Financial management is the operational activity of a business that is responsible for obtaining and effectively

utilising the funds necessary for efficient operations

Joseph and Massie

Financial management is that managerial activity which is concerned with the planning and controlling of the firm’s financial resources

SCOPE AND FUNCTIONS OF FINANCIAL MANAGEMENT

First approach(Traditional approach)

Second Approach Third approach(Modern approach)

1. Investment decision2. Financing decision3. Dividend decision

Capital budgetingworking capital decision

OBJECTIVES OR GOALS OF FINANCIAL MANAGEMENT

I . Profit maximisation

Reasons

a. Profit is the test of economic efficiencyb. It is difficult to survive with out profitc. It leads to efficient allocation of resourcesd. Profit ensure maximum social welfare(i,e maximum

dividend to shareholders, timely payment to creditors, more and more wages to employees, more employment opportunities etc)

DISADVANTAGES OF PROFIT MAXIMISATION

I . PROFIT MAXIMISATION

1. AmbiguityIt is vague and ambiguous concept

2. Timing of benefitIt ignores the time pattern of benefit

Alternative (A) Alternative (B)

Period I 5000 -

Period II 10000 10000

Period III 5000 10000

Total 20000 20000

3. Quality of benefits

Alternative A AlternativeB

RecessionPeriod(I)

900 -

Normal Period (II)

1000 1000

BoomPeriod (III)

1100 2000

Total 3000 3000

II . WEALTH MAXIMISATION

TIME VALUE OF MONEY

A B10000 loan

One Year

Market value of interest 10%

Reasons

1. More purchasing power2. An investor can profitably invest which make him to give a higher value

TIME VALUE OF MONEY

Compounding value concept(Future value of present money)

Discounting orPresent value concept(Present value of future money)

RISK AND RETURN

The chance of future loss that can be foreseenRisk :

The unforeseen chance of future loss or damage

Eg : Earth quake, Coup

Uncertainty :

It represents the benefits derived by a business from its operations

Return:

METHODS OF RISK MANAGEMENT

Avoidance of risk

Prevention of risk

Transfer of risk

Retention of risk

Insurance

CAPITAL BUDGETING

Investment in fixed assets

Benefits derived in future which spreads over no: of years

NEED FOR CAPITAL BUDGETING

Large investments

Irreversible nature

Difficulties of investment decision

Long term effect on profitability

EVALUATION OF INVESTMENT PROPOSALS

Traditional methods Discounted cash flow method

1. Payback period method 2. Average rate of return method

1. Net present value (NPV method)2. Internal rate of return method (IRR)3. Profitability index (PI method)

I. TRADITIONAL METHOD

1. Pay back period method or pay out or pay off period method

Representing the no of years required to recover the original investment

Under this method projects are ranked on the basis of length of payback period

Payback period = Initial investment

annual cash inflow

Note: Annual cash inflow is the annual earnings (Profit before depreciation and after tax)

Payback period = Initial investment cumulated annual cash inflow

Un even cash inflow

Investment proposals are judged on the basis of their relative profitability

Projects with higher rate of return is accepted

ARR = Average income after tax and depreciation x100 Average investment

Average investment = Original investment

2

Average investment = original Cost - Scrap value

2

+ additional W.C +Scrap value

2. Average rate of return method or Rate of return method or Accounting rate of return method

II. DISCOUNTED CASH FLOW METHODS

OR TIME ADJUSTED TECHNIQUE

1 Net present value method

Best method for evaluating the capital investment proposals

It gives consideration to the time value of money

Formula=Discounted cash inflow-Discounted cash outflow

Note1 : If only in the beginning initial investment is made, then the discounted cash outflow will be the same i.e.,

initial investment

Note2 : Cash inflow means profit before depreciation and after tax

If NPV is zero or positive the project can be accepted

2. Profitability index method

This method is also called benefit cost ratio

PI = Present value of cash inflow Present value of cash outflow

PI is equal to or more than one the proposal can be accepted

3. Internal rate of return (IRR)

IRR is that rate at which the sum of discounted cash inflow equals the sum of discounted cash outflows

L = Lower discount rate P1 = Present Value at lower rateP2 = Present Value at higher rateQ = Actual investmentD = Difference in rate

P1 – Q IRR = L+

P1-P2 xD

COST OF CAPITAL

Rate of return expected by the suppliers of capital

Importance of cost of capital

Capital budgeting decision

(Business must earn at least a rate which is equal to its cost of capital in order to

make at least a break even)

Capital structure decision (Raise capital from different sources which optimizes the risk and cost factors)

COMPUTATION OF COST OF CAPITAL

I. COST OF DEBT (PERPETUAL OR IRREDEEMABLE)

a. Debt issued at par = Kd =(1-T)R

Kd =Cost of debt, T=Marginal Tax rateR= Debenture interest rate OR R= Annual Interest :- Net Proceeds of Loan or debentures

b. Debt issued at premium or discount

Formula = Kd = (1-T)R

Here R = I Where I = Annual interest payment NP

NP = Net proceeds of loan or debentures

II. COST OF REDEEMABLE DEBT

a. Issued at par redeemable at par

Kd= I+(Rv-Sv)/nm

(Rv +Sv)/2

I = annual interest Rv = Payable value at the time of maturitySv=Sales price or (face value of debt - Expenses)Nm = Term of debt or no: of years

b. Debt issued at premium redeemable at par

Kd = I + F - P Nm Nm

(Rv + Sv)/2

P = premium on debentureF=Flotation cost

c. Issued at discount redeemable at par

D = Discount on debentureF=Flotation cost

Kd = I + F + D Nm Nm

(Rv + Sv)/2

III. COST OF PREFERENCE SHARES

a. Cost of preference shares : Irredeemable

Kp= d

P0 (1-F)

WhereKp = Cost of preference sharesd = Constant annual dividend payment Po= Expected sales price of preference sharesF= Flotation cost

Kp= d+(Rv-Sv)/nm

(Rv+Sv)/2

b. Cost of preference share : Redeemable

IV. COST OF EQUITY CAPITAL

a. Dividend approach

P0 = face value or market price per share G=growth rate

Ke= D1

P0+g

b. Earnings approach

Ke = Cost of equityE0 = Current earnings per share or Total earnings

Share outstandingP0 = Current net proceeds per share or (net proceeds per share - flotation cost)

Ke= E0

P0

V. COST OF RETAINED EARNINGS

Kr = Ke(1-T) ( 1-B)

T= TaxB=Brokerage

Ke = Shareholders required rate of return

Or

Ke = D1 +g

P0

WEIGHTED AVERAGE COST OF CAPITALOR OVERALL COST OF CAPITAL

It involves the following steps

1. Calculation of the cost of each specific source of funds.

2. Assigning weights to specific costThis involves determination of the proportion of each source of

funds in the total capital structure of the company.

3. Adding of the weighted cost of all sources of funds to get an overall weighted average cost of capital.