
3. Currentandfuture
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4. Compoundinganddiscounting
SelfAssessmentQuestions2
1. Sinkingfund
2. PresentValuePV
3. Perpetuity
4. CapitalRecoveryFactor.
AnswerstoTerminalQuestions
1. (Hint:Useruleof72and69)
2. 30000*FVIFA(9%,20Y)=30000*51.160=Rs.1534800
3. A*FVIFA(12%,10y)=400000whichis400000/17.549=Rs.22795
4. 20000*PVIFA(105,5y)=20000*3.791=Rs.75820
5. 5000*FVIFA(10%,5y)=5000*6.105=Rs.23205
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Unit4 ValuationOfBondsAndShares
4.1 Introduction
4.2 ValuationofBonds
TypesofBonds
4.2.1 IrredeemableorPerpetualBonds
4.2.2 RedeemableorBondswithMaturityPeriod
4.2.3 ZeroCouponBond
BondyieldMeasures
4.2.1 HoldingPeriodRateofReturn
4.2.2 CurrentYield
4.2.3 YieldtoMaturity(YTM)
4.2.4 BondValueTheorems
4.3 ValuationofShares
4.3.1 ValuationofPreferenceShares
4.3.2 ValuationofOrdinaryShares
4.4 Summary
SolvedProblems
TerminalQuestions
AnswerstoSAQsandTQs
4.1 Introduction
Valuationistheprocessoflinkingriskwithreturnstodeterminetheworthofanasset.Assetscanbe
realorfinancialsecuritiesarecalledfinancialassets,physicalassetsarerealassets.Theultimate
goalof any individual investor ismaximizationof profits. Investmentmanagement isa continuous
processrequiringconstantmonitoring.Thevalueofanassetdependsonthecashflowitisexpected
toprovideover theholdingperiod.Thefact thatasondate there isnomethodbywhichpricesof
shares and bonds can be accurately predicted should be kept in mind by an investor before he
decides to take an investment decision. The present chapter will help us to know why some
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51
securitiesarepricedhigher thanothers.Wecandesignour investment structurebyexploiting the
variablestomaximizeourreturns.
Ordinarysharesareriskierthanbondsordebenturesandsomesharesaremoreriskythanothers.
Theinvestorwouldthereforecommitfundsonashareonlyifheisconvincedabouttherateofreturn
beingcommensuratewithrisk.
LearningObjectives:
Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.
1. KnowthemeaningofvalueasusedinFinanceTheory.
2. UnderstandthemechanicsofBondvaluation,and
3. Understandthemechanicsofvaluationofequityshares.
Concept of Intrinsic value: A security can be evaluated by the series of dividends or interest
paymentsreceivableoveraperiodoftime.Inotherwords,asecuritycanbedefinedasthepresent
valueofthefuturecashstreamstheintrinsicvalueofanassetisequaltothepresentvalueofthe
benefitsassociatedwith it. Theexpected returns (cash inflows)arediscountedusing the required
returncommensuratewiththerisk.Mathematically,itcanberepresentedby:
V0=C1/(1+i)1+C2/(1+i)2+C3/(1+i)3+Cn/(1+i)n
=Cn/(1+i)n
WhereV0=Valueoftheassetattimezero(t=0)
P0=Presentvalueoftheasset
Cn=Expectedcashflowattheendofperiodn
i=Discountrateorrequiredrateofreturnonthecashflows
n=Expectedlifeofanasset.
Example:
Assumingadiscount rateof10%and thecashflowsassociatedwith2projectsAandBovera3
yearperiod,determinethevalueoftheassets.
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Year CashflowsofA(Rs.)
CashflowsofB(Rs)
1 20000 10000
2 20000 20000
3 20000 30000
Solution:
ValueofassetA=20000PVIFA(10%,3y)
=20000*2.487
=Rs.49470
ValueofassetB=10000PVIF(10%,1)+20000PVIF(10%,2)+30000PVIF(10%,3)
=10000*0.909+20000*0.826+30000*0.751
=9090+16520+22530
=Rs.48140
Example:
CalculatethevalueofanassetiftheannualcashinflowisRs.5000peryearforthenext6yearsand
thediscountrateis16%.
Solution:
Valueoftheasset=Cn/(1+i)n
=5000/(1+0.16)6
Or =5000PVIFA(16%,6y)
=5000*3.685
=Rs.18425
4.1.1ConceptsofValue
Bookvalue:Bookvalueisanaccountingconcept.Valueiswhatanassetisworthtodayintermsof
theirpotentialbenefits.Assetsarerecordedathistoricalcostandthesearedepreciatedoveryears.
Bookvaluemayincludeintangibleassetsatacquisitioncostminusamortizedvalue.Thebookvalue
ofadebtisstatedattheoutstandingamount.Thedifferencebetweenthebookvalueofassetsand
liabilities isequal to theshareholdersnetworth. (Networth is thesumtotalofpaidupcapitaland
reservesandsurplus).Bookvalueo