objective importance and scope of fm

8/7/2019 Objective Importance and Scope of FM

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Meaning Importance and Objectives of Financial Management

Finance Finance may be defined as the art and science of managing

money. The major areas of finance are 1. Financial Services & 2.

Managerial Finance/Corporate Finance/Financial Management.

Financial Services It is concerned with the design and delivery of

advice and financial products to individuals, businesses and

government within the areas of banking and related institutions,

personal financial planning, investments, real estate, insurance and

so on.

Financial Management It is concerned with the duties of the

financial managers in the business firm. Actively managing the

financial affairs of any type of business, namely, financial and non

financial, private and public, large and small, profit seeking and not

for profit. They perform various tasks such as budgeting, financial

forecasting, cash management, credit administration and so on.

Finance and other related Disciplines

Finance and Economics

Economics is broadly divided into two broad areas 1.

Macroeconomics 2. Microeconomics

What financial managers need to understand related to

macroeconomics environment:-

1.How monetary policy affects the cost and availability of funds.2.Knowledge of fiscal policy and its effects on the economy.3.Knowledge of various financial institutions.


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4.Understand the consequences of various levels of economicactivity and changes in economic policy for their decision

environment.

What financial managers need to understand related toMicroeconomics:-

1.Supply and demand relationship and profit maximisationstrategies.

2.Issues related to the mix of productive factors, optimal saleslevel and product pricing strategies.

3.Measurement of utility preference, risk and determination ofvalue, and

4.The rationale of depreciating assets.5.Marginal analysis.

Finance and Accounting

Accounting helps financing in different ways by providing the input

for the various financial decisions and it provides the various tools

which helps the financial managers to undertake their decisions withdue care and diligence.

But accounting and finance are different from each other in the

following two aspects first is the Treatment of Funds and Decision

Making.

Importance of Financial Management

1.Investment Decision2.Capital Budgeting3.Working Capital Management4.Financing or Capital Structure Decision5.Dividend Policy Decision


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Objectives of Financial Management

The main objective of the Financial Manager is to use the mix of

Investment, Financing and Dividend Decisions for the maximisation

of wealth.

Wealth Maximisation or Profit Maximisation ............?????

Profit/EPS Maximisation Decision Criterion

According to this approach the three decisions should be focussed on

maximisation of the profit/EPS.

Arguments in Favour of Profit Maximisation:-

1.Profit is a test of Economic Efficiency.2.Profit is a yardstick by which economic performance can be

judged.

3.Proof of Efficient Allocation of Resources.4.It ensures maximum Social Welfare.

Arguments against Profit Maximisation:-

1.Ambiguity(A). It is vague and ambiguous concept.

(B). It has no precise connotation.

(C). Amenable to different Interpretations by different people.

2. Timing of Benefits

3. Quality of Benefits.

What should be an appropriate operational decision criterion for

financial management?


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An appropriate operational decision criterion for financial

management should be (i) Precise and Exact, (ii) Based on bigger the

better principle, (iii) Consider both Quality and Quantity dimension

of benefits and (iv) Recognise the time value of money.

Wealth Maximisation Decision Criterion

It is based on the concept of cash flow generated rather than

accounting profit which is used as the basis of the measurement of

benefits in the case of the profit maximisation criterion.

Arguments in Favour of Wealth Maximisation

1.Avoids the ambiguity associated with accounting profits as it isbased on the cash flows generated.

2.Considers both quality and quantity dimensions.3.Incorporates time value of money.

Economic Value Added

Focus on Stake Holders


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Time Value of Money

Why should Money have time value? Here are some important

reasons for this phenomenon.

Money can be employed productively to generate real returns. For

instance, if a money sum of Rs. 100 invested in raw materials and

labour results in finished goods worth Rs. 105, we can say that the

investment of Rs. 100 has earned a rate of return of 5%.

In an inflationary period a rupee today has higher purchasing power

than a rupee in future.

Since future is characterised by uncertainty, individuals prefer

current consumption to future consumption.

The manner in which these three determinants combined to

determine the rate of interest can be symbolically represented as

follows:-

Nominal or Market interest rate

= Real rate of interest or return + expected rate of Inflation + Risk

premiums to compensate for uncertainty.

Two methods of taking care of time value of money:-

1.CompoundingUnder this method we find the future values of all the cash flows at

the end of the time horizon at a particular rate of interest. Therefore,

in this case we will be comparing the future value of the initial

outflow of Rs. 1000 as at the end of year four with the sum of the


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future values of the early cash inflows at the end of year four. This

process can be represented as follows.

0 - 1000 Present Value at Yr 41 250 Future Value2 500 Future Value

3 750 Future Value

4 750 Future value

Discounting

Under the method of discounting, in time value of money, we

compare the initial outflow with the sum of present value (PV) of thefuture inflows at a given rate of interest.

0 - 10001 250 Present Value

2 500 Present Value

3 750 Present Value

4 750 Present Value

Example 1

If X has a sum of Rs. 1000 to be invested, and there are two schemes,

one offering a rate of interest of 10%, compounded annually, and

other offering a simple rate of interest of 10%, which one should he

opt for assuming that he will withdraw the amount at the end of (a)

1 Year (b) 2 Year, and (c) 5 Years?

Future Value of a Single Flow

A generalised procedure for calculating the future value of a single

cash flow compounded annually is as follows:

Future Value(n) = Present Value (1+k)n


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Where, FV(n) = Future value of the initial flow n years hence

PV = Initial cash flow

K = Annual Rate of interest

n = Life of investment.

Example 2

The fixed deposit scheme of a bank offers the following interest rates

Period of Deposits Rate Per Annum

46 days to 179 days 10.00%

180 days to 1 year 10.50%1 Year and above 11.00%

An amount of Rs. 10000 invested today will grow in three years to ?

Solution:

Future Value(n) = Present Value (1+k)n

=Pv * FVIF(11,3)

=10000(1.368)

=Rs. 13,680

Growth Rate

The compound rate of growth for a given series after a period of

time can be calculated by employing the future value interest factor

table.

Years 1 2 3 4 5 6

Profits 95 105 140 160 165 170

We can determine the compound rate of growth for the above series

in the following two steps:


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a.The ratio of profits for year 6 to year 1 is to be determined i.e.,170/95=1.79.

b.The FVIFk(n-1) table is to be looked at. Look at the future valuewhich is close to 1.79 for the row for 5 years.

The value close to 1.79 is 1.762 and the interest rate

corresponding to this is 12%. Therefore the compound rate of

growth is 12%.

Increased Frequency of Compounding

The generalised formula for shorter compounding periods is

FVn = PV(1+k/m)m*n

Where, FVn = Future value after n years

PV = Cash Flow Today

K = Nominal interest rate per annum

m = Number of times compounding is done in an year

n = Number of years for which compounding is done.

Example:-

In a particular investment scheme deposits can be made for

periods ranging from 6 months to 10 years. Interest to be

compounded quarterly.

Rate of Interest for 12 to 23 months = 9%


An amount of Rs. 1000 invested for 2 years will grow to ?

FVn = PV(1+k/m)m*n

Where, m = frequency of compounding during a year


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= 1000(1+0.10/4)8

= 1000(1.025)8

= 1000*1.2184 = 1218

Effective vs. Nominal Rate of Interest

r= (1+k/m)m-1

Where, r = Effective rate of interest

k = Nominal Rate of interest

m = Frequency of compounding per year.

Future value of Multiple Flows

Suppose we invest Rs. 1000 now (beginning of the year 1 ), Rs .

2000 at the beginning of the year two and Rs. 3000 at the

beginning of the year three, how much will these flows

accumulate to at the end of year three at a rate of interest of 12%

p.a?

To determine the accumulated sum at the end of year three, we

have to just add the future compounded values of Rs. 1000, Rs.

2000 and Rs. 3000.

FV(Rs. 1000) + FV(Rs. 2000) + FV(Rs. 3000)

At k = 0.12, the sum is equal to

= Rs. 1000*FVIF (12,3) + 2000*FVIF(12,2) + 3000*FVIF(12,1)

= Rs. [(1000*1.405) + (2000*1.254) + (3000*1.120)]

= Rs. 7273


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Future Value of Annuity

FVAn = A[(1+K)n-1/k]

Where, A = Amount deposited at the end of the year for n years

K = Rate of interest (expressed in decimals)

n = Time horizon

FVAn = Accumulation at the end of n years.

Example:-

As per the investment scheme a fixed sum is deposited every

month for 12 to 120 months. The period of deposit should be in

multiples of three months.



Interest to be compounded quarterly.

Amount of deposit = Rs. 5 per month.

Rate of interest = 9% p.a compounded quarterly

Effective rate of interest P.a = (1+0.09/4)4-1 = 0.0931

Rate of interest per month = (r+1)1/m-1

= (1+0.0931)1/12-1

= 1.0074 - 1 = .0074 = .74%

Maturity value can be calculated using the formula

FVAn = A{(1+k)n-1/k}

= 5{(1+0.0074)12-1/0.0074}


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= 5 * 12.50

= Rs. 62.50

Present Value of a Single Flow

If we invest Rs. 1000 today at 10% rate of interest for a period of 5

years we will get Rs. 1000*FVIF(10,5) = 1000*1.611 = 1611 at the

end of five years. The sum of Rs. 1611 is called the accumulation

of Rs. 1000 for the given values of k and n. The sum of Rs. 1000

invested today to get Rs. 1611 at the end of 5 years is called the

present value of Rs.1611 for the given values of k and n.

Therefore, follows that to determine the present value of a future

sum we have to divide a future sum by the FVIF value

corresponding to the given value of k and n present value of Rs.

1611 receivable at the end of five years at 10% rate of interest.

= Rs. 1611/FVIF(10,5) = Rs. 1611/1.611 = Rs. 1000

PV = FVn*PVIF(K,n)

Example:-

Interest rate = 12% certificate has a value of Rs. 100 after one year

what would be the issue price of the certificate if the interest is to

be compounded quarterly?

The effective rate of interest has to be calculated first:

r=(1+k/m)m 1

r = (1+ 0.12/4)4 - 1

= 12.55%

The issue price of the certificate is


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PV = FVn/(1+k)n

= 100/(1+0.1255)1

= Rs. 88.85

Example:-

Amount can be invested for a period of 1 to 10 years. The rate of

interest is 12% p.a compounded quarterly. What would be the

issue price of a certificate of Rs. 100000 to be received after 10

years?

PV = FVn/(1+k)n

Firstly the effective rate of interest has to be calculated

R = [1+0.12/4]4 1

= 12.55%

The issue price of the cash certificate can now be calculated as

= 100000/(1+0.1255)10

=30,658

Present Value of Uneven Multiple Flows

Present Value of an Annuity

The present value of an annuity receivable at the end of every year

for a period of n years at a rate of interest k is equal to


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PVAn = A*[(1+k)n 1 / k (1+k)n]

Example:-

A lump sum deposit is remitted and the principal is received with the

interest @ 12% p.a in 12 or 24 monthly instalments, interest is

compounded quarterly. What amount should be deposited initially

to receive a monthly instalment of Rs. 100 for 12 months.

Firstly, the effective rate of interest has to be calculated:

r=(1+k/m)m 1

= (1+ 0.12/4)4 - 1

= 12.55%

After calculating the effective rate of interest p.a the effective rate of

interest per month has to be calculated which is nothing but:-

=(1.1255)1/12 1

= .00990

The initial deposit can now be calculated as below

PVAn = A*[(1+k)n 1 / k (1+k)n]

= 100[(1+.00990)12 1/.00990(1+.00990)12]

= 100[.1255/.01114]

= 100*11.26

= Rs. 1126

Capital Recovery Factor


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A loan of Rs. 100000 has to be paid in five equal annual instalments

and the loan is at the rate of 14% p.a. Calculate the amount of each

instalment to be paid.

If r is defined as the equated annual instalment , we are given that

R*PVIFA(14%,5) = 100000

Therefore, R = Rs. 100000/PVIFA(14%,5)

= Rs. 100000/3.433

= Rs. 29129.


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Risk and Return

The Concept of Return

The objective of the any investor is to maximise expected returns

from his investment subject to various constraints, primarily risk.

Return is the motivating force, inspiring the investor in form of

rewards, for undertaking the investment.

The importance of return in any investment decision can be traced

to the following factors:

y Enables investors to compare alternative investments interms of what they have to offer the investor.

y Measurement of historical returns enables the investors toassess how well they have done.

y Measurement of historical returns also helps in estimation offuture returns.

Returns are of two types:-

1.Realized and

2.ExpectedRealized return This is ex-post return or return that was earned.

Expected Return This is the return that investors expect to earn

over some future period.

The Components of Return

Return is basically made up of two components:-

y The periodic cash receipts or income on the investment in theform of interest dividends etc.

y The appreciation in the price of the asset is referred to ascapital gain.


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Measuring the Rate of Return

It is the income from the security in the form of cash flows and the

difference in price of the security between the beginning and end of

the holding period expressed as a percentage of the purchase priceof the security at the beginning of the holding period.

Rate of Return

K = Dt + (Pt-Pt-1)/Pt-1

Where, k = rate of return

Pt = Price of the security at the end of the holding period

Pt-1 = Price of the security at the beginning of the holding

period or purchase price.

Dt = Income or cash flows receivable from the security at

Time t

Example:-

If a share of a company is purchased for Rs.3580 an year back and

sold for Rs. 3800 this year and the company paid the dividend of Rs.

35 for the year what is the rate of return of this security.

K = Dt + (Pt-Pt-1)/Pt-1

= 35 + (3800-3580)/3580 = 7.12%

Example:-

If a 14% Rs.1000 debentures was purchased for Rs. 1350 and the

price of this security rises to Rs. 1500 by the end of an year. What is

the rate of return for this debenture?


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K = Dt + (Pt-Pt-1)/Pt-1

= 140+(1500-1350)/1350 = 21.48%

Probabilities and Rate of Return

What are probabilities?

A probability is a number that describes the chances of an event

taking place. Probabilities are governed by following rules and range

from 0 to 1.

y A probability can never be larger than one.y The sum total of probabilities must be equal to 1.y A probability can never be a negative number.y If an outcome is certain to occur it is assigned a probability of 1

while impossible outcomes are assigned a probability of 0.

y The possible outcomes must be mutually exclusive andcollectively exhausted.

Expected rate of return k is calculated by summing the products of

the rates of return and their respective probabilities.

K=Sum of Piki

Where, k = expected rate of return.

Pi = Probability associated with the ith possible outcome.

ki = Rate of return from the ith possible outcome.

Example:-

The probability distributions and the corresponding rates of return of

a company are shown below.

Possible Outcomes(i) Probability of

Occurrence (Pi)

Rate of Return (%)

(Ki)


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1 0.10 50

2 0.20 30

3 0.40 10

4 0.20 -10

5 0.10 -30

How do we calculate the expected rate of return?

K = piki

= (0.10)(0.50) + (0.20)(0.30) + (0.40)(0.10) + (0.20)(-0.10) + (0.10)

(-0.30)

= 0.05+0.06+0.04-0.02-0.03 = 0.1

= 10%

Risk

Risk and return go hand in hand in investments and finance. One

cannot talk about returns without talking about risk, because,

investment decisions always involve a trade off between risk and

return. Risk can be defined as a change that the actual outcome from

an investment will differ from the expected outcome. This means

that, the more variable the possible outcome that can occur, the

greater the risk

Risk and Expected Rate of Return

A Company

Pi Ki(%)


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1 0.05 38

2 0.20 23

3 0.50 8

4 0.20 -7

5 0.05 -221.00

k = 8%

B Company

Pi Ki(%)

1 0.10 90

2 0.25 50

3 0.30 20

4 0.25 -10

5 0.10 -50

1.00

k= 20%

Sources of Risk

What are the various source of risk? What are the factors which

make any financial asset risky?

y Interest Rate Risky Market Risky Inflation Risky Business Risky Financial Risk and


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y Liquidity Risk

Measurement of Total Risk

There are different ways to measure the variability of returns.

Range - The range of the returns, the difference between the

highest possible rate of return and the lowest possible rate of

return is one measure, but the range is based on only two

extreme values.

Variance The variance of an assets rate of return can be found

as a sum of squared deviation of each possible rate of return from

the expected rate of return multiplied by the probability that the

rate of return occurs.

N - 2

VAR(k) = MPi(ki-k)

I=1

Where, VAR(k) = Variance of returns

Pi = Probability associated with the possible outcome.

Ki = Rate of return from the possible outcome.

k = Expected rate of return.

n = Number of years.

Standard Deviation


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The most popular way of measuring variability of returns is standard

deviation. The standard deviation is simply the square root of the

variance of the rates of return as explained above:-

S.D = Square root of VAR (k)

The S.D and variance are conceptually equivalent quantitative

measures of total risk. S.D is preferred to range because of the

following advantages.

1.S.D considers every possible event and assigns each event aweight equal to its probability.

2.S.D is a very familiar concept and many calculators andcomputers are programmed to calculate it.

3.S.D is a measure of dispersion around the expected value.4.S.D is obtained as the square root of the sum of the square

differences multiplied by their probabilities. This facilitates

comparison of risk as measured by S.D and expected returns

as both are measured in the same cost. This is why S.D ispreferred as a measure of risk.

Possible

Outcomes

Ki(%) Ki-k (ki-k)2 Pi Pi(ki-k)2

1 50 40 1600 0.10 160

2 30 20 400 0.20 80

3 10 0 0 0.40 04 -10 -20 400 0.20 80

5 -30 -40 1600 0.10 160

Mpi(Ki-

k)2=480


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S.D = Square root of VAR (k)

= Square root of 480 = 21.9%

Portfolio and Risk

What is a portfolio?

An investment portfolio refers to the group of assets that is owned

by an investor.

Investing in a single security is always more riskier that investing in

two or more securities.

As the saying goes NEVER PUT ALL YOUR EGGS IN ONE BASKET.

Lets understand with an example:-

Weather

Conditions

Return On A

Stocks

Return on B

Stocks

Return on

Portfolio(50%A

+ 50%B)

Ra(%) Rb(%) Rp(%)Rainy 0 20 10

Normal 10 10 10

Sunny 20 0 10

Possible

Outcomes

Probability Ra Rb Rp

Rainy 1/3 0 20 10

Normal 1/3 10 10 10

Sunny 1/3 20 0 10

Expected

Rate of

10% 10% 10%


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return k

S.D Square root

of66.67=

8.16%

Square root

of66.67=

8.16%

Perfectly Negatively Correlated

Perfectly Positively Correlated

Diversifiable and Non-Diversifiable Risk

Because of the fact that returns on stock do not move in the same

direction risk can be reduced by diversification but there is a limit on

the amount of risk that can be reduced through diversification we

can trace this by two major reasons.

Degree of Correlation

The amount of risk reduction depends on the degree of positive

correlation between stocks. The lower the degree of positive

correlation, the greater is the amount of risk reduction that is

possible.

Non Diversifiable Risk

It is that part of total risk that is related to the general economy or

the stock market as a whole and hence cannot be eliminated by

diversification.

Non diversifiable risk is also referred to as market risk or systematic

risk.


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Diversifiable risk on the other hand, is that part of the total risk that

is specific to the company or industry and hence can be eliminated

by diversification.

Diversifiable risk is also called unsystematic risk or specific risk.

Non-Diversifiable or Market Risk Factors

1.Major Changes in tax rates2.War and other Calamities3.An increase or decrease in inflation rates4.A change in economic policy5.Industrial Recession6.An increase in international oil prices, etc.

Diversifiable or Specific Risk Factors

1.Company Strike2.Bankruptcy of a major supplier3.

Death of a key company officer

4.Unexpected entry of a new competitor into the market etc.

Risk of stocks in a Portfolio

How do we measure the risk of stocks in a portfolio?

A portfolios S.D is a good indicator of its risk to the extent that if

addition of a stock to the portfolio increase the portfolios S.D, the

stock adds risk to the portfolio.

How does one measure non- diversifiable or market risk?


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It is generally measured by Betacoefficient. Beta measures therelative risk associated with any individual portfolio as measured in

relation to the risk of the market portfolio. The market portfolio

represents the most diversifies portfolio of risky assets an investor

could buy since it includes all risky assets. The relative risk can be

expressed as:-

Betaj = Non-Diversifiable Risk of asset or portfolio/Risk of market

Portfolio.

Thus, the beta coefficient is the measure of the non-diversifiable or

systematic risk of an asset related to that of the market portfolio.

Value of Beta Factor Indication1 Average Risk

>1 Above Average Risk


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independent variable km, in the single index model or the market

model developed by William Sharpe.

Kj = Alphaj +(Betaj)km + ej

The beta parameter Betaj in the model represents the slope of the

above regression relationship and as explained earlier, measures the

responsiveness of the security or portfolio to the general market and

indicates how extensively the return of the portfolio or security will

vary with the changes in market return.

Beta Defined The ratio of the securities covariance of return with

the market to the variance of the market.

Year Kj Kj-

kj(Assumed

mean)

Km Km-

km(Assumed

mean)

P P(kj-

kj)*(km-

km)

P(km-

km)raise

to

power 2

1 20 0 10 0 0.1 0 0

2 50 30 30 20 0.1 60 40

3 -50 -70 -30 -40 0.1 280 160

4 -10 -30 -10 -20 0.1 60 405 90 70 50 40 0.1 280 160

6 20 0 10 0 0.1 0 0

7 -10 -30 10 0 0.1 0 0

8 20 0 10 0 0.1 0 0

9 20 0 -10 -20 0.1 0 40

10 50 30 -30 20 0.1 60 40

1.0 740 480

Assumed Kj = 20

Assumed Km= 10


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Bj = cov(kjkm)/var(km)

=Submission of p (kj-kj)(km-km)/submission p (km-km) raise to the

power 2

= 740/480

=1.54

Alpha A = Assumed mean of Kj bj(assumed mean of km)

= 20 (1.54*10)

= 4.6%

The alpha A indicates what the return of the security or portfolio will

be when the market return is zero.

For example a security having alpha of +5% would earn five percent

even if the market return is zero, and would earn extra 5% at all

levels of market return and vice versa.

What do these figures of alpha and beta imply?

When we say that the security has a beta of 1.54 we mean that if the

return on the market portfolio rises by 10%, the return on the

security j will rise by 15.4% an alpha of 4.6% implies that the

security earns 4.6% over the above market rate of return.

Capital Asset Pricing Model (CAPM)

The CAPM establishes a linear relationship between the required

rate of return of a security and its systematic or undiversifiable risk

or beta.


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Mathematically it can be represented as follows:-

Kj=Rf + Bj(km- Rf)

Where,

Kj = expected or required rate of return on security j

Rr = risk free rate of return

Bj = beta coefficient of security j

km = return on market portfolio

Assumptions of CAPM

1.Investors are risk averse and use the expected rate of returnand standard deviation of return as appropriate measures of

risk and return for their portfolio. In other words, the greater

the perceived risk of portfolio, the higher return a risk averse

investor expects to compensate the risk.

2.Investors make their decisions based on a single period horizon.3.Transaction costs are low enough to be ignored and assets can

be bought and sold in any quantity. The investor is limited only

by his wealth and the price of the asset.

4.Taxes do not affect the choice of buying assets.5.All individuals assume that they can buy assets at the going

market price and they all agree on the nature of the return and

the risk associated with each investment.

CAPM enables us to be much more precise about how trade- offs

between risk and return are determined in the financial markets.


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In CAPM the expected rate of return can also be thought of as a

required rate of return because the market is assumed to be in

equilibrium.

Expected Rate of Return is the return that an investor expects toearn.

Required Rate of Return of a security is the minimum expected rate

of return needed to induce an investor to purchase it.

What do investors require when they invest?

Required Rate of Return = Risk Free Rate + Risk Premium

CAPM provides an explicit measure of the risk premium.

Risk Premium = Beta of security j (km- Rf)

This beta coefficient above is the non diversifiable risk of the asset

relative to the rate of the market. If beta exceeds 1 the investor

assigns a higher risk premium to the asset than to the market.

Example:-

Beta of Asset = 1.5

Required Rate of Return on the market (km) = 15%

Risk free Interest Rate (Rf) = 6%

Kj = Rf + Beta factor(Km Rf)

= 0.06 + 1.5(0.15 0.06)

= o.195 or 19.5%

The Security Market Line (Hand Outs)


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Working Capital Management

Working Capital in its simplest form could be defined as the amount

required for meeting the current liabilities of the business or to cope

up the normal day to day expenditure of the business.

Types of Working Capital

Gross Working Capital

Net Working Capital

Objective of Working Capital Management

The goal of working capital management is to manage the firmscurrent assets and liabilities in such a way that a satisfactory level of

working capital is maintained.

Factors Affecting the Requirement of Working Capital

y General Nature of Business Public utilities (i) Cash Sale (ii)Sale of Services Vs. Trading, Financial and Mfg Industries.

y Production Cycle Bakery Vs. Heavy Machineryy Business Cycle Recovery, Boom, Recession and Depression.y Production Policy - Seasonaly Credit Policy Long Credit Period Vs. Short Credit periody Growth and Expansiony Vagaries in the Availability of Raw Materials Easily available

throughout the Year Vs. Not available easily throughout the

year.

y Profit level Level of Taxes, Dividend Policy and DepreciationPolicy

y Price Level Changesy Operating Efficiency


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Operating Cycle Approach to Working Capital Management

Shorter the operating cycle better it is.

Raw Material Storage Period

1.Annual consumption of raw materials, components etc.2.Average daily consumption of raw material by dividing the first

point above by 360.

3.Average stock of raw materials, components etc. opening +closing stock /2.

4.Raw material storage period = 3/2 = n1 days. Conversion Period

1.Annual cost of production = Opening WIP + Raw materialconsumed + other manufacturing costs like wages fuel etc. +

Depreciation Closing WIP.

2.Average daily cost of production = 1/3603.Average stock of WIP = opening WIP + Closing WIP /2 4.Average conversion period = 3/2 = n2 days

Finished Goods Storage Period

1.Annual cost of sales = Opening stock of finished goods + cost ofproduction + Excise duty + Selling and distribution costs +

General administrative costs + Financial costs Closing stock of

finished goods.

2.Average daily cost of sales = 1/3603.Average stock of finished goods = Opening stock + Closing

stock/2

4.Finished goods storage period = 3/2 = n3 days Average Collections Period

1.Annual credit sales of the company.


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2.Average daily credit sales = 1/3603.Average balance of sundry debtors = Opening balance + Closing

balance /2

4.Average collection period = 3/2 = n4 daysAverage Payment Period

1.Annual credit purchases made by a company.2.Annual daily credit purchases = 1/3603.Average balance of sundry creditors = opening balance +

closing balance /2

4.Average payment period = 3/2 = n5 days.Gross Operating Cycle = n1 + n2 + n3 + n4

Net Operating Cycle = n1 + n2 + n3 + n4 n5

Example:-

Calculate the gross and net operating cycle periods from the data

given below:-

Particulars Amount

(Rs. In

Lakh)

1.Opening Balances ofy Raw Materials, Stores and Spares, etcy Work in Processy

Finished Goodsy Accounts Receivabley Accounts Payable

2.Closing Balances ofy Raw Materials, Stores and Spares, etcy Work in Process

3454.84

56.15

637.92

756.45

2504.18

4095.41

72.50


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y Finished Goodsy Accounts Receivabley Accounts Payable

3.Purchases of Raw Materials, Stores and Spares,etc.

4.Manufacturing Expenses etc.5.Depreciation6.Customs and Excise Duty7.Selling administration and financial expenses8.Sales

1032.74

1166.32

3087.47

10676.10

1146.76

247.72

35025.56

4557.48

54210.65

Solution:-

A.Raw Material Storage Period1.Annual Consumption of Raw Materials

= Opening Stock + Purchases Closing Stock

= 3454.84 + 10676.10 4095.41

= 10035.532.Average daily consumption of raw materials:-

= 10035.53/360 = 27.88

3.Average stock of Raw Materials= (3454.84 + 4095.41)/2

4.Raw Material Storage Period= 3775.13/27.88 = 135 days

B.Average Conversion or Work-in-process Period1.Annual Cost of Production

= Opening WIP + Consumption of Materials + Manufacturing

Expenses + Depreciation Closing WIP

=56.15 + 10035.53 + 1146.76 + 247.72 72.50

=11413.66


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2.Average Daily Cost of Production= 11413.66/360 = 31.70

3.Average Stock of Work- in Progress= (56.15 + 72.50)/2 = 64.33

4.Average Conversion Period= 64.33/31.70 = 2 days

C.Finished Goods Storage Period

1.Annual cost of sales= Opening stock of finished goods + cost of production + Selling,

administration and financial expenses + customs and excise

duties closing stock of finished goods.

= 637.92 + 11413.66 + 4557.48 + 35025.56 1032.74

= 50601.88

2.Average daily cost of sales= 50601.88/360 = 140.56

3.Average inventory of finished goods= (637.92 + 1032.74)/2 = 835.33

4.Finished goods storage period= 835.33/140.56 = 6 days

D.Average Collection Period1.Annual Sales = 54210.652.Average Daily Sales

= 54210/360

= 150.59

3.Average Book Debts=(756.45+1166.32)/2


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= 961.38

4.Average Collection Period= 961.38/150.59

= 6 days

E.Average Payment Period1.Annual Purchases

= 10676.10

2.Average Daily Purchases= 10676.10/360

= 29.66

3.Average balance of trade creditors= (2504.18 + 3087.47)/2

= 2795.82

4.Average payment period= 2795.82/29.66 = 94 days

Operating Cycle Period

= 135 + 2 + 6 + 6 94 = 55 days


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Financing Current Assets

At any point of time a manufacturing company will have some

minimum level of currents assets which is largely influenced by the

operating cycle period to carry on the operations without breakthese current assets are more in the nature of fixed assets and,

therefore, can be regarded as permanent or fixed component of

current asset.

Fluctuating Component of Current Assets

Over and above the minimum level, the current assets of a company

vary depending upon the level of activity or operations. Thus, the

level of current assets associated with the business activity can be

regarded as the fluctuating or temporary component of current

assets.

The Behaviour of Current Assets

Spontaneous Sources of Financing Current Assets

yAccrued expenses

y Provisionsy Obtaining Trade Credity Cost of Trade Credity Cost of Trade Credit vs. Opportunity Cost of Cashy Flexibility to Cash i.e. if not availed cash discount pay on last

date of credit.

yImage of the Company

Short Term Bank Finance

y Cash CreditParticulars Situation A Situation B


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1.SanctionedLimit

2 2

2.Value ofSecurity

2 3

3.MarginRequirement

20% 20%

4.Value ofSecurity less

Margin

1.6 2.4

5.Drawing PowerMin of 1 and 4

1.6 2

y Overdraft : Similar to CC only difference is the type ofsecurities.

Cash credit operates against the securities of inventory and

accounts receivables while overdraft account operates against

securities like shares, life insurance policies and sometimes in rare

cases mortgage of fixed assets.

y Discounting of Billsy Letter of credit This is opened by a bank in favour of its

customers undertaking the responsibility to pay the supplier in

case its customer fails to make payment for the goods

purchased from the supplier.

y Security Before providing for the accommodation towardsfinancing the current assets of a company, the bank will ask for

a security in the form of hypothecation and/or pledge.y Hypothecation By and large, security in the form of

hypothecation is limited to movable properties like

inventories. Under hypothecation agreement, the goods

hypothecated will be in the possession of the borrower.


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y Pledge In pledge system, the goods/documents in the formof share certificates, Insurance Policies etc. which are provided

as the form of security will be in the possession of the bank

lending funds but not with the borrowing company.

Public Deposits For Financing Current Assets

Mobilisation of funds from general public by offering reasonably

attractive rates of interest has become an important source. The

deposits thus mobilized from public by non-financial manufacturing

companies are known as public deposits.

Features of Public Deposits

y A company cannot raise more than 10% of its Paid up sharecapital and free reserves.

y Govt. companies can accept deposits up to 35% of their paid upcapital and free reserves.

y Maximum maturity period three years minimum maturityperiod six months.

y Company inviting deposits from the public is required to issuean advertisement in the newspapers and the same has to be

filed with the registrar of companies before releasing it to

press.

Commercial Paper and Factoring

Commercial Paper These are short term promissory notes with afixed maturity period, issued mostly by leading, reputed, well

established, large corporations who have a very high credit rating. It

can only be issued by body corporate.


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It is mostly used to finance current transactions of a company and to

meet its seasonal need for funds. They are rarely used to finance the

fixed assets or the permanent portion of the working capital.

Factoring

Factoring is an arrangement between a financial intermediary called

a Factor and a Seller of goods and services.

Factor perform the following services:-

y Purchases all accounts receivable of the seller for immediatecash.

y Administers the sales ledger of the seller.y Collects the accounts receivable.y Assumes the losses which may arise from bad debts.y Provides relevant advisory services to the seller.

Servicing and Discount Charges

For rendering the services of collection and maintenance of sales

ledger, the factor charges a commission which varies between 0.4%to 1%.

Types of Factoring

1.Recourse Factoring2.Non- Recourse or Full Factoring3.Maturity Factoring4.Invoice Discounting


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Inventory Management

It involves the control of assets being produced for the purposes of

sale in the normal course of operations. Inventories include raw

material, work- in process, and finished goods inventory. The goal ofeffective inventory management to the company is to minimize the

total cost associated with holding inventories.

The Role of Inventory In Working Capital

1.Current Assets2.Level of Liquidity3.Liquidity lags:- a. Creation Lags b. Storage Lags c. Sale Lag4.Circulating Activity

The Purpose of Inventories

Benefits we accrue from holding inventories:-

1.Avoiding Lost Sales2.Gaining Quantity Discounts3.

Reducing Order Discounts

4.Achieving Efficient Production Runs5.Reducing Risk of production Shortages

Types of Inventory

Four kinds of inventories may be identified:

1.Raw Materials Inventory2.

Storage and Spares

3.Work-in-process Inventory4.Finished Goods Inventory

Costs Associated With Inventories

The five categories costs of holding inventories are:


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1.Material Costs2.Ordering Costs3.Carrying Costs4.Cost of Funds Tied up with Inventory5.Cost of Running out of Goods

Inventory Management Techniques

Economic Order Quantity

The economic order quantity (EOQ) refers to the optimal order size

that will result in the lowest total of order and carrying costs for an

item of inventory given its expected usage, carrying costs and

ordering cost. By calculating the economic order quantity, the firm

determine the order size that will minimize the total inventory costs.

EOQ = Under root of 2UF/PC

Example:-

A firm expects a total demand for its product to be 10000 units,

while the ordering cost per order is Rs. 100 and the carrying cost perunit is Rs. 2.

EOQ = Under root of 2*10000*100/2 = 1000 units.

Safety Stock

Once again in real life situations one rarely comes across lead times

and usage rates that are known with certainty. When usage rate and

or lead time vary, then the reorder level should naturally be at a levelhigh enough to cater to the production needs during the

procurement period and also provide some measures of safety for at

least partially neutralizing the degree of uncertainty.

The question will naturally arise as the magnitude of safety stock.


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Reorder Point Formula

At what point in the level of inventory a reorder has to be placed for

replenishment of stock.

Reorder Point

= S * L + F * Under root of S * R * L

Where,

S= Usage in units per day

L= Lead time in days

R= Average number of units per order

F= Stock out acceptance factor

Example:

For a company the average daily usage of a material is 100 units, lead

time for procuring material is 20 days and the average number ofunits per order is 2000 units. The stock out acceptance factor is

considered to be 1.3. What is the reorder level for the company?

Solution:

From the data contained in the problem we have

S = 100 units

L = 20 Days

R = 2000 Units

F = 1.3


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Reorder Level = S * L + F * under root of S*R*L

= 100 * 20 + 1.3 * Under root of 100 * 2000 * 20

= 2000 * 1.3 + 2000 = 4600

Stock-Level Subsystem

This stock level subsystem keeps track of the goods held by the firm,

the issuance of goods and the arrival of orders. It maintains records

of the current level of inventory. Current level is calculated by taking

the beginning inventory, adding the inventory purchased and

deducting the cost of goods sold. Whenever this subsystem reports

that an item is at or below the reorder point level, the firm will beginto place an order for the item.

Inventory Planning

y The Production Sidey The Marketing Sidey Inventory Data Base

Other Inventory Management Techniques

The ABC system.

The VED analysis.

Pricing of Inventories

y FIFOy LIFOy Weighted Average Cost methody Standard Price Methody Replacement/Current Price Method


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Receivables Management

Finished goods sold on credit get converted into receivables which

when realized, generate cash.

Purpose of Receivables

y To increase total sales; because when a company sells goodson credit, it will be in a position to sell more goods than if it

insists on immediate cash payments.

y To increase profits; because this results in an increase insales not only in volume, but also because companies charge

a higher margin of profit on credit sales as compared to cash

sales.

y To meet increasing competition; and for this the companymay have to grant better credit facilities than those offered

by its competitors.

Cost of Maintaining Receivables

y Additional Fund Requirement for the Companyy Administrative Costsy Collection Costsy Defaulting Costs

Impact of Credit Policy

The credit policy of a company can be regarded as a kind of trade-off

between increased credit sales leading to increase in profit and the

cost of having larger amount of cash locked up in the form of

receivables and the loss due to the incidence of bad debts.

The term credit policy encompasses the policy of a company in

respect of the credit standards adopted, the period over which credit


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is extended to customers, any incentive in the form of cash discount

offered, as also the period over which the discount can be utilized by

the customers and the collection effort made by the company.

The various variables associated with credit policy are:

1.Credit Standards2.Credit Period3.Cash Discount4.Collection Program

Credit Standards

Rigid Credit Standards

1.Low level of Sales2.Less amount of money locked up in receivables3.Virtually no or less bad debts losses4.Less amount to be spent for the collection.

Flexible Credit Standards

1.High Level of Sales2.More money locked up in receivables3.More losses in the form of bad debts4.More amount to be spent in the collection

Example:

The existing sales of a company are Rs. 2 crore. The current

customers are drawn having high or good credit rating. Withpartially liberalized credit standards sales are likely to go up by Rs. 24

lakh, the mix of new customers will be rated as 67% Fair and 33%

Limited. The average collection period is 45 days and the incidence of

bad debt losses is 10% for the new customers. The contribution to

sales ratio for the company is 20% and the cost of funds is 15%.


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Solution:-

Additional profit from increased sales

= Increase in Sales Revenue * Contribution/Sales Revenue

= 2400000 * 20/100 = 480000

Additional Receivables

= Additional Sales Revenue/360 * Collection Period

= 2400000/360 * 45 days = Rs. 300000

Additional Investment in Receivables

= Amount of Receivables * Variable Cost/Sales Revenue

= 300000 * 80/100 = Rs. 240000

Cost of Financing the Additional Investment in Receivables

= 240000 * 15/100

= 36000

Total Amount of Bad Debt Losses

= New Sales * Bad Debts %

= Rs. 2400000 * 10/100 = 240000

a.Additional profit on new sales = Rs. 480000b.Cost of financing additional investment in receivables = Rs.

36000c. Amount of bad debt losses in new sales = Rs. 240000

Net additional benefit (a-b-c) = Rs. 204000

Credit Period


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The credit period refers to the length of the time allowed to

customers to pay for their purchases it generally varies from 15 days

to 60 days.

Example:

A companys existing sales are Rs. 180 lakh. It is currently extending a

credit period of net 30 days to its customers. The companies

contribution to sales ratio is 20 % and the cost of funds is 15%.

Company wishes to increase the sales by Rs. 16 lakh to be achieved

by means of increasing the discount period to 45 days. The bad

debt losses on additional sales are expected to be 5%. Should the

company go for policy change?

Solution:

Additional profit arising out of new sales

= Amount of additional sales * (Contribution/Sales)

= Rs. 1600000 * 20/100 = Rs. 320000

As the credit period will increase from 30 to 45 days the increase on

receivables on existing sales will be

(45-30) * (1800000/360) = Rs. 750000

As the increase in receivables is only on existing sales which have

arisen because of lengthening credit period by 15 days, the full

amount of Rs. 750000 will be regarded as investment in receivables.

The amount of receivables arising out of new sales

= Amount of new sales * (45/360) = Rs. 200000

The investment in receivables in new sales

= 200000 * (Variable cost/ Sales revenue)


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= Rs. 200000 * 80/100

= Rs. 160000

The total amount of investment in receivables

= Rs. 750000 + Rs. 160000

= Rs. 910000

The cost of additional investment in receivables

= Rs. 910000 * (15/100)

= Rs. 136500

The cost of bad debts on new sales

= Rs. 1600000 * 5/100

= Rs. 80000

The amount of additional cost associated with increasing credit

period = Rs. 136500 + 80000 = Rs. 216500

The net additional benefit

= Rs. 320000 Rs. 216500 = Rs. 103500

Cash Discount

Collection Program

The collection program consists of the following:

y Monitoring the state of receivablesy Despatch of letters to customers whose due date is

approaching

y Telegraphic and telephone advice to customers around the duedate


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y Threat of legal action to overdue amounty Legal action against overdue accounts.

The Process of Credit Evaluation

Before granting credit to a customer, a firm seeks information of the

creditworthiness of that customer. In judging the creditworthiness of

an applicant, three basic factors- the three Cs have to be considered.

y Charactery Capacityy Collateral

With the help of following ratios we evaluate the financial capacity of

the customer after getting the financial statements:

a.Current Ratio = Current Assets/Current Liabilitiesb.Quick Ratio = (Current Assets Prepaid Expenses

Inventory)/Current Liabilities

c. Average Payment Period= Average balance of sundry creditors/Average daily(credit)

purchases

d.Average collection period= Average balance of sundry debtors/ Average daily credit sales

e.Capital structure ratio/ Debt to equity ratio= Debt/ Equity

f. Return on equity= Net profit after tax and preference share dividend/ Owners

equity

Obtaining Bank Reference

Firms Experience

Monitoring of Receivables


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Days Sales Outstanding

The average number of days sales outstanding at any time, say end

of the month can be obtained from the following formula:

Days sales outstanding = Accounts receivable at time chosen/

Average daily sales

Ageing Schedule

The age-wise distribution of accounts receivable at a given time is

depicted in the ageing schedule:

Age 1st

Quarter 2nd

Quarter 3rd

Quarter 4th

Quarter

0-30 days 40% 42% 44% 46%

31-60 30% 28% 26% 25%

61-90 20% 22% 25% 23%

120 10% 8% 5% 6%


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Cash Management

Cash, the most liquid asset and also referred to as the life blood of a

business is of vital importance to the daily operations of the business

firm.

Profits vs. Cash

There is a general tendency to confuse profits with cash. But there is

a difference between the two. Profits can be said to be the excess of

income over the expenditure of the business entity, for a particular

accounting period. They include both cash incomes and non-cash

incomes. Similarly both expenses in cash/cheque and non cash

expenses where there is no actual outflow of cash at the time of

accounting are included. Cash refers to the cash as well as the bank

balances of a company at the end of the accounting period, as

reflected in the balance sheet. While profits reflect the earning

capacity of a company, cash reflects its liquidity position.

Meaning of Cash

There are two ways of viewing the term cash. In a narrow sense it

includes actual cash in the form of notes and coins and bank drafts

held by a firm and the deposits withdraw able on demand. And in

broader sense, it includes even marketable securities which can be

immediately sold or converted into cash.

Need for and Objective of Cash Management

Why do Companies Hold Cash

y Transaction Motivey Precautionary Motive Safety Cushion for Contingenciesy Speculative Motive Sudden fall in prices of raw material

Objectives of Cash Management


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y Cash Forecasting and Cash BudgetExample:

XYZ industries a manufacturer of certain items. Its sales figures are

given below.

Actual Sales

Rs.

Forecasted Sales

Rs.

November 100000 January 100000

December 100000 February 100000

March 100000

April 100000

May 100000June 100000

y Cash and credit sales are expected to be 20% and 80%respectively.

y Receivables from credit sales are expected to be collected asfollows: 50% of receivable in one month from the date of sale

and rest 50% in the following month.y No bad debt losses.y Rs. 50,000 expected from the sale of a machine in March and

Rs. 2000 expected as interest on securities in June.

y The payment for the purchases to be made after a month frompurchase. The payment for purchases in December will be

made in January.

Actual

Purchases Rs.

Forecasted

Purchases Rs.

December 40000 January 40000

February 40000

March 45000

April 50000


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May 55000

June 55000

yMiscellaneous cash purchases of Rs. 2500 per month areplanned from January through June.

y Wage payments are expected to be Rs. 16000 per month,January through June. Manufacturing expenses expected to be

Rs. 20000 per month; general administrative and selling

expenses are expected to be Rs. 10000 per month.

y Dividend payment of Rs. 20000 and tax payment of Rs. 18000are scheduled in June.

y A machine worth Rs. 55000 proposed to be purchased on cashin March.

y Opening cash balance is Rs. 20000. The management policy isto maintain a minimum cash balance of Rs. 18000.

y Given the above information work out a statement of cashreceipts forecast, Cash payments forecast and the cash budget

for the period January June.

Solution:-

Forecast of Cash Receipts (January to June)

Items of Cash

Receipts

Januar

y

Februar

y

March April May June

1.Cash Sales 20000 20000 24000 24000 28000 280002.Collection

on CreditSales

80000 80000 80000 88000 96000 10400

0

3.Sale ofMachine

50000

4.Interest onSecurities

2000


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Total Cash

Receipts

10000

0

100000 15400

0

11200

0

12400

0

13400

0

Forecast of Cash Payments (January June)

Item of Cash

Payment

Januar

y

Februar

y


1.Payment onCredit

Purchases

40000 40000 40000 4500

0

5000

0

55000

2.Misc. CashPurchases

2500 2500 2500 2500 2500 2500

3.WagePayments

16000 16000 16000 16000

16000

16000

4.ManufacturingExpenses

20000 20000 20000 2000

0

2000

0

20000

5.GeneralAdministration

& Selling

Expenses

10000 10000 10000 1000

0

1000

0

10000

6.Dividend 200007.Tax 180008.Capital

Equipment

Purchase

55000

Total Cash

Payments

88500 88500 14350

0

9350

0

9850

0

14150

0

Cash Budget for the Period (Jan June)

Item Januar

y

Februar

y


1.OpeningCash

20000


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Balance

2.TotalReceipts

10000

0

100000 15400

0

11200

0

12400

0

13400

0

3.TotalPayments

88500 88500 14350

0

93500 98500 14150

04.Net Cash

Flow (2-3)

11500 11500 10500 18500 25500 (7500)

5.CumulativeNet Cash

Flow

11500 23000 33500 52000 77500 70000

6.OpeningCash

Balance +Cum- NCF

31500 43000 53500 72000 97500 90000

7.MinimumCash

Balance

1800018000 18000 18000 18000 18000

8.Surplus orDeficit in

relation to

Min. Cash

Flows

13500 25000 35500 54000 79500 72000

Cash Reports

Cash budgets are nothing but short-term forecasts and their

advantage lies in their amenability in monitoring actuals for

exercising control. The purpose of monthly cash reports will be

served when cash inflows and outflows do not fluctuate very much

and the collections and payment patterns are stabilized.

For a multi-product multi branch company, it is better to have a cash

report both product wise and branch wise.


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Thus a cash report provides a comparative picture of actual with

forecasted figures and help in controlling and revising cash forecasts

continuously. Cash reports can be prepared in several forms and the

important ones are:

1.Daily Cash Report2.Daily Treasury Report3.Cash Report for the Month of .......

The daily cash report provides information on the cash position on a

daily basis. Though this information is helpful for control purposes, it

does not indicate the position of accounts receivables, payables and

marketable securities of a company. Hence a close watch is required

to get a comprehensive picture of changes in cash, marketable

securities, debtors, and creditors. Therefore we need to prepare a

daily treasury report which will indicate the opening and closing net

treasury positions.

Factors for Efficient Cash Management

y Prompt Billing and Mailingy Collection of Cheques and Remittance to Cash i.e

Decentralisation

y Centralised Purchases and Payment to Suppliers.Investment of Surplus Cash

Criteria for Investment

y Securityy Yieldy Liquidityy Maturity

Forms of Liquidity and Choice of Liquidity Mix


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Forms of Liquidity

y Cash Balance in Current Accounty Keeping reserve Drawing power under cash credit/overdrafty Marketable Securitiesy Investment in Intercorporate Deposits

Choice of Liquidity Mix

y Uncertainty surrounding cash flow projectionsy Attitude of the management towards risky Ability to raise non cash funds and / or control its cash flows.


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Treasury Management

The organization of finance department differs from company to

company. There is no statutory pattern. Legally and theoretically the

right of managing a company vests in its shareholders, but there

number being large and scattered, this task is entrusted to the Board

of Directors. To learn about the constitution of treasury, a study can

be made about the constitution of finance department. The finance

department can be headed by the Vice President (Finance) to whom

the treasurer and the controller are responsible.

Treasury

The treasury in the finance department deals with the liquid assets

and thus the treasurer has a major responsibility of being a custodian

of cash and other liquid assets. The other functions of a treasurer

are:

y Formulate capital structure for the organisation in accordancewith business goals and implement the same.

y Management of liquid assets including cash.y Acts as a cashier.y Role of an authorized signatory on payment cheques including

the authority to approve such cheques.

y Reconciliation in checking accounts.y Overall management of the credit function of the firm.y Authority to utilize surplus cash of the company in short-term

beneficial investments.

y Establishes the company policy with respect to decision ontrade discounts and vendor payment aging.

y Establishes relationship with the bankers and investors.


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Controller

Just as the treasurer deals with liquid assets, the controller of the

organisation has to record the transactions of these liquid assets. It is

the combined and effective working of both the departments thatgives rise to an effective system of internal controls.

Functions of controller are:

y Records all transactions in the general ledger, the accountsreceivables and the accounts payables sub ledger, transactions

with respect to fixed assets such as depreciation, inventory

control etc.

y Looks into the aspect of taxes and insurance.y Keeps track of the companys short term investments by

recording and reconciling the transactions with those of the

brokerage firms.

y Looks into the regulatory aspects and implementation of thecompanys policy on trade discounts and receivables aging.

y Acts as a planning director.y Keeping a record of the attendance of the employees, their

movement timings so as to facilitate in preparing payroll.

y Reporting information to the management.Other Aspects

The size of the treasury depends on the size of an organisation. Big

companies, usually the public limited companies and large private

sector giants like Reliance, ITC etc. may have large structures.

However, small organisations usually have the directors (Finance) to

take major policy decisions and fulfil the role of both the treasurer

and controller.


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Capital Budgeting

The capital budgeting decisions can be defined as the companys

decision to invest its current funds most efficiently in long-term

assets in anticipation of an expected flow of benefits over a series ofyears. Capital budgeting decisions occupy a very important place in

corporate finance for the following reasons:

y Once a decision is taken, it has far-reaching consequenceswhich extend over a considerably long period, and influences

the risk exposure of the firm.

y These decisions involve huge amounts of money.y These decisions are irreversible once taken.y These decisions are among the most difficult to make when the

company is faced with various potentially viable investment

opportunities.

While capital budgeting decisions are extremely important,

managers find it extremely difficult to analyze the pros and cons and

arrive at a decision because:

y Measuring costs and benefits of an investment proposalwhether it is for a mini-steel plant or a library is difficult

because all costs and benefits cannot be expressed in tangible

terms.

y The benefits of capital budgeting are expected to occur for anumber of years in the future which is highly uncertain.

y Because the costs and benefits occur at different points oftime, investment proposal, for a proper analysis of the viabilityof the all these have to be brought to a common time-frame.

Hence time value of money becomes very relevant here.


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Appraisal Criteria

A number of criteria have been evolved for evaluating the financial

desirability of a project.

Pay Back Period

The payback period measures the time length required to cover the

initial outlay in the project.

Example: The initial investment in a project whose estimated life is

say 5 years is Rs 20 lacs and it is expected that the project will

generate inflow of Rs. 8 Lacs per annum.

The payback period for the project is equal to 20/8 = 2.5 years.

On the other hand if the project is expected to generate amount

inflows of say Rs. 4 lacs, Rs. 6 lacs, Rs. 10 lacs, Rs. 12 lacs and Rs. 14

lacs over the period of five years the payback period will be equal to

three years.

Merits of payback period are:

y It is simple in both concept and application.y It helps in weeding out risky projects by favouring only those

projects which generate substantial inflows in earlier years.

Demerits of payback period are:

y It fails to consider the time value of money.y The cut off period is chosen rather arbitrarily and applied

uniformly for evaluating projects regardless of their life spans.

Consequently the firm may accept too many short-lived

projects and too few long-lived ones.


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To incorporate the time value of money in the calculation of payback

period a new method was introduced which is known as Discounted

payback period.

Accounting Rate of Return

The accounting rate of return or the book rate of return is typically

defined as follows:

Accounting rate of return (ARR) = Average profit after tax/ Average

book value of the investment.

To use it as an appraisal criterion, the ARR of the project is compared

with the ARR of the firm as a whole or against some externalyardstick like the average rate of return for the industry as a whole.

Example:

Year 0 1 2 3

Investment 100000

Sales

Revenue

120000 100000 80000

Operating

Expenses

(Excluding

Depreciation)

60000 50000 40000

Depreciation 30000 30000 30000

Annual

Income

30000 20000 10000

Average annual income = (30000+20000+10000)/3 = 20000

Average net book value if the investment = (100000+0)/2 = 50000

Accounting rate of return = 20000/50000 * 100 = 40%

The firm will accept the project if its target rate is less than 40%.


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Merits of ARR are:

y Like payback criterion, ARR is simple both in concepts andapplication. It appeals to businessmen who find the concept of

rate of return familiar and easy to work with rather thanabsolute quantities

y It considers the returns over the entire life of the project andtherefore serves as a measure of profitability(unlike the

payback period which is only a measure of total recovery)

Demerits of ARR are:

yIgnores the time value of money.

y Depends on accounting income not on cash flows.y Finally, the firm using ARR as an appraisal criterion must decide

on a yard-stick for judging the project and this decision is often

arbitrary. Often firms use their current book values as the yard

stick for comparison. In such cases if the firms rate of return

tends to be usually high or low, then firm can end up rejecting

good ones and accepting bad ones.

Net Present Value

The net present value is equal to the present value of future cash

flows and any immediate cash outflows. In the case of a project, the

immediate cash outflows will be investment and the net present

value will be equal to the present values of future cash inflows minus

the initial investment.

Example:

A ltd is considering the purchase of a new leather cutting machine to

replace an existing machine which has a book value of Rs. 3000 and

can be sold for Rs. 1500. The estimated salvage value of the old


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machine in four years would be zero, and it is depreciated on a

straight line basis. The new machine will reduce costs (before tax) by

Rs. 7000 per year i.e. Rs. 7000 cost savings over the old machine. The

new machine has a four year life, costs Rs. 14000 and can be sold for

an expected amount of Rs. 2000 at the end of the fourth year.

Assuming straight line depreciation and a tax rate of 40%, calculate

the cash flows associated with the investment and calculate the NPV

of the project assuming the cost of funds to the firm is 12% and

straight line method is used for tax purposes?

Solution:

Cash flows associated with the replacement decisions

Year 0 1 2 3 4

1. Net investment in new

machine

(12500)

2. Savings in costs 7000 7000 7000 7000

3. Incremental Depreciation 2250 2250 2250 2250

4. Pre-Tax profits 4750 4750 4750 4750

5. Taxes 1900 1900 1900 19006. Post-tax profits 2850 2850 2850 2850

7. Initial Flow (=1) (12500)

8. Operating Flow (= (6) + (3)) 5100 5100 5100 5100

9. Terminal Flow 2000

10. Net Cash flow(=7+8+9) 12500 5100 5100 5100 7100

Year 1 2 3 4

Net cashflows

5100 5100 5100 7100

PVIF @k =

12%

0.893 0.797 0.712 0.636

Present

Value (Rs.)

4554 4065 3631 4516


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Net present value

= (-12500) + (4554 + 4065 + 3631 + 4516)

= Rs. (-12500 + 16766)

= Rs. 4266

The decision rule based on NPV is obvious. A project will be accepted

if the NPV is positive and rejected if NPV is negative.

The NPV is a conceptually sound criterion of investment appraisal

because it takes into account the time value of money and considers

the cash flow stream in its entirety. Since NPV represents the

contribution the contribution to the wealth of the shareholders,

maximizing NPV is congruent with the objective of investment

decision making viz., maximization of shareholders worth. The only

problem lies with the NPV is the difficulty in comprehending the

concept. Most non-financial executives and businessmen find

Return on capital employed or Average rate of return easy to

interpret compared to absolute values like NPV.

Internal Rate of Return

The internal rate of return is that rate of interest at which the

present value of a project is equal to zero, or in other words, it is the

rate which equates the present values of the cash inflows to the

present values of the cash outflows. While under NPV method the

rate of discounting is known, under IRR this rate which makes NPV

zero has to be identified.

Example:

A project has the following patterns of cash flows:


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Year Cash Flow (Rs. In Lakh)

0 (10)

1 5

2 5

3 3.084 1.20

What is the IRR of this project?

Solution:

To determine the IRR, we have to compare the NPV of the project for

different rates of interest until we find that rate of interest at whichthe NPV of the project is equal to zero. To reduce the number of

iterations involved in this hit and trial process, we can use the

following short cut procedure:

Step 1

Find the average annual net cash flow based on given future net cash

inflows.

= (5 + 5 + 3.08 + 1.20)/4 = 3.57

Step 2

Divide the initial outlay by the average annual net cash inflows i.e.

10/3.57 = 2.801

Step 3

From the PVIFA table find that interest rate at which the present

value of an annuity of Rs. 1 will be nearly equal to 2.801 in 4 years

i.e. the duration of the project. In this case the rate of interest will be

equal to 15%.


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We use 15% as the initial value for starting the hit and trial process

and keep trying at successively higher rates of interest until we get

an interest rate at which the NPV is zero.

The NPV at r = 15% will be equal to:

= - 10 + (5 * .0870) + ( 5 * .756 ) + (3.08 * .658 ) + ( 1.2 * .572) = 0.84

NPV at r = 16 % will be equal to:

= - 10 + (5 * .862) + (5 * .743) + (3.08 * .641) + (1.2 * .552) = .66

NPV at r = 18% will be equal to:

= - 10 + (5 * .848) + (5 * .719) + (3.08 * .0609) + (1.2 * .516) = .33

NPV at r = 20% will be equal to:

= -10 + (5 * .833) + (5 * .694) + (3.08 * .609) + (1.20 * .482) = 0

We find that at r= 20%, the NPV is zero and therefore the IRR of the

project is 20%.

Merits of IRR are:

y It takes into account the time value of money.y It considers the cash flow stream over the entire investment

horizon.

y It does not use the concept of the required rate of return. Ititself provides a rate of return which is indicative of the

profitability of the proposal.

y It is consistent with the overall objective of maximisingshareholders wealth.Demerits of IRR are:

y It involves tedious calculations.


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y Under IRR method it is assumed that all intermediate cashflows are reinvested at IRR.


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Cost of Capital and Capital Structure Theories

The cost of capital to a company is the minimum rate of return that it

must earn on its investments in order to satisfy the various

categories of investors who have made investment in the form ofshares, debentures, or term loans. Unless the company earns this

minimum rate, the investors will be tempted to pull out of the

company.

The weighted arithmetic average of the cost of different financial

resources that a company uses is termed as its cost of capital.

Example:

Company A has a total capital base of Rs. 500 Lacs in the ratio of 1:1

of debt and equity. If the post tax costs of debt and equity are 7%

and 18% respectively, the cost of capital of the company will be

equal to the weighted average cost i.e.

(250/500 * 7%) + (250/500 * 18%) = 12.5%

Assumptions

Cost of capital works on two basic assumptions:

y The risk characterizing the new project under consideration isnot significantly different from the risk characterizing the

existing investments of the firm, and

y The firm will continue to pursue the same financing policies i.e.there will be no change in the debt-equity mix presently

adopted by the firm.

To calculate the cost of capital we need to calculate the cost of

various sources of finance which are:


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If A ltd. Realizes Rs. 97 per debenture and the corporate tax rate is

50%, what is the cost of the debenture to the company?

Solution:

Given:

i = Rs. 14

t = 0.5

P = Rs. 97

n = 10 years

F = Rs. 105

by putting these values in the above mentioned formula we will get

kd = [i(1 t) + (F P)/n]/(F + P)2

kd = [14(1 - .05) + (105 97)/10]/(105 + 97)/2

kd = 7.7%

Cost of Term Loans

The cost of term loans can be calculated by the following formula:

kt = i(1 t)

Where,

i = Interest Rate applicable to the new term loan.

t = Tax rate.

Cost of Preference Share Capital

Cost of preference share capital can be calculated by the following

formula:


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kp = ( D + (F P)/n)/ ( F + P)/2

Where:

kp = Cost of preference share capital

D = preference dividend per share payable annually

F = Redemption price

P = net amount realized per share and

n = maturity period.

Example:

The terms of a preference share issue made by a company are as

follows: 14% preference shares of Rs. 100 each dividend payable

annually. Share is redeemable after 12 years at par. If the netamount realized per share is Rs. 95, what is the cost of the

preference capital.

Solution:

Given,

D = 14,

F = 100,

P = 95, and

n = 12

Putting the given values in the above mentioned formula we get,


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kp = ( D + (F P/n)/ ( F + P)/2

kp = [14 + (100 95)/12] /( 100 + 95)/2

kp = 0.148 or 14.8%

Cost of Equity Capital

There are many approaches for estimating the cost of equity capital

as there is no fixed dividend or interest. There are several

approaches for calculating the cost of equity capital, like:

y Dividend forecast approach,y Capital asset pricing model,y Realized yield approach,y Earning price ratio approach, andy Bond yield plus risk premium approach.

Dividend Forecast Approach

As per dividend forecast approach the cost of equity capital can becalculated as follows:

ke = (D1/Pe) + g

Where:

Pe = price per equity share

D1 = Expected dividend per year at year one

Ke = rate of return required by the equity shareholders

g = growth rate.


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Example:

The market price per share of a company is Rs. 125. The dividend

expected per share after an year is Rs. 12 and the dividend is

expected to grow at a constant rate of 8% per annum. What is thecost of equity capital to the company.

Solution:

The cost of equity capital can be calculated as follows:

ke = (D1/Pe) + g = (12/125) + 0.08 = 17.6%

Realized Yield Approach

In this approach as the name suggests past returns on a security are

taken as a basis for calculating the return required by the investors in

future.

The assumptions of this approach are:

y The actual returns have been in line with the expected results.y The investors will continue to have the same expectations from

the security.

The realized return over n-year period is calculated as (W1 * W2

*...........Wn) raise to the power 1/n 1

Where Wt is referred as the wealth ratio, is calculated as

(Dt + Pt)/Pt - 1 and t = 1,2........n.

Dt = Dividend per share for year t payable at the end of year

Pt = Price per share at the end of year t.


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Example:

Year 1 2 3

DPS(Rs.) 1.50 2.00 1.50

Price per shareat year end 12.00 11.00 12.00

The price per share at the beginning of year 1 is Rs. 10.

Solution:

The wealth ratios are:

Year 1 2 3Wealth Ratio 1.35 1.08 1.23

Realized Yield = [(1.35 * 1.08 * 1.23) Raise to the power 1/3] 1

Capital Asset Pricing Model

According to this approach, the cost of equity can be reflected by the

following equation:

ki = Rf + Beta i (Rm Rf)

Where,

ki = rate of return required on security i

Rf = Risk free rate of return

Beta i = beta of security i

Rm = rate of return on market portfolio


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In all other cases there is scope for this approach not giving

accurate estimate.

The option (a) is not normally seen in real life situations, while it is

difficult to foresee the option (b). This approach should hence beused with caution.

Cost of Retained Earnings

Earnings of a firm can be reinvested or paid as a dividend to the

shareholder. If the firm retained part of its earning for future

growth of the firm, the shareholders will demand compensation

from the firm for using that money. As a result, the cost of

retained earnings simply represents a shareholders expected

return from the firms common stock. Viewing retained earnings

as fully subscribed issue of additional common stock the cost of

retained earnings can be said as,

kr = ke

Cost of External Equity

It comes into the picture when there are certain floatation costs

involved in the process of raising equity from the market. It is the

rate of return that the company must earn on the net funds

raised, in order to satisfy the equity holders demand for return.

Ke = ke/(1-f)

Where,

ke = rate of return required by the equity investors

Ke = cost of external equity

f = Floatation costs as a % of the current market price.


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Example:

A Ltd. has got Rs. 100 lacs of retained earnings and Rs. 100 lakh of

external equity through a fresh issue, in its capital structure. The

equity investors expect a rate of return of 18%. The cost of issuingexternal equity is 5%. Find out the cost of retained earnings and

the cost of external equity?

Solution:

Cost of retained earnings:

Kr = ke i.e. 18%

Cost of external equity raised by the company:

Now Ke = ( ke/1-f) = 0.18/(1 0.05) = 18.95%

Concept of Weighted Average Cost of Capital

Example:

ABC Ltd. has the following capital structure:

Rs. In Lacs

Equity Capital(Rs. 10 Lacs share at par value) 100

12% Preference share capital 10

Retained Earnings 120

14% Non convertible Debentures (70000 debentures at

par)

70

14% term loan from Bank 100

Total 400

The market price per equity share is Rs. 25. The next expected

dividend per share is Rs. 2 and the DPS is expected to grow at a


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constant rate of 8%, The preference shares are redeemable after

7 years at par and are currently quoted at Rs. 75 per share on the

stock exchange. The debentures are redeemable after 6 years at

par and their current market quotation is Rs. 90 per share. The

tax rate is 50%. Calculate the weighted average cost of capital.

Solution:

First calculate the costs of various sources of finance

(i) Cost of Equity = Ke= (D1/Po) + g = (2/25) + 0.08 = 0.16(ii) Cost of Retained earnings = Kr = Ke = o.16%(iii) Cost of preference shares =kp=(D+(f-p)/n)/(f+p)/2

= (12 + (100 -75)/7)/(100 + 75)/2 = 0.1780

(iv) Cost of debentures = [i(1-t) + (f-p)/n]/(f+p)/2= [14(1-.50) + (100 90)/6]/( 100 + 90)2 = 0.0912

(v) Cost of term loans = ki = 0.14(1 0.5) = 0.07

Then we will calculate the weights associated with the various

sources of funds:

(i) We = 100/400 = 0.25(ii) Wr = 120/400 = 0.30(iii) Wp = 10/400 = 0.025(iv) Wd = 70/400 = 0.175(v) Wi = 100/400 = 0.25Weighted average cost of capital

= Weke + Wrkr + Wpkp + Wdkd + Wiki

=(0.25 * 0.16) + (0.30 * 0.16) + (0.025 * 0.1780) + (0.175 * 0.0912)

+ (0.25 * 0.07) = 0.1259 = 12.59%


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Capital Structure

Meaning

The capital structure of a company refers to the mix of the long term

finances used by the firm. It is the financing plan of the company.

Importance of Capital Structure Decision

The objective of the company is to mix the sources of fund used by it

in a manner which maximizes the companys market price.

In simple terms companies look for the minimization of their cost of

capital. This proper mix of fund is referred to as capital structure.

This decision influences the risk and return of the investors. The

company will have to plan its capital structure at the time of

promotion itself and subsequently whenever it has to raise

additional funds. Whenever company needs to raise finance, it

involves a capital structure decision because it has to decide the

amount of finance to be raised as well as the source from which it is

to be raised.

Factors affecting working capital

y Leveragey Cost of Capitaly Cash flow projections of the companyy Size of the companyy Dilution of controly Floatation costs.

Features of an optimal capital structure

y Profitabilityy Flexibility


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y Controly Solvency

Theories of capital structure

objective importance and scope of fm

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