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Financial Management

Contents

Unit 1

Financial Management 1

Unit 2

Financial Planning 18

Unit 3

Time Value of Money 41

Unit 4

Valuation of Bonds and Shares 61

Unit 5

Cost of Capital 87Unit 6

Leverage 106

Unit 7

Capital Structure 129

Unit 8

Capital Budgeting 146

Edition: Spring 2010

BKID B1134 4t

Jan. 2010

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Unit 9

Risk Analysis in Capital Budgeting 186

Unit 10Capital Rationing 213

Unit 11

Working Capital Management 232

Unit 12

Cash Management 252

Unit 13

Inventory Management 271

Unit 14

Receivables Management 289

Unit 15

Dividend Decision 308

References 331

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DeanDirectorate of Distance EducationSikkim Manipal University

Board of Studies

Chairman Mr. Pankaj KhannaHOD Management & Commerce DirectorSMU DDE HR, Fidelity Mutual Fund

Additional Registrar Mr. Shankar JagannathanSMU DDE Former Group Treasurer

Wipro Technologies Limited

Controller of Examination Mr. Abraham MathewSMU DDE Chief Financial Officer

Infosys BPO, Bangalore

Dr. T. V. Narasimha Rao Ms. Sadhna Dash

Adjunct Faculty & Advisor Ex-Senior Manager, HRSMU DDE Microsoft India Corporation (Pvt.) Ltd.

Prof. K. V. VaramballyDirectorManipal Institute of Management

ManipalContent Preparation TeamContent Writing Content Editing Peer Review ByProf. V. Narayanan Dr. T.V. Narasimha RaoDean, M.S. Ramaiah Institute Adjunct Faculty & AdvisorManagement, Bangalore SMU, DDE, Bangalore 560 008

Edition: Spring 2010

This book is a distance education module comprising of collection of learning

material for our students.

All rights reserved. No part of this work may be reproduced in any form by any

means without permission in writing from Sikkim Manipal University of Health,

Medical and Technological Sciences, Gangtok, Sikkim.

Printed and Published on behalf of Sikkim Manipal University of Health, Medical and

Technological Sciences, Gangtok, Sikkim by Mr. Rajkumar Mascreen, GM, Manipal

Universal Learning Pvt. Ltd., Manipal 576 104. Printed at Manipal Press Limited,

Manipal.

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Financial management deals with the management of financial resources ofa business firm. It discusses the goals of financial management and

emphasises on shareholder value maximisation. Financial management

mainly comprises of all managerial actions relating to the three major

decision areas such as Investment, Financing and Dividends and working

capital management. This courseware comprises 15 units:

Unit 1: Financial Management

This unit explains the meaning and scope of financial

management. It examines the goal of corporate financial

management.

Unit 2: Financial Planning

This unit gives a brief account of the meaning and need for

financial planning.

Unit 3: Time Value of Money

This unit introduces the concepts of time value of money,

compounding and discounting of cash flows.

Unit 4: Valuation of Bonds and Shares

This unit explains the principles behind the valuations of bonds and

equity shares.

Unit 5: Cost of Capital

This unit describes the concept of cost of capital and the

computation of the weighted average cost of capital.

Unit 6: Leverage

This unit describes the concepts of operating, financial and

combined leverage and gives the procedure for computing the

different types of leverage.

Unit 7: Capital Structure

This unit introduces the concept of capital structure and the

importance thereof. It also discusses the various theories of capital

structure.

SUBJECT INTRODUCTION

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Unit 8: Capital Budgeting

This unit explains the meaning and significance of capital

budgeting decisions. It gives a detailed account of various

investment appraisal techniques.

Unit 9: Risk Analysis in Capital Budgeting

This unit gives the meaning of risk, types and sources of risk in

capital budgeting decisions. It also analyses the various

approaches for handling the risk factor in investment decisions.

Unit 10: Capital Rationing

This unit explains the meaning of capital rationing. It also examines

the steps involved in capital rationing process.

Unit 11: Working Capital Management

This unit gives the meaning of various concepts of working capital.

It gives a detailed account of the factors that influence the working

capital requirements of a firm.

Unit 12: Cash Management

Cash is an important component of working capital. It needs to be

managed efficiently so as to avoid either excess cash balances or

cash shortages. This unit looks at different cash management

tools.

Unit 13: Inventory Management

This unit describes briefly the various forms of inventory that a firmkeeps. A brief description and pricing of inventory along with the

determination of stock levels are also explained.

Unit 14: Receivables Management

This unit gives the meaning of receivables management. Costs of

maintaining receivables, formulation of credit policy and

determination of an optimal credit period are discussed.

Unit 15: Dividend Decision

Dividends are payments made by firm to its shareholders.

Dividends form a part of the returns expected by the shareholders.This unit explains the dividend policy matters of a business firm

and the different types of dividends.

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Financial Management Unit 1

Sikkim Manipal University Page No. 1

Unit 1 Financial Management

Structure:

1.1 Introduction

Learning objectives

1.2 Meanings and Definitions

1.3 Goals of Financial Management

Profit maximisation

Wealth maximisation

Wealth maximisation vs. Profit maximisation

1.4 Finance Functions

Financing decisions

Investment decisions

Dividend decisions

Liquidity decision

Organisation of Finance Function

1.5 Interface between Finance and Other Business Functions

Finance and accounting

Finance and marketing

Finance and production (operations)

Finance and HR

1.6 Summary

1.7 Terminal Questions

1.8 Answers to SAQs and TQs

1.1 Introduction

Financial Management of a firm is concerned with procurement and

effective utilisation of funds for the benefit of its stakeholders. It embraces all

those managerial activities that are required to procure funds at the least

cost and their effective deployment.

The most admired Indian companies are Reliance and Infosys. They have

been rated well by the financial analysts on many crucial aspects thatenabled them to create value for its share holders. They employ the best

technology, produce good quality goods or render services at the least cost

and continuously contribute to the shareholders wealth. The three core

elements of financial management are:

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a. Financial Planning

Financial Planning is to ensure the availability of capital investments toacquire the real assets. Real assets are land and buildings, plants and

equipments. Capital investments are required for establishing and

running the business smoothly.

b. Financial Control

Financial Control involves managing the costs and expenses of a

business. For example, it includes taking decisions on the routine

aspects of day to day management of collecting money due from the

firms customers and making payments to the suppliers of various

resources.

c. Financial Decisions

Decision needs to be taken on the sources from which the funds

required for the capital investments could be obtained.

There are two sources of funds - debt and equity. In what proportion

the funds are to be obtained from these sources is to be decided for

formulating the financing plan.

In this unit, you will learn about these core elements of financial management.

1.1.1 Learning objectives

After studying this unit, you should be able to understand:

The meaning of Business Finance

The objectives of Financial Management

The various interfaces between finance and other managerial functions

of a firm

1.2 Meaning and DefinitionsFinancial Management is the art and science of managing money.

Regulatory and economic environments have undergone drastic changes

due to liberalisation and globalisation of Indian economy. This has changed

the profile of Indian finance managers. Indian financial managers havetransformed themselves from licensed raj managers to well-informed

dynamic proactive managers capable of taking decisions of complex nature.

Traditionally, financial management was considered a branch of knowledge

with focus on the procurement of funds. Instruments of financing, formation,

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merger and restructuring of firms and legal and institutional frame work

occupied the prime place in this traditional approach.The modern approach transformed the field of study from the traditional

narrow approach to the most analytical nature. The core of modern

approach evolved around the procurement of the least cost funds and its

effective utilisation for maximisation of share holders wealth.

Self Assessment Questions

Fill in the blanks:

1. What has changed the profile of Indian finance managers?

2. Finance management is considered a branch of knowledge with focus on

the __________.

1.3 Goals of Financial ManagementFinancial Management means maximisation of economic welfare of its

shareholders. Maximisation of economic welfare means maximisation of

wealth of its shareholders. Shareholders wealth maximisation is reflected in

the market value of the firms shares. Experts believe that, the goal of the

financial management is attained when it maximises its value. There are two

versions of the goals of financial management of the firm Profit

Maximisation and Wealth Maximisation (see figure 1.1).

Figure 1.1: Goals of financial management

GOALS

Profit

Maximisation

Wealth

Maximisation

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1.3.1 Profit Maximisation

Profit maximisation is based on the cardinal rule of efficiency. Its goal is tomaximise the returns, with the best output and price levels. A firms

performance is evaluated in terms of profitability. Allocation of resources and

investors perception of the companys performance can be traced to the goal of

profit maximisation. Profit maximisation has been criticised on many accounts:

1. The concept of profit lacks clarity. What does profit mean?

o Is it profit after tax or before tax?

o Is it operating profit or net profit available to share holders?

Differences in interpretation on the concept of profit expose the

weakness of profit maximisation.

2. Profit maximisation ignores time value of money. It does not differentiate

between profits of current year with the profit to be earned in later years.

3. The concept of profit maximisation fails to consider the fluctuations in

profits earned from year to year. Fluctuations may be attributed to the

business risk of the firm.

4. The concept of profit maximisation apprehends to be either accounting

profit or economic normal profit or economic supernormal profit.

Profit maximisation fails to meet the standards stipulated in an operational

and a feasible criterion for maximising shareholders wealth, because of the

deficiencies explained above.

1.3.2 Wealth Maximisation

Wealth maximisation means maximising the net wealth of a companys

shareholders. Wealth maximisation is possible only when the company

pursues policies that would increase the market value of shares of the

company. It has been accepted by the finance managers as it overcomes

the limitations of profit maximisation.

The following arguments are in support of the superiority of wealth

maximisation over profit maximisation

Wealth maximisation is based on the concept of cash flows. Cash flows

are a reality and not based on any subjective interpretation. On the other

hand, profit maximisation is based on accounting profit and it also

contains many subjective elements.

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Wealth maximisation considers time value of money. Time value of

money translates cash flows occurring at different periods into acomparable value at zero period. In this process, the quality of cash

flows is considered critically in all decisions as it incorporates the risk

associated with the cash flow stream. It finally crystallises into the rate of

return that will motivate investors to part with their hard earned savings.

Maximising the wealth of the shareholders means positive net present

value of the decisions implemented.

Let us now look at some of the key definitions:

Positive net present value can be defined as the excess of present value

of cash inflows of any decision implemented over the present value of

cash out flows Time value factor is known as the time preference rate, that is, the sum

of risk free rate and risk premium.

Risk free rate is the rate that an investor can earn on any government

security for the duration under consideration

Risk premium is the consideration for the risk perceived by the investor

in investing in that asset or security.

Required rate of return is the return that the investors want for making

investment in that sector.

CaseletX Ltd is a listed company engaged in the business of FMCG (FastMoving consumer goods). Listed implies that the companys shares areallowed to be traded officially on the portals of the stock exchange. TheBoard of Directors of X Ltd took a decision in one of its Board meetingsto enter into the business of power generation. When the companyinformed the stock exchange at the conclusion of the meeting of thedecision taken, the stock market reacted unfavourably. The result wasthat the next days closing of quotation was 30 % less than that of theprevious day. Why did the market react unfavourably?

Investors in FMCG company might have thought that the risk profile ofthe new business that the company wants to take up is higher compared

to risk profile of the existing FMCG business of X ltd. when they want ahigher return, market value of the companys shares decline.

Therefore the risk profile of the company gets translated into a time valuefactor. The time value factor so translated becomes the required rate ofreturn.

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1.3.3 Wealth maximisation vs. Profit maximisation

Let us now see how wealth maximisation is superior to profit maximisation. Wealth maximisation is based on cash flow. It is not based on the

accounting profit.

Through the process of discounting, wealth maximisation takes care of

the quality of cash flows. Distant cash flows are uncertain. Converting

distant uncertain cash flows into comparable values at base period

facilitates better comparison of projects. There are various ways of

dealing with risk associated with cash flows. These risks are adequately

considered when present values of cash flows are taken to arrive at the

net present value of any project.

Corporates play a key role in todays competitive business scenario. Inan organisation, shareholders typically own the company but the

management of the company rests with the board of directors. Directors

are elected by shareholders. Company management procures funds for

expansion and diversification of capital markets.

In the liberalised set up, the society expects corporates to tap the capital

markets effectively for their capital requirements. Therefore, to keep the

investors happy throughout the performance of value of shares in the

market, management of the company must meet the wealth maximisation

criterion.

When a firm follows wealth maximisation goal, it achieves maximisation

of market value of share. A firm can practice wealth maximisation goal

only when it produces quality goods at low cost. On this account, society

gains because of the societal welfare. Maximisation of wealth demands

on the part of corporates to develop new products or render new

services in the most effective and efficient manner. This helps the

consumers as it brings to the market the products and services that

consumer needs.

Another notable feature of the firms committed to the maximisation of

wealth is that to achieve this goal, they are forced to render efficient

service to their customers with courtesy. This enhances consumer

welfare and benefit to the society.

From the point of evaluation of performance of listed firms, the most

remarkable measure is that of performance of the company in the share

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market. Every corporate action finds its reflection on the market value of

shares of the company. Therefore, shareholders wealth maximisationcould be considered a superior goal compared to profit maximisation.

Since listing ensures liquidity to the shares held by the investors,

shareholders can reap the benefits arising from the performance of

company only when they sell their shares. Therefore, it is clear that

maximisation of market value of shares will lead to maximisation of the

net wealth of shareholders

Therefore, we can conclude that maximisation of wealth is the appropriate

goal of financial management in todays context.

1.4 Finance FunctionsFinance functions deal with the functions performed by the finance

manager. They are closely related to financial decisions. In the course of

performing these functions, finance manager takes several decisions

(see figure1.2):

Finance decisions

Investment decisions

Liquidity decisions

Dividend decisions

Organisation of a finance function


Fill in the blanks:

3. Under perfect competition, allocation of resources shall be based on thegoal of ________.

4. _______ is based on cash flows.

5. _________ consider rime value of money.

6. What are the main goals of financial management?

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Figure 1.2: Finance manager decisions

1.4.1 Finance decisions

Financing decisions relate to the acquisition of funds at the least cost. Cost

has two dimensions:

Explicit Cost

Implicit cost

Explicit cost refers to the cost in the form of coupon rate, cost of floating and

issuing the security.

Implicit cost is not a visible cost but it may seriously affect the companys

operations especially when it is exposed to business and financial risk

In India, if a company is unable to pay its debts, creditors of the company

may use legal means to sue the company for winding up. This risk is

normally known as risk of insolvency. A company which employs debt as a

means of financing normally faces this risk especially when its operations

are exposed to high degree of business risk.

In all financing decisions, a firm has to determine the proportion of equity

and debt. The composition of debt and equity is called the capital structureof the firm.

Debt is cheap because interest payable on loan is allowed as deductions in

computing taxable income on which the company is liable to pay income tax

to the Government of India.

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An investor in a companys shares has two objectives for investing:

Income from capital appreciation (capital gains on sale of shares at

market price)

Income from dividends

It is the ability of the company to give both these incomes to its shareholders

that determines the market price of the companys shares.

The most important goal of financial management is maximisation of net

wealth of the shareholders. Therefore, management of every company

should strive hard to ensure that its shareholders enjoy both dividendincome and capital gains as per the expectation of the market.

Caselet

The interest rate on loan taken is 12%, tax rate applicable to thecompany is 50%, and then when the company pays Rs.12 as interest to

the lender, taxable income of the company will be reduced by Rs.12.

In other words, when the actual cost is 12% with a tax rate of 50%, the

effective cost becomes 6%. Therefore, the debt is cheap. But, every

instalment of debt brings along with it corresponding insolvency risk.

Another thing notable in connection to this is that the firm cannot avoid its

obligation to pay interests and loan instalments to its lenders and

debentures.

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Therefore, to declare a dividend of 12%, a company has to earn a pre-tax

profit of 19%. On the other hand, to pay an interest of 12%, the company

has to earn only 8.4%. This leads to the conclusion that for every Rs.100

procured through debt, it costs 8.4%, whereas the same amount procured in

the form of equity (share capital) costs 19 %. This confirms the established

theory that equity is costly but debt is a cheap and risky source of funds to

the corporate.

Financing decision involves the consideration of managerial control,

flexibility and legal aspects and regulatory and managerial elements.

1.4.2 Investment decisions

To survive and grow, all organisations have to be innovative. Innovationdemands managerial proactive actions. Proactive organisations

continuously search for innovative ways of performing the activities of the

organisation. Innovation is wider in nature. It could be:

expansion through entering into new markets

Solved Problem

Dividend = 12% on paid up value

Tax rate applicable to the company = 30%

Dividend tax = 10%

Compute the profit that the company must earn before tax, When acompany pays Rs.12 on paid up capital of Rs.100 as dividend

SolutionSince payment of dividend by an Indian company attracts dividend tax,the company when it pays Rs.12 to shareholders, must pay to the Govtof India

10% of Rs.12 = Rs.1.2 as dividend tax.Therefore dividend and dividend tax sum up to Rs.12 + Rs.1.2 = Rs.13.2.

Since this is paid out of the post tax profit, in this question, the companymust earn:

dividendthepay

anddeclaretorequiredprofittaxPrerate)Tax(1

paiddividendtaxPost

eapproximat19.Rs7.0

2.13

3.01

2.13

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adding new products to its product mix

performing value added activities to enhance customer satisfaction adopting new technology that would drastically reduce the cost of

production

rendering services or mass production at low cost or restructuring the

organisation to improve productivity

These innovations change the profile of an organisation. These decisions

are strategic because they are risky. However, if executed successfully with

a clear plan of action, investment decisions generate super normal growth to

the organisation.

A firm may become bankrupt, if the management fails to execute thedecisions taken. Therefore, such decisions have to be taken after taking into

account all the facts affecting the decisions and their execution.

There are two critical issues to be considered in these decisions.

Evaluation of expected profitability of the new investments.

Rate of return required on the project.

The Rate of Return required by an investor is normally known as the hurdle

rate or the cut-off rate or the opportunity cost of capital.

Investments in buildings and machineries are to be conceived and executed

by a firm to enter into any business or to expand its business. The processinvolved is called Capital Budgeting. Capital Budgeting decisions demand

considerable time, attention and energy of the management. They are

strategic in nature as the success or failure of an organisation is directly

attributable to the execution of Capital Budgeting decisions taken.

Investment decisions are also known as Capital Budgeting Decisions and

hence lead to investments in real assets.

1.4.3 Dividend decisions

Dividends are pay-outs to shareholders. Dividends are paid to keep the

shareholders happy. Dividend decision is a major decision made by a

finance manager. It is based on formulation of dividend policy. Since the

goal of financial management is maximisation of wealth of shareholders,

dividend policy formulation demands the managerial attention on the impact

of its policy on dividend and on the market value of its shares.

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Optimum dividend policy requires decision on dividend payment rates so as

to maximise the market value of shares. The payout ratio means whatportion of earnings per share is given to the shareholders in the form of cash

dividend. In the formulation of dividend policy, the management of a

company will have to consider the relevance of its policy on bonus shares.

Dividend policy influences the dividend yield on shares. Dividend yield is an

important determinant of an investors attitude towards the security (stock) in

his portfolio management decisions.

The following issues need adequate consideration in deciding on dividend

policy:

Preferences of share holders Do they want cash dividend or capital gains?

Current financial requirements of the company

Legal constraints on paying dividends

Striking an optimum balance between desires of share holders and the

companys funds requirements

1.4.4 Liquidity decision

Liquidity decisions deals with Working Capital Management. It is concerned

with the day-to-day financial operations that involve current assets and

current liabilities.

The important elements of liquidity decisions are: Formulation of inventory policy

Policies on receivable management

Formulation of cash management strategies

Policies on utilisation of spontaneous finance effectively

1.4.5 Organisation of finance function

Financial decisions are strategic in character and therefore, an efficient

organisational structure is required to administer the same. Finance is like

blood that flows throughout the organisation. In all organisations, CFOs play

an important role in ensuring proper reporting based on substance of thestake holders of the company. Finance functions are organised directly

under the control of board of directors, because of the crucial role these

functions play. For the survival of the firm, there is a need to ensure both

long term and short term financial solvency.

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Weak functional performance by financial department will weaken

production, marketing and HR activities of the company. The result would bethe organisation becoming anaemic. Once anaemic, unless crucial and

effective remedial measures are taken up, it will pave way for corporate

bankruptcy. Under the CFO, normally two senior officers manage the

treasurer and controller functions.

A Treasurer performs the following functions.

Obtaining finance

Liaison with term lending and other financial institutions

Managing working capital

Managing investment in real assetsA Controller performs the following functions.

Accounting and auditing

Management control systems

Taxation and insurance

Budgeting and performance evaluation

Maintaining assets intact to ensure higher productivity of operating

capital employed in the organisation

In India, CFOs have a legal obligation under various regulatory provisions to

certify the correctness of various financial statements and information

reported to the stake holders in the annual report. Listing norms, regulations

on corporate governance and other notifications of Govt. of India have

adequately recognised the role of finance function in the corporate set up in

India.

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1.5 Interface between Finance and other Business Functions

1.5.1 Finance and accounting

From the hierarchy of the finance function of an organisation, the controller

reports to the CFO. Accounting is one of the functions that a controller

discharges. Accounting and finance are closely related. For computation of

Return on Investment, earnings per share and for various ratios of financial

analysis, the data base will be accounting information. Without a proper

accounting system, an organisation cannot administer the effective function

of financial management.

The purpose of accounting is to report the financial performance of the

business for the period under consideration. All the financial decisions are

futuristic based on cash flow analysis. All the financial decisions consider

quality of cash flows as an important element of decisions. Since financial

decisions are futuristic, it is taken and put into effect, under conditions of

uncertainty. Assuming the condition of uncertainty and incorporating the

effect on decision making, results in use of various statistical models. In the

selection of the statistical models, element of subjectivity creeps in.

1.5.2 Finance and marketing

Marketing decisions generally have financial implications. Selections of

channels of distribution, deciding on advertisement policy and remunerating

the salesmen, have financial implications. In fact, the recent behaviour of

rupee against US dollar (appreciation of rupee against US dollar), affected


Fill in the blanks:

7. ________ lead to investment in real assets.

8. _____ relate to the acquisition of funds at the least cost.

9. Formulation of inventory policy is an important element of _______.

10. Obtaining finance is an important function of _________.

11. What are the two critical issues to be considered under investmentdecisions?

12. Define rate of return.

13. The most important decision made by a finance manager is ________.

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the cash flow positions of export oriented textile units and BPOs and other

software companies.It is generally believed that the currency in which marketing manager

invoices the exports, decides the cash flow consequences of the

organisation, if and only if the company is mainly dependent on exports.

Marketing cost analysis, a function of finance managers, is the best example

of application of principles of finance on the performance of marketing

functions by a business unit. Formulation of policy on credit management

cannot be done unless the integration of marketing with finance is achieved.

Deciding on credit terms to achieve a particular level of sales has financial

implications because sanctioning liberal credit may result in huge and bad

debt. On the other hand, conservative credit terms may depress the sales.

Relation between Inventory and Sales:

Co-ordination of stores administration with that of marketing management is

required to ensure customer satisfaction and good will. But investment in

inventory requires the financial clearance because funds are locked in and

the funds so blocked have opportunity cost of capital.

1.5.3 Finance and production (operations)

Finance and operations management are closely related. Decisions on plant

layout, technology selection, productions or operations, process plant size,

removing imbalance in the flow of input material in the production or operationprocess and batch size are all operation management decisions. Their

formulation and execution cannot be done unless they are evaluated from the

financial angle. The capital budgeting decisions are closely related to

production and operation management. These decisions make or mar a

business unit. Failure to understand the implications of the latest technological

trend on capacity expansions has cost even blue chip companies.

Many textile units in India became sick because they did not provide

sufficient finance for modernisation of plant and machinery. Inventory

management is crucial to successful operation management. But

management of inventory involves quite a lot of financial variables.

1.5.4 Finance and HR

Attracting and retaining the best man power in the industry cannot be done

unless they are paid salary at competitive rates. If an organisation

formulates and implements a policy for attracting the competent man power,

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it has to pay the most competitive salary packages to them. However, by

attracting competent man power, capital and productivity of an organisationimproves.

1.6 Summary

Financial Management is concerned with the procurement of the least cost

funds and its effective utilisation for maximisation of the net wealth of the

firm. There exists a close relation between the maximisation of net wealth of

shareholders and the maximisation of the net wealth 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 between the investors expectation and the organisations

growth.


1. What are the objectives of financial management?

2. How does a finance manager arrive at an optimal capital structure?

3. Examine the relationship of financial management with other functional

areas of a firm.

4. Examine the relationship between finance and accounting.

5. Examine the relationship between finance and marketing.

Caselet

Infosys does not have physical assets similar to that of Indian Railways.

But if both were to come to capital market with a public issue of equity,

Infosys would command better investors acceptance than the Indian

Railways. This is because the value of human resources plays an

important role in valuing a firm.

The better the quality of man power in an organisation, the higher the

value of the human capital and consequently the higher the productivity

of the organisation. Indian Software and IT enabled services have been

globally acclaimed only because of the man power they possess. But it

has a cost factor -. the best remuneration to the staff.

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Answers to Self Assessment Questions

1. Effective utilisation

2. Liberalisation and globalisation of Indian economy

3. Procurement of funds.

4. Profit maximisation.

5. Wealth maximisation

6. Wealth maximisation

7. Investment decisions.

8. Financing decisions

9. Liquidity

10. Treasurers

11. The two critical issues are

evaluation of expected profitability of the new investment

rate of return required on the project

12. Rate of return is normally defined as the hurdle rate or cut-off rate or

opportunity cost of the capital

13. Dividend decision

Answers to Terminal Questions

1. Refer 1.32. Refer 1.4.1

3. Refer 1.5

4. Refer 1.5.1

5. Refer 1.5.2

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Unit 2 Financial Planning

Structure:

2.1 Introduction

Learning Objectives

Objectives of financial planning

Benefits that accrue to a firm out of financial planning

Guidelines for financial planning

2.2 Steps in Financial Planning

Forecast of income statement

Forecast of balance sheet

Computerised financial planning system2.3 Factors affecting Financial Plan

2.4 Estimation of Financial Requirements of a Firm

2.5 Capitalisation

Cost theory

Earnings theory

Over-capitalisation

Under-capitalisation

2.6 Summary



2.1 Introduction

Liberalisation and globalisation policies initiated by the government have

changed the dimension of business environment. Therefore, for survival and

growth, a firm has to execute planned strategies systematically. To execute

any strategic plan, resources are required. Resources may be manpower,

plant and machinery, building, technology or any intangible asset.

To acquire all these assets, financial resources are essentially required.

Therefore the finance manager of a company must have both long-range

and short-range financial plans. Integration of both these plans is required

for the effective utilisation of all the resources of the firm.

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The long-range plans must include:

Funds required for executing the planned course of action

Funds available at the disposal of the company

Determination of funds to be procured from outside sources


After studying this unit you should be able to:

Explain the steps involved in financial planning.

Explain the factors effecting financial planning.

List out the cases of over-capitation.

Explain the effects of under-capitation.

2.1.2Objectives of financial planning

Let us start with defining financial planning as an essential objective.

Financial planning is a process by which funds required for each course of

action is decided.

A financial plan has to consider capital structure, capital expenditure and

cash flow. Decisions on the composition of debt and equity must be taken.

Financial planning or financial plan indicates:

The quantum of funds required to execute business plans

Composition of debt and equity, keeping in view the risk profile of theexisting business, new business to be taken up and the dynamics of

capital market conditions

Formulation of policies, giving effect to the financial plans under

consideration

2.1.3 Benefits of financial planning

Financial planning also helps firms in the following ways.

A financial plan is at the core of value creation process. A successful

value creation process can effectively meet the bench-marks of

investors expectations.

Financial planning ensures effective utilisation of the funds. To manage

shortage of funds, planning helps the firms to obtain funds at the right

time, in the right quantity and at the least cost as per the requirements of

finance emerging opportunities. Surplus is deployed through well

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planned treasury management. Ultimately, the productivity of assets is

enhanced. Effective financial planning provides firms the flexibility to change the

composition of funds that constitute its capital structure in accordance

with the changing conditions of the capital market.

Financial planning helps in formulation of policies and instituting

procedures for elimination of wastages in the process of execution of

strategic plans.

Financial planning helps in reducing the operating capital of a firm.

Operating capital refers to the ratio of capital employed to the sales

generated. Maintaining the operating capability of the firm through the

evolution of scientific replacement schemes for plant and machinery andother fixed assets will help the firm in reducing its operating capital.

A study of annual reports of Dell computers will throw light on how Dell

strategically minimised the operating capital required to support sales.

Such companies are admired by investing community.

2.1.4 Guidelines for financial planning

The following are the guidelines of a financial plan:

Never ignore the coordinal principle that fixed asset requirements be met

from the long term sources.

Make maximum use of spontaneous source of finance to achieve highest

productivity of resources.

Maintain the operating capital intact by providing adequate out of the

current periods earnings. Give due attention to the physical capital

maintenance or operating capability.

Never ignore the need for financial capital maintenance in units of

constant purchasing power.

Employ current cost principle wherever required.

Give due weight age to cost and risk in using debt and equity.

Keeping the need of finance for expansion of business, formulate plough

back policy of earnings.

Exercise thorough control over overheads.

Operating capital = Capital employed / Sales generated

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Seasonal peak requirements to be met from short term borrowings

from banks.

2.2 Steps in Financial Planning

There are six steps involved in financial planning which are as shown in

figure 2.1

Figure 2.1: Steps in financial planning

Establish corporate objectives

The first step in financial planning is to establish corporate objectives.

Corporate objectives can be grouped into qualitative and quantitative.

For example, a companys mission statement may specify create

economic value added. However this qualitative statement has to be

stated in quantitative terms such as a 25 % ROE or a 12 % earnings

growth rates. Since business enterprises operate in a dynamic

environment, there is a need to formulate both short run and long run

objectives.

Formulate strategies

The next stage in financial planning is to formulate strategies for

attaining the defined objectives. Operating plans helps achieve thepurpose. Operating plans are framed with a time horizon. It can be a five

year plan or a ten year plan.

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Delegate responsibilities

Once the plans are formulated, responsibility for achieving sales target,operating targets, cost management bench-marks, profit targets is to be

fixed on respective executives.

Forecast financial variables

The next step is to forecast the various financial variables such as sales,

assets required, flow of funds and costs to be incurred. These variables

are to be translated into financial statements.

Financial statements help the finance manager to monitor the deviations

of actual from the forecasts and take effective remedial measures. This

ensures that the defined targets are achieved without any overrun of

time and cost.

Develop plans

This step involves developing a detailed plan of funds required for the

plan period under various heads of expenditure. From the plan, a

forecast of funds that can be obtained from internal as well as external

sources during the time horizon is developed. Legal constrains in

obtaining funds on the basis of covenants of borrowings is given due

weight-age. There is also a need to collaborate the firms business risk

with risk implications of a particular source of funds. A control

mechanism for allocation of funds and their effective use is alsodeveloped in this stage.

Create flexible economic environment

While formulating the plans, certain assumptions are made about the

economic environment. The environment, however, keeps changing with

the implementation of plans. To manage such situations, there is a need

to incorporate an inbuilt mechanism which would scale up or scale down

the operations accordingly.

2.2.1 Income Statement

There are three methods of preparing income statement: Percent of sales method or constant ratio method

Expense method

Combination of both these two

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Percent of sales method

This approach is based on the assumptions that each element of cost bearssome constant relationship with the sales revenue.

Caselet

Raw material cost is 40% of sales revenue for the year ended 31.03.2007.

However, this method assumes that the ratio of raw material cost to sales

will continue to be the same in 2008 also. Such an assumption may not

look good in most of the situations.

If in case, raw material cost increases by 10% in 2008 but selling price of

finished goods increases only by 5%. In this case raw material cost will be

44 / 105 of the sales revenue in 2008. This can be solved to some extentby taking average for same representative years. However, inflation,

change in government policies, wage agreements and technological

innovation totally invalidate this approach on a long run basis.

Budgeted expense method

Expenses for the planning period are budgeted on the basis of anticipated

behaviour of various items of cost and revenue. This demands effective

database for reasonable budgeting of expenses.

Combination of both these methods

The combination of both these methods is used because some expenses

can be budgeted by the management taking into account the expected

business environment while some other expenses could be based on their

relationship with the sales revenue expected to be earned.

2.2.2 Balance sheet

The following steps discuss the forecasting of the balance sheet.

Compute the sales revenue, having a close relationship with the items of

certain assets and liabilities, based on the forecast of sales and the

historical database of their relationship

Determine the equity and debt mix on the basis of funds requirements

and the companys policy on capital structure

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Case Study

The following details have been extracted from the books of X Ltd

Table 2.1: Income statement

2006 2007

Sales less returns 1000 1300

Gross Profit 300 520

Selling Expenses 100 120

Administration 40 45

Deprecation 60 75

Operating Profit 100 280

Non operating income 20 40EBIT (Earnings Before Interest & Tax) 120 320

Interest 15 18

Profit before tax 105 302

Tax 30 100

Profit after tax 75 202

Dividend 38 100

Retained earnings 37 102

Table 2.2: Balance sheet

Liabilities 2006 2007 Assets 2006 2007

Shareholders fund Fixed assets 400 510

Share capital Less depreciation 100 120

Equity 120 120 300 390

Preference 50 50 Investments 50 50

Reserves andsurplus

122 224

Secured loans 100 120 Current assets,Loans and

AdvancesUnsecured loans 50 60 Cash at bank 10 12

Receivables 80 128

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Current liabilities Inventories 200 300

Trade creditors 210 250 Loans andAdvances

50 80

Provisions Miscellaneousexpenditure

10 24

Tax 10 60

Proposeddividend

38 100

700 984 700 984

Forecast the income statement and balance sheet for the year 2008 based onthe following assumptions:

Sales for the year 2008 will increase by 30% over the sales value for 2007.

Use percent of sales method to forecast the values for various items ofincome statement using the percentage for the year 2007.

Depreciation is charged at 25% of fixed assets.

Fixed assets will increase by Rs.100 million

Investments will increase by Rs.100 million

Current assets and current liabilities are to be decided based on theirrelationship with the sales in the year 2007

Miscellaneous expenditure will increase by Rs.19 million

Secured loans in 2008 will be based on its relationship with the sales in theyear 2007

Additional funds required, if any, will be met by bank borrowings

Tax rates will be 30 %

Dividends will be 50 % of the profit after tax

Non operating income will increase by 10%

There will be no change in the total amount of administration expenses tobe spent in the year 2008

There is no change in equity and preference capital in 2008

Interest for 2008 will maintain the same ratio as it has in 2007 with thesales of 2007

The forecast of the income statement and the balance sheet for the year 2008has been briefly explained in table 2.3 and in the table 2.4

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Table 2.3: Income statement

Particulars Basis Working Amount (Rs.)

Sales Increase by 30% 1300 x 1.3 1690

Cost of sales Increase by 30% 780 x 1.3 1014

Gross profit Sales-cost of sales 1690-1014 676

Selling expenses 30% increase 120 x 1.3 156

Administration No change 45

Depreciation % given

4

100390

123(Rounded off)

Operating profit C - (D + E + F) 352Non-operating income Increase by 10% 1.1 x 40 44

Earnings BeforeInterest and Taxes(EBIT)

396

InterestSalesof

1300

18

1300

169018

23

(Decimal

ignored)

Profit before tax 373

Tax 112

Profit after tax 261

Dividends 130

Retained earnings 131


Particulars Basis Working Amount (Rs.)

Assets

Fixed Assets Given 510

Add: Addition 100

610

Depreciation 120 + 123243

1. Net fixed assets 367

2. Investments 150

3. Current Assets &Loans & advances

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Cash at bank

1300

12

1300

169012

16

(Rounded off)Receivables

1300

128

1300

1690128

166

Inventories

1300

300

1300

1690300

390

Loans & Advances

1300

80

1300

169080

104

4. Miscellaneous

ExpenditureGiven 24 + 19 43

Total 1236

Liabilities

1. Share Capital

Equity 120

Preference 50

2. Reserves & Surplus Increase bycurrent yearsretainedearnings

355

3. Secured Loan

1300

60

1300

169060

78

Bank borrowings 40

(DifferenceBalancing

figure)

4. Unsecured Loan 60 60

5. Current Liabilities &Provision

Trade creditors

1300

250

1300

1690250

325

Provision for tax

1300

60

1300

169060

78

Proposed Dividend Current year given 130

Total Liabilities 1236

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2.2.3 Computerised financial planning system

All corporate forecasts use computerised forecasting models. Additionalfunds required to finance the increase in sales could be ascertained using a

mathematical relationship based on the following:

Additional Funds Required = Required Increase in Assets Spontaneous

increase in Liabilities Increase in Retained Earnings

(This formula has been recommended by Eugene F. Brigham and Michael

C. Earnhardt in their book Financial Management Theory and Practice,

10th edition, published on 31st July 1998)

Prof. Prasanna Chandra, in his book Financial Management,(6th edition-

manohar publishers and distributors) has given a comprehensive formula forascertaining the external financial requirements.

Here

)s(S

A = Expected increase in assets, both fixed assets and current

assets, required for the expected increase in sales in the next year.

)s(SL

= Expected spontaneous finance available for the expected

increase in sales.

MS1 (1-d) = It is the product of profit margin, expected sales for the next

year and the retention ratio.

Retention ratio = 1 payout ratio

Payout ratio refers to the ratio of the dividend paid to the earnings per

share.

1m = Expected change in the level of investments and miscellaneous

expenditure.

SR = It is the firms repayment liability on term loans and debenture for

the next year.

EFR =S

)s(L

S

)s(A

ms (1-d) (1m + SR)

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The formula described above has certain features:

Ratios of assets and spontaneous liabilities to sales remain constantover the planning period

Dividend payout and profit margin for the next year can be reasonably

planned in advance

Since external funds requirements involve borrowings from financial

institution, the formula rightly incorporates the managements liability on

repayments

Solved Problem

X Ltd. has given the following forecasts: Sales in 2008 will increase from

Rs. 1000 to Rs. 2000 in 2007. The balance sheet of the company as on

December 31, 2007 gives the details as shown below:


Liabilities Rs. Assets Rs.

Share Capital Net Fixed Assets 500

Equity (Shares of Rs.10each)

100 Inventories 200

Reserves & Surplus 250 Cash 100

Long term loan 400 Bills Receivable 200

Creditors for expenses

outstanding

50

Trade creditors 50

Bills Payable 150

1000 1000

Taking into account the following information, the external funds

requirements for the year 2008 has to be ascertained:

The companys utilisation of fixed assets in 2007 was 50 % of capacity

but its current assets were at their proper levels.

Current assets increase at the same rate as sales.

Companys after-tax profit margin is expected to be 5%, and its payout

ratio will be 60 %.

Creditors for expenses are closely related to sales (Adapted from IGNOU

MBA).

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Solution

Preliminary workings

A = Current assets = Cash + Bills Receivables + Inventories

= 100 + 200 +200 = 500

500.Rs10001000

500)s(

S

A

L = Trade creditors + Bills payable + Expenses outstanding

= 50 + 150 + 50 = Rs. 250

250.Rs10001000

250)s(

S

L

M (Profit Margin) = 5 / 100 = 0.05

S1 = Rs.2000

1-d = 1 0.6 = 0.4 or 40 %

1m = NIL

SR = NIL

Therefore: sS

L

S

)s(AEFR

- ms1 (1-d) (1m + SR)

= 500 250 (0.05 x 2000 x 0.4) (0 + 0)

= 500 250 40 - (0 + 0)

= Rs. 210

Therefore external fund requirements for 2008 will be Rs. 210. Thisadditional fund requirement will be procured by the firm, based on its

policy on capital structure.


Fill in the blanks

1. Corporate objectives could be group into ___ and ___.

2. Control mechanism is developed for _____ and their effective use.

3. Seasonal peak requirements to be met from __________________

from banks.

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2.3 Factors affecting Finanical Plan

The various other factors affecting financial plan are listed down in figure 2.2

Figure 2.2: Factors affecting financial plan

Nature of the industry

The very first factor affecting the financial plan is the nature of the

industry. Here, we must check whether the industry is a capital intensive

or labour intensive industry. This will have a major impact on the totalassets that a firm owns.

Size of the company

The size of the company greatly influences the availability of funds from

different sources. A small company normally finds it difficult to raise

funds from long term sources at competitive terms.

On the other hand, large companies like Reliance enjoy the privilege of

obtaining funds both short term and long term at attractive rates

Status of the company in the industry

A well established company enjoys a good market share, for its products

normally commands investors confidence. Such a company can tap the

capital market for raising funds in competitive terms for implementing

new projects to exploit the new opportunities emerging from changing

business environment

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Sources of finance available

Sources of finance could be grouped into debt and equity. Debt is cheapbut risky whereas equity is costly. A firm should aim at optimum capital

structure that would achieve the least cost capital structure. A large firm

with a diversified product mix may manage higher quantum of debt

because the firm may manage higher financial risk with a lower business

risk. Selection of sources of finance is closely linked to the firms

capability to manage the risk exposure.

The capital structure of a company

The capital structure of a company is influenced by the desire of the

existing management (promoters) of the company to retain control over

the affairs of the company. The promoters who do not like to lose theirgrip over the affairs of the company normally obtain extra funds for

growth by issuing preference shares and debentures to outsiders.

Matching the sources with utilisation

The prudent policy of any good financial plan is to match the term of the

source with the term of the investment. To finance fluctuating working

capital needs, the firm resorts to short term finance. All fixed asset

investments are to be financed by long term sources, which is a cardinal

principle of financial planning.

FlexibilityThe financial plan of a company should possess flexibility so as to effect

changes in the composition of capital structure whenever need arises. If

the capital structure of a company is flexible, there will not be any

difficulty in changing the sources of funds. This factor has become a

significant one today because of the globalisation of capital market.

Government policy

SEBI guidelines, finance ministry circulars, various clauses of Standard

Listing Agreement and regulatory mechanism imposed by FEMA and

Department of corporate affairs (Govt. of India) influence the financial

plans of corporates today. Management of public issues of shares

demands the compliances with many statues in India. They are to be

complied with a time constraint.

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2.4 Estimations of Financial requirements of a Firm

The estimation of capital requirements of a firm involves a complex process.Even with expertise, managements of successful firms could not arrive at

the optimum capital composition in terms of the quantum and the sources.

Capital requirements of a firm could be grouped into fixed capital and

working capital.

The long term requirements such as investments in fixed assets will

have to be met out of funds obtained on long term basis

Variable working capital requirements which fluctuate from season to

season will have to be financed only by short term sources

Any departure from this well accepted norm causes negative impact onfirms finances.

2.5 Capitalisation

Capitalisation of a firm refers to the composition of its long term funds andits capital structure. It has two components Debt and Equity.


Fill in the blanks

8. Capital requirement of a firm could be grouped into ____ and _____.

9. Variable working capital will have to be financed only by _______.


Fill in the blanks:

4. ______ has a major impact on the total assets that the firm owns.

5. Sources of finance could be grouped into ______ and _____.

6. ___________ of any good financial plan is to match the term of the

source with the term of the source with the term of the investment.

7. _____ refers to the ability to _____ whenever needed.

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After estimating the financial requirements of a firm, the next decision that

the management has to take is to arrive at the value at which the companyhas to be capitalised.

There are two theories of capitalisation for the new companies:

Cost theory

Earnings theory

Figure 2.3 displays the two theories.

Figure 2.3: Theories of capitalisation

2.5.1 Cost theory

Under this theory, the total amount of capitalisation for a new company is

the sum of:

Cost of fixed assets

Cost of establishing the business

Amount of working capital required

It helps promoters to estimate the amount of capital required for

incorporation of company, conducting market surveys, preparing

detailed project report, procuring funds, procuring assets both fixed

and current, running a trial production and successfully producing,

positioning and marketing its products or rendering of services

If done systematically, it will lay foundation for successful initiation of

the working of the firm

Merits of cost approach

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If the firm establishes its production facilities at inflated prices, the

productivity of the firm will become less than that of the industry.

Net worth of a company is decided by the investors and the earnings

of a company. Earning capacity based net worth helps a firm to

arrive at the total capital in terms of industry specified yardstick

(operating capital based on bench marks in that industry), cost

theory fails in this respect.

2.5.2 Earnings theory

Earnings are forecasted and capitalised at a rate of return, which actually isthe representative of the industry. Earnings theory involves two steps:

Estimation of the average annual future earnings

Estimation of the normal earning rate of the industry to which the

company belongs

Earnings theory is superior to cost theory because of its lesser

chances of being either under or over capitalisation

Comparison of earnings approach to that of cost approach will makethe management to be cautious in negotiating the technology and

the cost of procuring and establishing the new business

The major challenge that a new firm faces is deciding on

capitalisation and its division thereof into various procurement

sources

Arriving at the capitalisation rate is equally a formidable taskbecause the investors perception of established companies cannot

be really unique of what the investors perceive from the earning

power of the new company

Demerits of cost approach

Merits of earnin s theor

Demerits of earnin s theor

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Due to this problem, most of the new companies are forced to adopt the

cost theory of capitalisation. Ideally every company should have normalcapitalisation, which is a utopian way of thinking.

Changing business environment, role of international forces and dynamics

of capital market conditions force us to think in terms of what is optimal

today need not to be so tomorrow.

Even with these constraints, management of every firm should continuously

monitor its capital structure to ensure and avoid the bad consequences of

over and under capitalisation.

2.5.3 Over-capitalisation

A company is said to be over-capitalised, when its total capital (both equityand debt) exceeds the true value of its assets.

It is wrong to identify over-capitalisation with excess of capital because most

of the over-capitalised firms suffer from the problems of liquidity. The correct

indicator of over-capitalisation is the earnings capacity of the firm.

If the earnings of the firm are less than that of the market expectation, it will

not be in a position to pay dividends to its shareholders as per their

expectations. This is a sign of over-capitalisation. It is also possible that a

company has more funds than its requirements based on current operation

levels and yet have low earnings.Over-capitalisation may be considered on the account of:

Acquiring assets at inflated rates

Acquiring unproductive assets

High initial cost of establishing the firm

Companies which establish their new business during boom condition

are forced to pay more for acquiring assets, causing a situation of over-

capitalisation once the boom conditions subside

Total funds requirements have been over estimated

Unpredictable circumstances (like change in import-export policy,

change in market rates of interest and changes in international economic

and political environment) reduce substantially the earning capacity of

the firm. For example, rupee appreciation against US dollar has affected

earning capacity of the firms engaged mainly in the export business

because they invoice their sales in US dollar

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Inadequate provision of depreciation, adversely effects the earning

capacity of the company, leading to over-capitalisation of the firm Existence of idle funds

Effects of over-capitalisation

Decline in earnings of the company

Fall in dividend rates

Market value of the companys share falls, and the company loses

investors confidence

Company may collapse at any time because of anaemic financial

conditions which affect its employees, society, consumers and its

shareholders. Employees will lose jobs. If the company is engaged in the

production and marketing of certain essential goods and services to the

society, the collapse of the company will cause social damage

Remedies of over capitalisation

Over-capitalisation often results in a company becoming sick Restructuring

the firm helps avoid such a situation. Some of the other remedies of over-

capitalisation are:

Reduction of debt burden

Negotiation with term lending institutions for reduction in interest

obligation

Redemption of preference shares through a scheme of capital reduction

Reducing the face value and paid-up value of equity shares

Initiating merger with well managed profit making companies interested

in taking over ailing company

2.5.4 Under-capitalisation

Under-capitalisation is just the reverse of over-capitalisation. A company is

considered to be under-capitalised when its actual capitalisation is lower

than the proper capitalisation as warranted by the earning capacity.

Symptoms of under-capitalisation

The following bullets display the symptoms of under-capitalisation.

Actual capitalisation is less than the warranted by its earning capacity

Rate of earnings is exceptionally high in relation to the return enjoyed by

similar situated companies in the same industry

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Causes of under-capitalisation

The following bullets display the causes of under-capitalisation. Under estimation of the future earnings at the time of the promotion of

the company

Abnormal increase in earnings from the new economic and business

environments

Under estimation of total funds requirement

Maintaining very high efficiency through improved means of production

of goods or rendering of services

Companies which are set-up during the recession period will start

making higher earning capacity as soon as the recession is over

Purchase of assets at exceptionally low prices during recession

Effects of under-capitalisation

The following bullets display some of the effects of under-capitalisation.

Under-capitalisation encourages competition by creating a feeling that

the line of business is lucrative

It encourages the management of the company to manipulate the

companys share prices

High profits will attract higher amount of taxes

High profits will make the workers demand higher wages. Such a feeling

on the part of the employees leads to labour unrest High margin of profit may create an impression among the consumers

that the company is charging high prices for its products

High margin of profits and the consequent dissatisfaction among its

employees and consumer, may invite governmental enquiry into the

pricing mechanism of the company

Remedies

The following bullets display the remedies of under-capitalisation.

Splitting up of the shares, which will reduce the dividend per share

Issue of bonus shares, which will reduce both the dividend per share and

the earnings per share

Both over-capitalisation and under-capitalisation are detrimental to the

interests of the society.

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2.6 Summary

Financial planning deals with the planning, execution and the monitoring of

the procurement and utilisation of the funds. Financial planning process

gives birth to financial plan. It could be thought of as a blue-print explaining

the proposed strategy and its execution

There are many financial planning models. All these models forecast the

future operations and then translate them to income statements and balance

sheets. It will also help the finance managers to ascertain the funds to be

procured from the outside sources The essence of all these is to achieve a

least cost capital structure which would match with the risk exposure of the

company

Failure to follow the principle of financial planning may lead a new firm of

over or under capitalisation, when the economic environment undergoes a

change

Ideally every firm should aim at optimum capitalisation or it might lead to a

situation of over or under capitalisation. Both are detrimental to the interests

of the society. There are two theories of capitalisation - cost theory and

earnings theory.


Fill in the blanks

10. _____ of a firm refers to the composition of its long term funds.

11. Two theories of capitalisation for new companies are ______ and

earnings theory.

12. A company is said to be ________, when its total capital exceeds

the true value of its assets.

13. A company is considered to be _______ when its actual

capitalisation is lower than its proper capitalisation as warranted by

its earning capacity.

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1. Explain the steps involved in Financial Planning2. Explain the factors affecting Financial Plan

3. List out the causes of over-capitalisation

4. Explain the effects of under-capitalisation


Answers to Self Assessment Questions

1. Qualitative, Quantitative

2. Allocation of funds

3. Short term borrowings

4. Nature of the industry

5. Debt, Equity

6. The product policy

7. Flexibility in capital structure, effect changes in the composites of

capital structure

8. Fixed capital, working capital

9. Short term sources

10. Capitalisation

11. Cost theory

12. Over-capitalised

13. Under-capitalised

Answers to Terminal Questions

1. Refer to 2.2

2. Refer to 2.3

3. Refer to 2.5.3

4. Refer to 2.5.4

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Unit 3 Time Value of Money

Structure:

3.1 Introduction

Learning objectives

Rationale

3.2 Future Value

Time preference rate or required rate of return

Compounding technique

Discounting technique

Future value of a single flow

Doubling periodIncreased frequency of compounding

Effective vs. Nominal rate of interest

Future value of series of cash flows

Future value of annuity

Sinking fund

3.3 Present Value

Discounting or present value of a single flow

Present values of a series of cash flows

Present values of perpetuity

Present value of an uneven periodic sum

Capital recovery factor

3.4 Summary

3.5 Solved Problems



3.1 Introduction

In the previous unit, you have learnt that wealth maximisation is far more

superior to profit maximisation. Wealth maximisation considers time value of

money, which translates cash flows occurring at different periods into acomparable value at zero period.

For example, a firm investing in fixed assets will reap the benefits of such

investments for a number of years. However, if such assets are procured

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through bank borrowings or term loans from financial institutions, there is an

obligation to pay interest and return of principle.Decisions, therefore, are made by comparing the cash inflows

(benefits/returns) and cash outflows (outlays). Since these two components

occur at different time periods, there should be a comparison between the

two.

In order to have a logical and a meaningful comparison between cash flows

occurring over different intervals of time, it is necessary to convert the

amounts to a common point of time. This unit is devoted to a discussion of

techniques of doing so.


After studying this unit, you should be able to:

Explain the time value of money

Understand the valuation concepts

Calculate the present and the future values of lump sums and annuity

flows

3.1.2 Rationale

Time value of money is the value of a unit of money at different time

intervals. The value of the money received today is more than its value

received at a later date. In other words, the value of money changes over a

period of time. Since a rupee received today has more value, rationalinvestors would prefer current receipts over future receipts. That is why, this

phenomena is also referred to as Time preference of money. Some

important factors contributing to this are:

Investment opportunities

Preference for consumption

Risk

These factors remind us of the famous English saying, A bird in hand is

worth two in the bush.The question now is: why should money have time

value?

Some of the reasons are:

Production

Money can be employed productively to generate real returns. For

example, if we spend Rs. 500 on materials, Rs. 300 on labour and

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Rs. 200 on other expenses and the finished product is sold for Rs. 1100,

we can say that the investment of Rs. 1000 has fetched us a return of10%.

Inflation

During periods of inflation, a rupee has higher purchasing power than a

rupee in the future.

Risk and uncertainty

We all live under conditions of risk and uncertainty. As the future is

characterised by uncertainty, individuals prefer current consumption over

future consumption. Most people have subjective preference for present

consumption either because of their current preferences or because of

inflationary pressures.

3.2 Future Value

3.2.1 Time preference rate or required rate of return

The time preference for money is generally expressed by an interest rate,

which remains positive even in the absence of any risk. It is called the risk

free rate.

For example, if an individuals time preference is 8%, it implies that he is

willing to forego Rs. 100 today to receive Rs. 108 after a period of one year.

Thus he considers Rs. 100 and Rs. 108 as equivalent in value. In reality

though this is not the only factor he considers. He requires another rate for

compensating him for the amount of risk involved in such an investment.

This risk is called the risk premium.

There are two methods by which the time value of money can be calculated:

Compounding technique

Discounting technique

3.2.1.1 Compounding techniqueIn the compounding technique, the future values of all cash inflows at the

end of the time horizon at a particular rate of interest are calculated. The

amount earned on an initial deposit becomes part of the principal at the end

of the first compounding period.

Required rate of return = Risk free rate + Risk premium

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The compounding of interest can be calculated by the following equation:

Where, A = Amount at the end of the period

P = Principle at the end of the year

i = Rate of interest

n = Number of years

Example

Mr. A invests Rs. 1,000 in a bank which offers him 5% interest compounded

annually. Substituting the actual figures for the investment or Rs. 1000 in the

formulan, we arrive at the values shown in table 3.1.

Table 3.1: Interest compounded annually

Year 1 2 3

Beginning amount Rs.1000 Rs.1050 Rs.1102.50

Interest rate 5% 5% 5%

Amount of interest 50 52.50 55.13

Beginning principal Rs.1000 Rs.1050 Rs.1102.50

Ending principal Rs.1050 Rs.1102.50 Rs.1157.63

As seen from table 3.1, Mr. A has Rs. 1050 in his account at the end of the first

year. The total of the interest and principal amount Rs. 1050 constitutes the

principal for the next year. He thus earns Rs. 1102.50 for the second year. This

becomes the principal for the third year. This compounding procedure will

continue for an indefinite number of years.

Let us now see how the values in table 3.1 are arrived at.

Amount at the end of year 1 = Rs. 1000 (1+0.05) == Rs. 1050

Amount at the end of year 2 = Rs. 1050 (1+0.05) == Rs. 1102.50

Amount at the end of year 3 = Rs. 1102.50 (1+0.05) == Rs. 1157.63

The amount at the end of the second year can be ascertained by substituting

Rs.1000 (1+0.05) for Rs.1050, that is,

Rs.1000 (1+0.05) (1+0.05)=Rs.1102.50Similarly, the amount at the end of the third year can be ascertained by

substituting Rs.1000 (1+0.05) for Rs.1102.50, that is,

Rs.1000 (1+0.05) (1+0.05) (1+0.05)=Rs.1157.63

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3.2.1.2 Discounting technique

In the discounting technique, the present value of the future amount isdetermined. Time value of the money at time 0 on the time line is calculated.

This technique is in contrast to the compounding approach where we

convert the present amounts into future amounts.

3.2.2 Future value of a single flow (lump sum)

The process of calculating future value will become very cumbersome if they

have to be calculated over long maturity periods of 10 or 20 years. Ageneralised procedure of calculating the future value of a single cash flow

compounded annually is as follows:

Solved Problem

Mr.A requires Rs.1050 at the end of the first year. Given the rate of

interest as 5%,find out how much Mr. A would invest today to earn this

amount.

Solution

If P is the unknown amount, then

P (1+0.05) =1050

P=1050/ (1+0.05)

=Rs.1000

Thus Rs. 1000 would be the required principal investment to have

Rs. 1050 at the end of the first year at 5% interest rate. The present

value of the money is the reciprocal of the compounding value.

Mathematically, we have

Where P is the present value for the future sum to be received,

A is the sum to be received in future,

i is the interest rate and

n is the number of years.

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Where, FVn = future value of the initial flow in n years hence

PV = initial cash flowi = annual rate of interest

n = life of investment

The expression n)i1( represents the future value of the initial investment

of Re. 1 at the end of n number of years. The interest rate i is referred to

as the Future Value Interest Factor (FVIF). To help ease the calculations,

the various combinations of i and n can be referred to in the table 3.1. To

calculate the future value of any investment, the corresponding value of

n)i1( from the table 3.1 is multiplied with the initial investment.

3.2.2.1 Doubling period

A very common question arising in the minds of an investor is how long will

it take for the amount invested to double for a given rate of interest. There

are 2 ways of answering this question.

Solved Problem

The fixed deposit scheme of a bank offers the interest rates, as shown in

the table 3.2:

Table 3.2: Fixed deposit scheme of a bank

Period of deposit Rate per annum

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1. One is called rule of 72. This rule states that the period within which the

amount doubles is obtained by dividing 72 by the rate of interest.For instance, if the given rate of interest is 10%, the doubling period is

72/10, that is, 7.2 years.

2. A much accurate way of calculating doubling period is the rule of 69,

which is expressed as 0.35+69/interest rate. Going by the same example

given above, we get the number of years as 7.25 years {0.35 + 69/10

(0.35 +6.9)}.

3.2.2.2 Increased frequency of compounding

So far we have seen the calculation of the time value of money. It has been

assumed that the compounding is done annually.

Let us now see the effect on interest earned when compounding is done

more frequently - half-yearly or quarterly

Going by the calculations, we see that one gets more interest if

compounding is done on a more frequent basis. The generalised formula for

shorter compounding periods is:

Example

If we have deposited Rs.10, 000 in a bank which offers 10% interest per

annum compounded semi-annually, the interest earned is as shown in

table 3.3.

Table 3.3: Interest earned

Amount invested Rs.10,000

Interest earned for first 6 months10000*10%*1/2 (for 6 months) Rs.500

Amount at the end of 6 months Rs.10,500

Interest earned for second 6 months

105000*10%*1/2 Rs.525

Amount at the end of the year Rs.11,025

If in the above case, compounding is done only once in a year the

interest earned will be 10000*10% which is equal to Rs. 1000 and we

will have Rs. 11000 at the end of first year.

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Where, FVn = future value after n years

PV = cash flow todayi = nominal interest rate per annum

m = number of times compounding is done during a year

n = number of years for which compounding is done

3.2.2.3 Effective vs. Nominal rate of interest

We have just learnt that interest accumulation by frequent compounding is

much more than the annual compounding. This means that the rate of

interest given to us, that is 10% is the nominal rate of interest per annum.

If the compounding is done more frequently, say semi-annually, the principal

amount grows at 10.25% per annum. 0.25% is known as the Effective

Rate of Interest. The general relationship between the effective and

nominal rates of interest is as follows:

Where,

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