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E2-E3

Finance

Financial Management

WELCOME

• This is a presentation for the E2-E3 (Finance)

• Module for the Topic: Introduction to financial

management

• Eligibility: Those who have got the Upgradation from E2

to E3.

• This presentation is last updated on 15-3-2011.

• You can also visit the Digital library of BSNL to see this

topic.

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Financial Management Definitions

Financial management is the operation activity of a

business that is responsible for obtaining and effectively

utilizing the funds necessary for efficient operations.

-- Joseph and Massie

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. Financial management is the area of business

management devoted to a judicious use of capital and a

careful selection of sources of capital in order to enable

a business firm to move in the direction of reaching its

goals.

J.F.Bradlery

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. Financial management may be defined as that area or

set of administrative functions in an organization which

relate with arrangement of cash and credit so that

organization may have the means to carryout its

objective as satisfactorily as possible.

Howard and Opton

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Introduction to financial management

Financial management is concerned with :

• Raising of funds in a most economic and suitable

manner

• Using these funds profitably.

• Planning future operations.

• Controlling current performances.

• Controlling future developments

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Introduction to financial management

• Objectives of financial management

– Maximisation of the profits of the firm

– Maximisation of the shareholders wealth

– Maximisation of cash flow

– Maximising return on capital employed

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Introduction to financial management

• EVA : is emerging as a popular measure to understand and

evaluate financial performance of the company.

– EVA compares the return on capital employed with cost of

the capital. i.e, returns earned by the company in excess of

the minimum expected return of the shareholder

– EVA will increase if

• Operating profits grow without additional capital

• If additional capital invested gives higher returns

• Unproductive capital is liquidated

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Introduction to financial management

• Theory of financial management is based on the following

– Time value of money

– Risk – return trade off

– Cash flows and accounting profits

– Incremental cash flows

– Tax implications are incorporated before a decision is

made

– Market price of a share is right and reflects all

information available with the public

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Long-term funds procurement

• Long-term funds are necessary for

– The initial setting up of a business organization,

– Its expansion and also

– Meeting a part of its operational requirements

• Long term funds may be in the form of owner participation,

bonds, debentures or loans from institutions

• Accurate assessment of the requirements of LT funds is

necessary to avoid distress through either short-fall or

unnecessary payment of interest-charges.

• Availability, cost, existing capital structure and repayment terms

are to be taken into consideration while making decisions for LT

funds.

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Capital Structure

Funds, the life blood of every enterprise, are required for

the financing of fixed assets and current assets. Following

are the sources of long term finance commonly employed

by business firms:-

• Retained earnings

• Equity Capital

• Preference Capital

• Debenture capital

• Term loans

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Retained Earnings

Evaluation

Firm’s Point of View –Retained earnings are viewed

very favourably by most corporate managements for

the following reasons:

1. Readily available internally.

2. Effectively represent infusion of additional equity

in the firm.

3. No dilution of control.

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Retained Earnings

Disadvantages of retaining earnings are

• The amount that can be raised by way of retained

earnings may be limited. The quantum of retained

earnings tends to be highly variable.

• The opportunity cost of retained earnings is quite high.

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Equity Capital

Equity capital presents ownership capital as equity

shareholders collectively own the company. They enjoy

the rewards and bear the risk of ownership.

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Equity Capital

Evaluation

The most important source of long-term funds, equity

capital offers the following advantages:-

1. It represents permanent capital. Hence, there is

no liability for repayment.

2. It does not involve any fixed obligation for

payment of dividends.

3. It enhances the creditworthiness of the

company.

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Preference Capital

Preference capital represents a hybrid form of financing

– it partakes some characteristics of equity and some

attributes of debentures.

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Preference Capital

Evaluation

There are some advantages in issuing preference

capital from the company’s point of view :-

1. There is no legal obligation to pay preference

dividend. A company does not face bankruptcy,

or legal action if it skips preference dividend.

2. There is no dilution of control.

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Debenture Capital

Debentures are instruments for raising long term debt

capital. Debenture holders are creditors of the company.

The obligation of the company towards its debenture

holders is similar to that of a borrower who promises to

pay interest and capital at a specified times.

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Debenture Capital

Evaluation

Debenture offer the following advantages to the

issuing company –

1. Cost of debt capital , represented by debentures,

is lower than the cost of preference or equity

capital.

2. Debenture financing does not result in dilution of

control.

3. The fixed monetary burden associated with

debenture financing , irrespective of changes in

price level, has appeal to many companies.

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Term Loan

Term loans, also referred to as term finance, represent a

source of debt finance which is generally repayable in

more than one year but less than 10 years. They are

employed to finance acquisition of fixed assets and

working capital margin. Term loan differ from short term

bank loans which are employed to finance short[term

working capital and liquidated over a period of time,

usually less than one year.

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Term Loan

Evaluation

Term loans offer the following advantages to the

borrower:-

• In post-tax terms, the cost of term loans is lower

than the cost of equity capital or preference

capital.

• Term loan do not result in dilution of control, as

lenders do not have the right to vote.

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Comparison of Long-term Sources of Financing

Instrument Cost Dilution of

control

Risk Restraint on

Mgmt.

Retained

Earnings

High No Nil No

Eq.Capital High Yes Nil No

Pref. Cap High No Negligible No

Debenture Low No High Some

Term loans Low No High Moderate

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Capital Structure Planning

Issues relating to Capital Structure Planning

There is no one optimum capital structure which is

suited to all the enterprises.

External forces and regulations influence the capital

structure. Such regulations relate to the fiscal and

monetary policies of the Government.

Management Policies regarding their reliance on

various sources.

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Capital Market

The Capital market can be looked as :-

a) A market for new securities issued by

companies, known as the Primary Market, or

b) A market for trading securities already issued,

known as the Secondary Market

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Long term investment decision

• Key considerations in making investment decisions are:

1. What is the scale of the investment - can the

company afford it?

2. How long will it be before the investment starts to

yield returns?

3. How long will it take to pay back the investment?

4. What are the expected profits from the investment?

5. Could the money that is being ploughed into the

investment yield higher returns elsewhere?

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Nature of CAPEX Decisions

• Cost: Huge investments

• Time: When to Invest? Consequences in uncertain future

• Irreversibility: Irreversible or reversible at a substantial

cost or at heavy loss

• Consequence extend over a long period of time

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Nature of CAPEX Decisions

• Complexity:

– Forecasting future cash outflows and inflows are

difficult

– Constantly changing technologies

– Constantly changing customer preferences

– Severe Competition in Telecom sector

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Steps in CAPEX Decisions

• Identification of potential Investment Opportunities by

carefully screening the :

• New / emerging technologies

• New uses for existing technologies / infrastructure

• Customer needs perceived through market surveys

and customer feedback

• Need to spread to different / New locations

• New opportunities indicated by the growth path of

competitors

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Steps in CAPEX Decisions

• Preliminary Screening of Opportunities

Criteria typically applied are

• Compatibility with the company’s existing technology

• Existing and potential skill

• Organizational environment

• Lead time

• Easy availability of technology / equipment and their

potential sources

• Reasonableness of costs

• Associated risks (like obsolescence)

• Competition in the segments

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Steps in CAPEX Decisions

• Feasibility Studies Involves :

• Preparation of detailed Project Report

• Examining the marketing, technical, financial and

economic feasibility aspects

• Specific estimates of cost and benefits

• Means of raising funds

• Schedules of implementation

• Profitability estimates

• Social benefits

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Steps in CAPEX Decisions

• Implementation :

• Equipment selection And procurement

• Construction

• Training

• Trial run

• Commissioning

• Equipment maintenance planning

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Steps in CAPEX Decisions

• Dealing with implementation delays :

• PERT (Project evaluation review technique)

• CPM (critical path method)

• Assigning specific time bound responsibilities to the

nominated project managers for different

implementation stages in clear terms

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Steps in CAPEX Decisions

• Performance review :

After implementation the project must be reviewed

• To see whether it matches the revenue and

performance projections made in the project report

• Reasons for variations

• Appropriate remedial action

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Appraisal of CAPEX Decision

• Market Appraisal

• Size of the market in the area

• Expected share of the project

• Past trends

• Expected future trends

• Results of market surveys

• Assessment of specific customer requirements in the

area

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Appraisal of CAPEX Decision

• Technical Appraisal :

• Technical feasibility

• Required scale of operations

• Existing infrastructure of power, land and buildings

etc.,

• Required technology to support anticipated customer

requirements

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Appraisal of CAPEX Decision

• Economic appraisal

• Social cost benefit analysis

• Especially in respect of government supported

projects and Government specified targets

• Indicates the impact of the project on the society it

serves

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Appraisal of CAPEX Decision

• Financial appraisal

• The investment analysis must estimate the cash outflows

(on investments and working capital outflows) and the

cash inflows (Revenue) and apply the standard decision

rules to determine whether the investment satisfies the

requisite decision criteria

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A’s OF FINANCIAL MANAGEMENT

• Anticipating financial needs.

• Acquiring financial resources.

• Allocating funds in business

• Administering the allocation of funds.

• Analyzing the performance of funds.

• Accounting and reporting to managers.

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