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Leverage
Finance
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain
leverage are borrowing money, buying fixed assets and using derivatives. Wikipedia
CASH FLOW STATEMENT
_A statement of changes in financial position on
cash basis, commonly known as the cash flow
statement, summarizes the causes of changes in
cash position between dates of the two balance
sheets.
_ It indicates the sources and uses of cash.
_This statement analyzes changes in noncurrent
accounts as well as current accounts (other than
cash) to determine the flow of cash.
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Sources of Cash
_The profitable operations of the firm,
_ Decrease in assets (except cash),
_ Increase in liabilities (including debentures or
bonds), and
_ Sale proceeds from an ordinary or preference
share issue.
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Uses of Cash
_The loss from operations
_Increase in assets (except cash)
_Decrease in liabilities
_Redemption of redeemable preference
shares
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_Cash dividends
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Comprehensive Cash Flow Statement:
Financial Resources Basis
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ACME Company
USES OF THE STATEMENT OF CHANGES IN
FINANCIAL POSITION
It helps to answer the following questions:
_ What is the liquidity position of the firm?
_ What are the causes of changes in the firm’s working capital or cash
position?
_ What fixed assets are acquired by the firm?
_ Did the firm pay dividends to its shareholders or not? If not, was it due to
shortage of funds?
_ How much of the firm’s working capital needs were met by the funds
generated from current operations?
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Cont…
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_ Did the firm use external sources of finances to meet its needs of
funds?
_ If the external financing was used, what ratio of debt and equity
was maintained?
_ Did the firm sell any of its non-current assets? If so, what were the
proceeds from such sales?
_ Could the firm pay its long-term debt as per the schedules?
_ What were the significant investment and financing activities of
the firm that did not involve working capital?
Financial Management
Important Business Activities
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_Production
_Marketing
_Finance
Real And Financial Assets
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_ Real Assets: Can be Tangible or Intangible
_ Tangible real assets are physical assets that include
plant, machinery, office, factory, furniture and building.
_ Intangible real assets include technical know-how,
technological collaborations, patents and copyrights.
_ Financial Assets are also called securities, are
financial papers or instruments such as shares and
bonds or debentures.
Equity and Borrowed Funds
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_ Shares represent ownership rights of their holders.
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Shareholders are owners of the company. Shares can of
two types:
_ Equity Shares
_ Preference Shares
_ Loans, Bonds or Debts: represent liability of the firm
towards outsiders. Lenders are not owners of the
company. These provide interest tax shield.
Equity and Preference Shares
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_ Equity Shares are also known as ordinary shares.
_ Do not have fixed rate of dividend.
_ There is no legal obligation to pay dividends to equity
shareholders.
_ Preference Shares have preference for dividend
payment over ordinary shareholders.
_ They get fixed rate of dividends.
_ They also have preference of repayment at the time of
liquidation.
Finance and Management
Functions 6
_All business activities involve acquisition
and use of funds.
_Finance function makes money available
to meet the costs of production and
marketing operations.
_Financial policies are devised to fit
production and marketing decisions of a
firm in practice.
Finance Functions
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Finance functions or decisions can be
divided as follows
_ Long-term financial decisions
• Long-term asset-mix or investment decision or capital
budgeting decisions.
• Capital-mix or financing decision or capital structure
and leverage decisions.
• Profit allocation or dividend decision
_ Short-term financial decisions
• Short-term asset-mix or liquidity decision or working
capital management.
Financial Procedures and
Systems 8
_For effective finance function some routine
functions have to be performed. Some of these
are:
_Supervision receipts and payments and safeguarding
of cash balances
_Custody and safeguarding of securities, insurance
policies and other valuable papers
_Taking care of the mechanical details of new outside
financing
_Record keeping and reporting
Finance Manager’s Role
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_Raising of Funds
_Allocation of Funds
_Profit Planning
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_Understanding Capital Markets
Financial Goals
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_Profit maximization (profit after tax)
_Maximizing earnings per share
_Wealth maximization
Profit Maximization
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_Maximizing the rupee income of firm
_Resources are efficiently utilized
_Appropriate measure of firm performance
_Serves interest of society also
Objections to Profit
Maximization 12
_It is Vague
_It Ignores the Timing of Returns
_It Ignores Risk
_Assumes Perfect Competition
_In new business environment profit
maximization is regarded as
_ Unrealistic
_ Difficult
_ Inappropriate
_ Immoral
Maximizing Profit after Taxes
or EPS 13
_Maximising PAT or EPS does not
maximise the economic welfare of the
owners.
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_Ignores timing and risk of the expected
benefit
_Market value is not a function of EPS.
_Maximizing EPS implies that the firm
should make no dividend payment so long
as funds can be invested at positive rate of
return—such a policy may not always
work.
Shareholders’ Wealth
Maximization 14
_Maximizes the net present value of a
course of action to shareholders.
_Accounts for the timing and risk of the
expected benefits.
_Benefits are measured in terms of cash
flows.
_Fundamental objective—maximize the
market value of the firm’s shares.
Need for a Valuation
Approach 15
_SWM requires a valuation model.
_The financial manager must know,
_ How much should a particular share be worth?
_ Upon what factor or factors should its value
depend?
Overview of Financial
Management 16
Agency Problems: Managers Versus
Shareholders’ Goals
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_There is a Principal Agent relationship
between managers and shareholders.
_In theory, Managers should act in the best
interests of shareholders.
_In practice, managers may maximise their
own wealth (in the form of high salaries and
perks) at the cost of shareholders.
Agency Problems: Managers
Versus Shareholders’ Goals 18
_Managers may perceive their role as reconciling
conflicting objectives of stakeholders. This
stakeholders’ view of managers’ role may
compromise with the objective of SWM.
_Managers may avoid taking high investment and
financing risks that may otherwise be needed to
maximize shareholders’ wealth. Such “satisfying”
behaviour of managers will frustrate the objective
of SWM as a normative guide.
_This conflict is known as Agency problem and
it results into Agency costs.
Agency Costs
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_Agency costs include the less than
optimum share value for shareholders and
costs incurred by them to monitor the
actions of managers and control their
behaviour.
Financial Goals and Firm’s Mission
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and Objectives
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_Firms’ primary objective is maximizing the welfare
of owners, but, in operational terms, they focus on
the satisfaction of its customers through the
production of goods and services needed by them.
_Firms state their vision, mission and values in
broad terms.
_Wealth maximization is more appropriately a
decision criterion, rather than an objective or a
goal.
_Goals or objectives are missions or basic
purposes of a firm’s existence.
Financial Goals and Firm’s Mission
and Objectives
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_The shareholders’ wealth maximization is
the second-level criterion ensuring that the
decision meets the minimum standard of the
economic performance.
_In the final decision-making, the judgement
of management plays the crucial role.
_The wealth maximization criterion would
simply indicate whether an action is
economically viable or not.
Organisation of the Finance
Functions 22
_Reason for placing the finance functions in
the hands of top management
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_ Financial decisions are crucial for the survival of the
firm.
_ The financial actions determine solvency of the firm
_ Centralisation of the finance functions can result in a
number of economies to the firm.
Organisation of Finance
Function 23
Organization for finance function
Organization for finance function
in a multidivisional company
Status and Duties of Finance
Executives 24
_The exact organisation structure for
financial management will differ across
firms.
_The financial officer may be known as the
financial manager in some organisations,
while in others as the vice-president of
finance or the director of finance or the
financial controller.
Role of Treasurer and
Controller 25
_Two officers—the treasurer and the
controller—may be appointed under the
direct supervision of CFO to assist him or
her.
_The treasurer’s function is to raise and
manage company funds while the
controller oversees whether funds are
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correctly applied.
Financial and Economiic
Enviirronmentt
Fiinanciiall Enviironmentt
• Businesses interact continually with the
ffiinanciiall marrketts..
• Fiinanciiall Marketts are composed of all
institutions and procedures for bringing buyers
and sellers of financial instruments together.
• The purpose of financial markets is to
efficiently allocate savings to ultimate users.
Fllow off Funds iin tthe Economy
INVESTMENT SECTOR
FINANCIAL
INTERMEDIARIES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIAL
INTERMEDIARIES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
IINVESTMENT
SECTOR
Businesses
Government
Households
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IINVESTMENT
SECTOR
Fllow off Funds iin tthe Economy
FINANCIAL
INTERMEDIARIES
SAVIINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
SAVIINGS
SECTOR
Households
Businesses
Government
INVESTMENT
SECTOR
Fllow off Funds iin tthe Economy
FINANCIAL
INTERMEDIARIES
SAVINGS SECTOR
FIINANCIIAL BROKERS
SECONDARY MARKET
FIINANCIIAL
BROKERS
Investment
Bankers
Mortgage
Bankers
INVESTMENT
SECTOR
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Fllow off Funds iin tthe Economy
FIINANCIIAL
IINTERMEDIIARIIES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
FIINANCIIAL
IINTERMEDIIARIIES
Commercial Banks
Savings Institutions
Insurance Cos.
Pension Funds
Finance Companies
Mutual Funds
INVESTMENT
SECTOR
Fllow off Funds iin tthe Economy
FINANCIAL
INTERMEDIARIES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
SECONDARY
MARKET
Security
Exchanges
OTC
Market
INVESTMENT
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SECTOR
Fllow off Funds iin tthe Economy
Allllocattiion off Funds
• In a rational world, the highest expected returns will be
offered only by those economic units with the most
promising investment opportunities.
• Resulltt:: Savings tend to be allocated to the most efficient
uses.
• Funds will flow to economic units that are willing
to provide the greatest expected return (holding
risk constant).
Riisk--Expectted
Retturn Proffiille
RISK
EXPECTED RETURN (%)
US Treasury Biilllls ((riisk--ffree securiittiies))
Priime--grade Commerciiall Paper
Long-term Government Bonds
Investment-grade Corporate Bonds
Medium-grade Corporate Bonds
Preferred Stocks
Conservative Common Stocks
Speculative Common Stocks
What Influences Securiitty
Expectted Retturns?
• Marrkettabiilliitty is the ability to sell a
significant volume of securities in a
short period of time in the secondary
market without significant price
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concession.
• Deffaulltt Riisk is the failure to meet
the terms of a contract.
Rattiings by IInvesttmentt
Agenciies on Deffaulltt Riisk
IInvesttmentt grade represents the top four categories.
Below investment grade represents all other categories.
What Influences Expectted
Securiitty Retturns?
• Taxabiilliitty considers the expected tax
consequences of the security.
• Matturiitty is concerned with the life
of the security; the amount of time
before the principal amount of a
security becomes due.
Term Sttructture off
IIntterestt Rattes
A yield curve is a graph of the relationship between yields and term to
maturity for particular securities.
Upward Sllopiing Yiielld Curve
Downward Sloping Yield Curve
0 2 4 6 8 10
YIELD (%)
0 5 10 15 20 25 30
(Usual)
(Unusual)
YEARS TO MATURITY
Economic Environment
• Economic Environment refers to all forces which have an economic impact
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on Business.
• The economic environment consists of the demand dynamics, supply
situation, pricing factors, degree of competitiveness, and impact of
profitability. It includes the fiscal policy, monetary policy and the taxation
policy, the FDI norms, the investment criterion and financing decisions.
Economic environment includes:
• Growth strategy
• Industry
• Agriculture
• Infrastructure
• Money and Capital Markets
• Per capita and national income
• Population
• New Economic Policy
