FINANCIAL MANAGEMENT

Objectives1. Wealth maximization.2. Profit maximization The main objective of Financial

management is to increase the value of the company.That is maximizing shareholders wealth.Hence,wealth maximization is superior to profit maximization.

Contd…

Financial ManagementStudies the financial problems in

individual firms.Seek sources of financing.Seek profitable investments.

Financial Management Contd…https://www.youtube.com/watch?v=pLuNpzvrDw8

PROJECT APPRAISAL

1.CAPITAL EXPENDITURE.Often involve bigger outlay of money & the benefits from capital expenditure are likely to accrue over a long period of time. Usually well over one year and often much longer.Therefore any proposed capital expenditure project should be properly appraised,and found to be worthwhile,before the decision is taken to go ahead with the expenditure.

Contd…Many different Investment projects exist including, Replacement of assets.New product or service developments.Product or Service expansions.Environmental and welfare proposals, etc..

Project Appraisal Techniques

1.The payback period.2.Accounting rate of return.(ARR).3.Net Present Value(NPV).4.Internal Rate of Return.(IRR).

1.The payback period.

This shows how long an investor has to wait to repay his investment. Payback is the time required for the cash inflows from capital investment project to equal the cash outflows. This is the time which elapses until the invested capital is recovered.Assumed that the cash flows occur evenly during the year.

Computation of Payback

Period.

1.For Constant Annual Cash Flows.

Payback Period = Initial Investment Annual Cash Inflows

Practice Question -01An expenditure of Rs.2 million is expected to generate net cash inflows of Rs.500,000 each year for the next seven years.Compute the payback period.

Answer –Payback Period = Initial Investment Annual Cash Inflow = 2,000,000 500,000 = 4 Years.

2. For Uneven Annual Cash Flows.

The payback has to be calculated by working out the cumulative cash flow over the life of a project.

Practice Question -02 A company intends to invest in a project with a total sum of Rs.100 million.The expected net cash flows from the project would be as follows.

Year Net cash flows (millions)01 Rs.3002 Rs.4503 Rs.2004 Rs.1505 Rs.10

Compute payback period of the project.

Answer –

Year NCF Cum NCF 0 (100) (100) 1 30 (70) 2 45 (25) 3 20 (5) 4 15 10 5 10 20

Pay back Period =3Yrs +(5/15*12) =3yrs +4 months.

3.Mutually Exclusive Projects.Faced with a choice between mutually exclusive projects,choose the project with the quickest payback (provided it meets the company’s target payback period).

Practice Question -03A Ltd. Is a company which evaluates two mutually exclusive projects and only one of them can be undertaken.The details of investment and cash flows from such projects are given below.

Project A Project B (Rs) (Rs)

Capital Assets (9,000) (10,000)ProfitYear 1 3,000 8,000Year 2 4,000 4,000Year 3 6,000 500Year 4 7,000 500Year 5 8,000 500

Select the project based on payback period.

Answer –Payback PeriodProject A=2 yrs + (2/6*12) = 2Yrs & 4 Months.

Project B=1 Yrs + (2/4*12) =1 Yrs & 6 Months

2.Accounting Rate of Return (ARR)(ROCE/ROI)A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.  ARR = Average Profit * 100

Average Investments

Notes1.The average profit is after depreciation.2.The average value of the investment represents the average capital employed over the life of the project.

Average Investment = Initial Investment + Residual Value

2Decision Criteria(Single Project) – Project ARR > Target ARR

Mutually Exclusive Projects Practice Question -04Project AInitial Investment Rs.450,000Scrap value at the end of year 5 Rs. 20,000

Year 1 2 3 4 5Annual CF’s (Rs.000) 200 150 100 100 100

Project BInitial Investment Rs.100,000Scrap value at the end of year 5 Rs. 10,000

Year 1 2 3 4 5Annual CF’s (Rs.000) 50 40 30 20 20

Calculate the ARR(ROI) for each project,and indicate which project should be chosen.

Answer-Project A =(650000-(450000-20000))/5 * 100

(450,000+20000)/2 = 18.72%

Project B =(160,000-(100,000-10,000))/5 *100 (100,000+10,000)/2 = 25.4%

Based on ARR technique the project “B” would be recommended since it will resulting higher ARR.

ROI (ARR/ROCE)https://www.youtube.com/watch?

v=7fB-3Xh2IXg

The Time Value of MoneyMoney received today is worth more than the

same sum received in the future,because it has a time value.

Today Rs.100.00 How much worth it in year 1?Eg:If offered the choice between Rs.100 now or the

expectation of Rs.100 in a year’s time,then most people will prefer the Rs.100 now.However,what if the choice is between Rs.100 now and Rs.105 in one year or Rs.110 or ….?

Suppose you are indifferent between Rs.100 now or the expectation of Rs.112 in one year –this would indicate that your time value of money can be expressed as an interest rate of 12% per annum.

Contd…Discounted cash flow (DCF) techniques take account of this time value of money when appraising investments.Reasons for time value of moneyConsumption Preferences.Impact of Inflation(Price Level).Risk

Compound InterestA sum invested to day will earn

interest.Compounding calculates the future value(terminal value) of a given sum invested today for a number of years.

To compound a sum,the figure is increased by the amount of interest it would earn over the period.

Contd… V = X(1+r)n

Where V = Future Value X = Initial Investment(Present Value) r = Interest rate n = Number of time periods.

Practice Question -05

Rs.100,000 is invested in an account for five years .The interest rate is 10% per annum.Compute the future value of the investment after five years.

AnswerV = X(1+r)nFuture Value = 100,000(1.10) 5

= Rs.161,051 Future value represent that

Rs.100,000/- to day is equivalent to Rs.161,051/- at the end of year 05,at the interest rate of 10% per annum.

There fore due to the rate of interest the time value of money is different from year 01 & year 05.

DiscountingPresent Value = Future Value *

Discount Rate

Discount Rate = 1 (1+r)n

Eg –How much should be invested now in order to have Rs.250million in eight years time?The account pays 12% interest per annum.

Contd..Discount Rate = 1 (1+r)n

= 1 (1.12)8

= 0.4038

PV = Rs.250Mn *0.4038 = Rs.100Mn

It means that Rs.250Mn in 08 years time is equivalent to Rs.100 Mn to day at the interest rate of 12% per annum.

Cost of Capital of the Company (WACC)This is computed based on the

actual cost of the finance of a project.This shows the average cost of different financing methods.

Eg : Asiri is a company which is engaged in hospital projects.The total investment of the company is Rs.1,000 Mn.The sources of finance are as follows.

WACC

Source of Finance Rs(Mn) Rate of Return

Shares & Equity 500 Dividend@20%

Debentures 300 Interest @ 18%

Long term Loan 200 Interest @ 16%

Calculation of WACC

Source Rs(Mn) Annual CostEquity 500 500 * 20% =100Debentures 300 300 * 18% = 54Loan 200 200 * 16% = 32

1000 186

WACC = 186 *100 1000

= 18.6%

WACC

The cost of capital represent the actual cost from the alternative source of finance.Accordingly where the project generate higher return than the company cost of capital,the project is viable.

Net Present Value (NPV)The net benefit or loss in present value

terms from an investment opportunity.

NPV =PV of Inflows – PV of OutflowsNPV = PV of net cash flows. Decision Criteria (Single Project)NPV is positive = Project AcceptNPV is negative = Project Not AcceptNPV is Zero = Just Accept

(Project Break Even)

NPV Contd…

https://www.youtube.com/watch?v=HFFkFMfotT0

https://www.youtube.com/watch?v=zGRVVSC4UUQ

NPV Mutually Exclusive Projects. Practice Question - 06 Healthcare Ltd is considering two mutually-exclusive projects

with the following details.

Project AInitial Investment Rs.450,000Scrap value at the end of year 5 Rs. 20,000

Year 1 2 3 4 5Annual CF’s (Rs.000) 200 150 100 100 100

Project BInitial Investment Rs.100,000Scrap value at the end of year 5 Rs. 10,000

Year 1 2 3 4 5Annual CF’s (Rs.000) 50 40 30 20 20

NPV

Assume that the initial investment is at the start of the project and the annual cash flows are at the end of each year.

Required : Calculate the Net Present Value for

projects A and B if the relevant cost of capital is 10%.

NPVComputation of NPV (Rs.000)Project AYear Invest Inflows NCF DF 10% PV 0 (450) - (450) 1.00

(450.00) 1 - 200 200 0.9091 181.82 2 - 150 150 0.8264 123.97 3 - 100 100 0.7513 75.13 4 - 100 100 0.6830 68.30 5 20 100 120 0.6209 74.51

NPV 74.00

NPVProject BYear Invest Inflows NCF DF 10% PV 0 (100) - (100) 1.00

(100.00) 1 - 50 50 0.9091

45.45 2 - 40 400.8264 33.05 3 - 30 30 0.7513 22.53 4 - 20 20 0.6830 13.66 5 10 20 30 0.6209 18.62

NPV 33.31

NPV contd..

Recommendation The both projects are profitable

as both will give you positive NPV. However since the projects are mutually exclusive, project A is recommended since the project A will generate higher NPV.

NPV Contd..

Timing of cash flowsY0 =NowY1 =End of year 1Y2 =End of year 2 If the cash flow occurred in start

of the year, then it should be considered as it generated in the previous year end.

Y1 = Beginning of Year 2

Annuity

An annuity is a constant cash flow from year to year.

PV of Annuity = Annuity * Annuity Factor

1Annuity Factor = (1+r)n - 1

r r = Discount rate n = No of years

Contd..

Eg :What is the present value of Rs.500,000 in contribution earned each year from years 1-5,when the required return on investment is 15%.

PV of Annuity = 500,000 *3.3522 =1,676,100

Internal Rate of Return (IRR)This is the rate of return at which

the project has a NPV of Zero.

Decision CriteriaIRR > COC = Accept the projectIRR < COC = Not accept.

IRR

IRR = L + NL * (H –L) NL - NH

L = Lower rate of interestH = Higher rate of interestNL = NPV at lower rate of interest.NH = NPV at higher rate of interest

IRR Contd..Practice Question -07 Calculate the internal rate of

return of the project with following NPV at different discounting factor.

At 10% the NPV was Rs.33,310/-At 20% the NPV is Rs.8,510/-At 30% the NPV is –Rs.9,150/-

Answer

IRR = L + NL * (H –L) NL - NH = 20% + 8510 * 10% (8510+9150) =24.8% IRR is at 24.8%,in other words

where the cash flow is discounted at 24.8%, NPV should be exactly 0.

THANK YOU !!