bb0011 managing financial resources set2

8/3/2019 BB0011 Managing Financial Resources Set2

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Q.1 Discuss the important finance functions.

Financial Management is indeed the key to successful business operations. Without proper

administration and effective utilization of finance, no business enterprise can utilize its potentials

for growth and expansion. The importance of financial management can be ascertained from the

study of the following points:

1. Successful promotion: Successful promotion of a business concern depends upon

efficient financial management. If the plan adopted fails to provide adequate capital to

meet the requirements of fixed and working capital and particularly the latter, the firm

cannot carry on its business successfully. Therefore, sound financial planning is quite

essential for the success of a business firm.

2. Smooth Running: Since finance is required at each stage of the business such as

promotion, incorporation, development, expansion and management of day-to-day

expenses, proper financial administration becomes necessary for the smooth running of a

business enterprise.

3. Decision making: Financial management provides scientific analysis of all facts and

figures through various financial tools such as ratio analysis, variance analysis, budgets

etc., Such an analysis helps the management to evaluate the profitability of the plan in

the given circumstances so that a proper decision can be taken to minimize the risk.

4. Solutions to Financial Problems: The efficient Financial Management helps the top

management by providing solutions to the various financial problems faced by it.


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5. Measure of performance: Financial Management is considered as a yard stick to

measure the performance of the firm.

The importance of Financial Management in an enterprise may very well be realized by the

following words: Financial Management is properly viewed as an integral part of overall

management rather than as a staff speciality concerned with fund raising operation. In addition to

raising funds, financial management is directly concerned with production, marketing and other

functions within an enterprise whenever decisions are made about the acquisition or distribution

of assets.

Thus, financial management has attained a good deal of importance in modern business.


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Q.2 What is the importance of studying future value and present value

concepts.

Compound Value Concept (Future Value)

In this concept the interest earned on the initial principal becomes a part of the principal at the

end of a compounding period.

This compounding process will continue for an indefinite time period.

Compounding of Interest Over N years: The compounding of interest can be calculated by

the following equation.

A = P (1 + i)n

In which

A = Amount at the end of period n

P = Principal at the beginning of the period.

i = Interest rate.

n = Number of years.

By taking illustration 2.1 we get

A = P (1 + i)n


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A = 1000 (1 + .10)3

A = 1,331

Computation by this formula can also become very time consuming if the number of years

become large, say 10, 20 or more. In such cases to save upon the computational efforts,

Compound Value table* can be used. The table gives the compound value of Re. 1, after n

years for a wide range of combination of i and n.

For instance, in the above illustration Table III gives the compound value of Re. 1 at 10% p.a. at

the end of 3 years as 1.331. Hence, the compound value of Rs. 1,000 will amount to:

1000 1.331 = Rs. 1331

Multiple Compounding Periods:

Interest can be compounded, even more than once in a year. For calculating the multiple

compounded value, above logic can be extended. For instance, in case of Semi-annual

compounding, interest is paid twice a year but at half the annual rate. Similarly in case of

quarterly compounding, interest rate effectively is 1/4th of the annual rate and there are four

quarter years.

Formula:
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In case of compounding we calculate the future value of a sum of money or series of payments,

while in case of present value concept, we estimate the present worth of a future

payment/installment or series of payments adjusted for the time value or money.

The basis of present value approach is that opportunity cost exists for money lying idle. That is to

say, that interest can be earned on the money. This return is termed as discounting rate.

Given a positive rate of interest, the present value of future rupee will always be lower. The

technique for finding the present value is termed as discounting.

Present value after n years:

Formula:

Where:

PV = principal amount the investor is willing to forego at present.

i = Interest rate.

A = Amount at the end of the period n.


With this formula, we can directly calculate the amount, any depositor would be willing to sacrifice

at present, with a time preference rate or discount rate of x%.


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Present Value of a Series of Cash Flows:

In a business situation, it is very natural that returns received by a firm are spread over a number

of years. An investment made now may fetch returns for a period after some time. Every

businessman will like to know whether it is worthwhile to invest or forego a certain sum now, in

anticipation of returns he expects to earn over a number of years. In order to take this decision he

will need to equate the total anticipated future returns, to the present sum he is going to sacrifice.

To estimate the present value of future series of returns, the present value of each expected

inflow will be calculated.

The present value of series of cash flows can be represented by the following

formula:

Where,

PV = sum of individual present values of each cashflow; C1, C2,

C3 ..


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Cn = Cash flows after period 1, 2, 3 .. n

i = Discounting rate.

Present value of an Annuity:

In the above case there was a mixed stream of cash inflows. An individual or depositor may

receive only constant returns over a number of years. This implies that the cash flows are equal

in amount. To find out the present value of annuity either we can find the present value of each

cash flow or use the annuity table. The annuity table gives the present value of an annuity Re. 1

for interest rate r over number of years n.


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Q.3 Discuss how financial management helps in maximizing shareholder

wealth through effective utilization of resources.

The important financial decisions to be taken by the manager are as follows:

1. Investment Decisions: This is concerned with the allocation of capital. It has to show the

funds can be invested in assets which would yield benefit in future. This is a decision

based on risk and uncertainty. Finance manager has to evaluate the investment in

relation to their expected return and risk to determine whether the investment is feasible

or not. Besides the financial manager is also entrusted with the management of existing

assets. The whole exercise is called "Capital Budgeting". This was the first technique

developed in financial management. This technique helps to know Net Present Value of

assets. To have a more profitable investment, the companies can think of amalgamations

and mergers internally and externally. That is why we have seen the emergence of

multinational companies.

2. Finance Decisions: This decision is concerned with the mobilization of finance for

investment. The finance manager has to take decisions regarding the acquisition of

finance. Whether entire capital required should be raised in the form of equity capital, or

the amount should be borrowed totally or a balance should be struck between equity and

borrowed capital has to be decided. Even the timing of acquisition of capital should also

be perfectly made. While determining the ratio between debt and equity, the finance

manager should ascertain the risk involved in obtaining each type of capital. Thus


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determining the best "Finance Mix" is another important task of the finance manager. The

best capital structure will always ensure wealth maximization.

3. Dividend Decision: This decision is concerned with the divisible profits of the company.

i) How much profit is to be flown back by capitalization?

ii) How much cash dividend should be paid to the shareholders?

iii) Maintenance of stable dividend rate over the period, are some of the issues

connected with this decision.

The dividend decision involves the determination of the percentage of profit earned by the

enterprise which is to be paid to its shareholders. The dividend pay out ratio must be evaluated in

the light of the objective of maximizing shareholders wealth. Thus, the dividend decision has

become a vital aspect of financing decision.

4. Current Assets Management: The finance manager should also manage the current

assets to have liquidity in the business. Investment of funds in current assets reduces the

profitability of the firm. However the finance manager should also equally look after the

current financial needs of the firm to maintain optimum production. While investing funds

in current assets, he must see that proper balance (trade off) is maintained between the

profitability and liquidity.

Every financial decision involves this trade off. At this level the market value of the companys

shares would be the maximum.


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The inter-relationship between market value, financial decisions, risk-return and trade off is

depicted in the chart.

Decisions, Return, Risk and Trade off.

In conclusion we can say that to maximize the wealth of the owners, the finance manager has to

take carefully the decisions relating to (i) Investment (ii) Dividend (iii) Financing and (iv) Current

Assets.
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Q.4 What is the principle of compounding vs discounting.

Compound Value Concept

In this concept the interest earned on the initial principal becomes a part of the principal at the

end of a compounding period.

Illustration: Rs. 1,000 invested at 10% is compounded annually for three years. Calculate the

Compounded value after three years.

This compounding process will continue for an indefinite time period.

Compounding of Interest Over N years: The compounding of interest can be calculated by

the following equation.

A = P (1 + i)n

In which

A = Amount at the end of period n

P = Principal at the beginning of the period.

i = Interest rate.


By taking illustration 2.1 we get


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A = P (1 + i)n

A = 1000 (1 + .10)3

A = 1,331

Computation by this formula can also become very time consuming if the number of years

become large, say 10, 20 or more. In such cases to save upon the computational efforts,

Compound Value table* can be used. The table gives the compound value of Re. 1, after n

years for a wide range of combination of i and n.

For instance, in the above illustration Table III gives the compound value of Re. 1 at 10% p.a. at

the end of 3 years as 1.331. Hence, the compound value of Rs. 1,000 will amount to:

1000 1.331 = Rs. 1331

Multiple Compounding Periods:

Interest can be compounded, even more than once in a year. For calculating the multiple

compounded value, above logic can be extended. For instance, in case of Semi-annual

compounding, interest is paid twice a year but at half the annual rate. Similarly in case of

quarterly compounding, interest rate effectively is 1/4th of the annual rate and there are four

quarter years.

Formula:

Where,

A = Amount after a period.

P = Amount in the beginning of the period.

i = Interest rate

M = Number of times per year compounding is made.
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n = Number of years for which compounding is to be done.

Discounting or present value concept

The concept of present value is the exact opposite of that of compound value.

In case of compounding we calculate the future value of a sum of money or series of payments,

while in case of present value concept, we estimate the present worth of a future

payment/installment or series of payments adjusted for the time value or money.

The basis of present value approach is that opportunity cost exists for money lying idle. That is to

say, that interest can be earned on the money. This return is termed as discounting rate.

Given a positive rate of interest, the present value of future rupee will always be lower. The

technique for finding the present value is termed as discounting.

Present value after n years:

Formula:

Where:

PV = principal amount the investor is willing to forego at present.

i = Interest rate.

A = Amount at the end of the period n.


With this formula, we can directly calculate the amount, any depositor would be willing to sacrifice

at present, with a time preference rate or discount rate of x%.

Example: If Mr X, depositor, expects to get Rs. 100 after one year at the rate of 10%, the amount

he will have to forego at present can be calculated as follows:


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Similarly, the present value of an amount of inflow at the end of n years can be computed.

Present Value of a Series of Cash Flows:

In a business situation, it is very natural that returns received by a firm are spread over a number

of years. An investment made now may fetch returns for a period after some time. Every

businessman will like to know whether it is worthwhile to invest or forego a certain sum now, in

anticipation of returns he expects to earn over a number of years. In order to take this decision he

will need to equate the total anticipated future returns, to the present sum he is going to sacrifice.

To estimate the present value of future series of returns, the present value of each expected

inflow will be calculated.

The present value of series of cash flows can be represented by the following formula:

Where,

PV = sum of individual present values of each cashflow; C1, C2,

C3 ..

Cn = Cash flows after period 1, 2, 3 .. n

i = Discounting rate.
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Q.5 What are the steps in capital budgeting.

Capital Budgeting Process involves the following steps:

1. Project generation

2. Project evaluation

3. Project selection

4. Project execution

Above steps are essential to any capital budgeting process. But individual situations of capital

budgeting may demand for any other steps relevant to the situation to make the process effective

one.

1. Project Generation: Investment proposals of various types may originate at different

levels within a firm. The investment proposals may fall into one of the following

categories:


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a) i) Proposals to add new product to the product line.

ii) Proposal to expand capacity in existing product lines.

b) Proposals to reduce the costs of the output of the existing products without altering the

scale of operation.

The investment proposals of any type can originate at any level; from top management level to

the level of workers. The proposals may originate systematically or haphazardly.

2. Project Evaluation: Project Evaluation involves two steps:

i) Estimation of benefits and costs. The benefits and costs must be measured in terms

of cash flows.

ii) Selection of an appropriate criterion to judge the desirability of the project.

3. Project Selection: Since capital budgeting decisions are of considerable significance,

the final approval of the project may generally rest on top management. However,

projects are screened at multiple levels.

4. Project Execution: The funds are appropriated for capital expenditure after the final

selection of investment proposals. The formal planning for the appropriation of funds is

called the capital budget. The project execution committee or the top management must


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ensure that the funds are spent in accordance with appropriations made in the capital

budget.


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Q.6 What are the factors on which the working capital requirements of a

Two wheeler manufacturing company will be based.

A host of factors influencing the levels of working capital needs for a firm can be categorized into

two groups, viz., internal factors and external factors.

A. Internal Factors :

1. Nature of Business: The composition of current assets is a function of

the size of a business and the industry to which it belongs. Small

companies have smaller proportions of cash, receivables and inventory

then large corporations. This difference becomes more marked in large

corporations. A public utility concern, for example, mostly employs

fixed assets in its operations, while a merchandising department

depends generally on inventory and receivables. Needs for working

capital are thus determined by the nature of an enterprise.

2. Size of Business: The size of business has also an important impact

on its working capital needs. Size may be measured in terms of a scale

of operations. A firm with larger scale of operation will need more

working capital than a small firm.

3. Firms Production Policy: A firm following uniform production policy

will have to pile stocks of materials during the off season periods and


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thus incur greater inventory costs and risk. The effect of seasonal

fluctuations upon working capital can be offset by pursuing the policy

of adjusting production plan to seasonal changes. In this case,

inventories are kept at minimum levels but the production manager

must shoulder the responsibility of constantly varying production

schedules in accordance with the changing demand. Obviously,

working capital needs of a firm with level production plan will be higher

than the one with varying production plan.

4. Firms Credit Policy: Credit control includes such factors as the

volume of credit sales, the terms of credit sales, the collection policy,

etc. With a sound credit control policy, it is possible for a firm to

improve its cash inflow.

5. Access to Money Market: The Working capital requirements of a firm

are conditioned by the firms access to different sources of money

market. Thus, the firm with readily available credit from banks and

trade. Credit facilities at liberal terms will be able to get by with less

working capital than a firm without such facilities.

6. Growth and Expansion of Business: Working capital requirements

of an enterprise tend to increase in correspondence with growth in

volume of sales. Additional Current assets will be needed to support

increased scale of operations. It can further be noted that a growing

enterprise requires additional funds continuously to fulfil the increasing

needs of the business.


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7. Profit Margin & Dividend Policy: Magnitude of working capital in a

firm is dependent upon its profit margin and dividend policy. As a

matter of fact, a high net profit margin reduces the working capital

requirements of the firm because it contributes towards the working

capital pool. To the extent net profit has been earned in cash, it

becomes a source of working capital. However, it should be noted that

whole of the profit earned is not available for working capital purposes.

The availability of net profits for working capital purposes depends

essentially upon the dividend policy pursued by the Company.

Distribution of high proportion of profits in the form of cash dividend results in a drain on cash

resources and thus reduces Companys working capital to that extent. Where the management

follows conservative dividend policy and retains larger portion of net profits, the Companys

working capital position is strengthened.

1. Depreciation Policy: The depreciation policy influences the level of working

capital by affecting tax Liability and retained earnings of the enterprise. Since

depreciation is tax deductible expense item, higher amount of depreciation

results in lower tax liability and greater profits. Similarly, the amount of net profits

will be less if higher amount of depreciation is charged. If the dividend policy is

linked with net profits, the firm can pay less dividend by providing more

depreciation. This will result in increased retained earnings and strengthen the

firms working capital position.


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2. Operating Efficiency of Firm: Operating efficiency of the firm results in optimum

utilization of resources at minimum cost. If a firm successfully controls operating

costs, it will be able to improve net profit margin which will, in turn, release

greater funds for working capital purposes.

3. Co-ordination of Activities in Firm: Where production and distribution activities

are coordinated, pressure on working capital will be minimized. In the absence of

coordination in production and distribution policies demand for working capital is

reduced.

B. External Factors:

1. Business Fluctuations: Seasonal fluctuations in sales affect the level

of variable working capital. Often, the demand for products may be of a

seasonal nature. Yet inventories have got to be purchased during

certain seasons only. The size of the working capital in one period

may, therefore, be bigger than that in another.

2. Business expands during the period of prosperity and declines during

the period of depression. Consequently, more working capital is

required during the period of prosperity and less during the period of

depression.

3. Technological Developments: Technological developments in the

area of production can have sharp effects on the need for working


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capital. If a firm switches over to new manufacturing process and

installs new equipments with which it is able to cut period involved in

converting raw materials into finished goods, permanent working

capital requirements of the firm will decrease. If the new machine can

utilize less expensive raw materials, the inventory needs may be

reduced.

4. Import Policy: Import policy of the government may also have its

bearing on the levels of working capital of the enterprises since they

have to arrange funds for importing goods at specified times.

5. Taxation Policy: In the event of regressive taxation policy of the govt.,

as it exists today in India, imposing heavy tax burdens on business

enterprises, they are left with very little profits for distribution and

retention purposes, consequently, they have to borrow additional funds

to meet their increased working capital needs. Thus pressure on

working capital is minimised particularly when liberal taxation policy is

followed.

6. Transport and Communication Developments: Where the means of

transport and communication in a country are not well developed,

industries may need additional funds to maintain big inventory of raw

materials and other accessories which would otherwise not be needed

where the transport and communication systems are highly developed.


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Thus, there are several factors affecting the working capital requirements. However, as a general

rule, it can be concluded that in most cases the period which elapses between the purchase of

materials and the receipt of sale proceeds of the finished goods will determine the working capital

requirements of any business. This requires that there should not be any unnecessary delay in

the production process and also in the realization of money from debtors. The Just in time

approach, as explained below, greatly helps in reducing processing time and thereby preventing

Locking of unnecessary funds in working capital.

Just in Time (JIT) Approach: This is an approach to manufacturing developed in Japan. Its

Philosophy is that items should be received at the exact time, at the exact place and in perfect

condition. The objective is to have a perfect matching between the output of a manufacturing firm

and needs of the market. In case something is not needed immediately, it is not manufactured.

Effort is made to minimize the time interval between starting the manufacturing process and the

product being ready for delivery to the customer. This time interval is known as throughput time,

which is the total of: processing time + Inspection Time + Conveyance Time + Waiting time.

In case of JIT approach, the ultimate objective is that throughput time does not exceed the

processing time. In other words, material is not allowed to wait at the store, factory floor or after

processing operation. This results in considerable elimination of buffer stocks and consequently

unnecessary locking of funds in working capital.

.

bb0011 managing financial resources set2

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