Financial Management: January 2009

Financial Management
Unit-I

Lecture no.: 1

Topic: Introduction to Financial Management

Introduction
Financial Management can be defined as:
The management of the finances of a business / organization in order to achieve financial objectives
Taking a commercial business as the most common organizational structure, the key objectives of financial management would be to:
• Create wealth for the business
• Generate cash, and
• Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested
There are three key elements to the process of financial management:
(1) Financial Planning
Management need to ensure that enough funding is available at the right time to meet the needs of the business. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit.
In the medium and long term, funding may be required for significant additions to the productive capacity of the business or to make acquisitions.
(2) Financial Control
Financial control is a critically important activity to help the business ensure that the business is meeting its objectives. Financial control addresses questions such as:
• Are assets being used efficiently?
• Are the businesses assets secure?
• Do management act in the best interest of shareholders and in accordance with business rules?

(3) Financial Decision-making
The key aspects of financial decision-making relate to investment, financing and dividends:
• Investments must be financed in some way – however there are always financing alternatives that can be considered. For example it is possible to raise finance from selling new shares, borrowing from banks or taking credit from suppliers
• A key financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via dividends. If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further

Lecture No.:2

Topic: Scope of financial management

Scope of financial management

In order to achieve the objectives of financial management, the financial manger of a business concern has to manage various aspects of finance function which lay down the scope of his duties. These aspects are discussed below;-

1. Estimating the financial requirements.

On the basis of their forecast of the volume of business operations of the company, the finance executives have to estimate the amount of fixed capital and working capital required in a given period of time, say one year two years 4 years and so on. Besides estimating the amount of capital, the finance executives also have to forecast the time when additional funds from outside
sources and approximately at what rate they will be committed to operations.

2. Determining the structure of capitalization.

After estimating the requirement of capital the finance executives have to decide about the composition of capital. They have to determine the relative proportions of owner's risk capital and borrowed capital and short-term and long-term debt-equity ratio. These decisions have to be taken in the light of cost of raising finance from different sources, period for
which funds are needed and several other factors.

3. Choice of source of finance.

The management can raise financial from various sources like shareholders, debenture holders, banks and other financial institutions, public deposits etc. Finance executive has to evaluate each source or method of finance and choose the best source keeping in view a combination of factors. For instance, public deposits though carry higher rates of interest than on debentures, do not require any security of the assets of the company. A company may choose this source if it does not wish to create a charge over its assets. Similarly, if a company does not want to dilute ownership, it will borrow money.

4. Investment decisions.

The funds raised from different sources are to intelligently invested in various assets so as to optimize the return on investment. The utilization of long-term funds needs a proper assessment of different alternative through capital budgeting and opportunity cost analysis. A part of the long-term funds has to be used in the working capital of the company. While making investment decisions, management should be guided by three important principles, viz., safety, liquidity and profitability.

5. Management of earnings.

The finance executive has to decide about the allocation of earnings among several competing needs. A certain amount out of the total earning may be kept as a reserve voluntarily or as a requirement by law; a portion of the earnings may be distributed among the ordinary and preference shareholders; yet another portion may be ploughed back or reinvested. The finance executive must consider the merit and demerits of alternative schemes of utilizing the funds generated from the company's own earnings.

6. Management of cash flow.

Cash is needed to payoff creditors, for purchase of materials, pay labor and to meet every day expenses. There should not be shortage of cash at any time as it will damage credit-worthiness of the company. There should not be excess cash than required because money has time value. In order to know The need of cash during different periods, the management should prepare a cash flow statement in advance.

Lecture no.:3

Topic: Organisation of financial Management

The responsibilities for financial management are spread throughout the organisation in the sense that financial management is, to an extent, an integral part of the job for the managers involved in planning, allocation of resources and control. For instance, the production manager (engineer) shapes the investment policy (proposal of a new plant); the marketing manager/analyst provides inputs in forecasting and planning; the purchase manager influences the level of investment in inventories; and the sales manager has a say in the determination of receivables policy.

Nevertheless, financial management is highly specialized in nature and is handled by specialists. Financial decisions are of crucial importance. It is, therefore, essential to set up an efficient organisation for financial management functions. Since finance is a major/critical functional area, the ultimate responsibility for carrying out financial management functions lies with the top management, that is, board of directors/managing director/chief executive or the committee of the board.

However, the exact nature of the organisation of the financial management function differs from firm to firm depending upon factors such as size, of the firm, nature of its business, type of financing operations, ability of financial officers and the financial philosophy, and so on. Similarly, the designation of the chief executive of the finance department also differs widely in case of different firms. In some cases, they are known as finance managers while in others as vice-president (finance), director (finance), and financial controller and so on. He reports directly to the top management. Various sections within the financial management area are headed by managers such as controller and treasurer.

The job of the chief financial executive does not cover only routine aspects of finance and accounting. As a member of top management, he is closely associated with the formulation of policies as well as decision making. Under him are controllers and treasurers, although they may be known by different designations in different firms. The tasks of financial management and allied areas like accounting are distributed between these two key financial officers. Their functions are described below.

The main concern of the treasurer is with the financing activities of the firm. Included in the range of his functions are:
(i) obtaining finance, (ii) banking relationship,
(iii) investor relationship, (iv) short-term financing, (v) cash management, (vi)
credit administration, (vii) investments, and (viii) insurance.

Lecture no.: 4

Topic: Objectives of Financial Management

Objectives of Financial Management
Ø Provide support for decision making. Financial management provides managers with the information and knowledge they need to support operational decisions and to understand the financial implications of decisions before they are made. It also enables managers to monitor their decisions for any potential financial implications and for lessons to be learned from experience, and to adapt or react as needed.

Ø Ensure the availability of timely, relevant and reliable financial and non-financial information. Financial management gives managers the information that either forms the basis for calculating financial information, or is used for management control and accountability purposes.

Ø Manage risks. Financial management enables an organization to identify, assess and consider the financial consequences of events that could compromise its ability to achieve its goals and objectives and/or result in significant loss of resources. Financial management is an important component of risk management and needs to be considered with the full range of business risks, such as operational and strategic risks as well as social, legal, political and environmental risks.

Ø Use resources efficiently, effectively and economically. Financial management is necessary to ensure that an organization has enough resources to carry out its operations, and that it uses these resources with due regard to economy, efficiency and effectiveness.

Ø Strengthen accountability. Financial management is essential for an organization to understand and demonstrate how it has used the financial resources entrusted to it and what it has accomplished with them.
Ø Provide a supportive control environment. Financial management contributes to promoting an organizational climate that fosters the achievement of financial management objectives - a climate that includes commitment from senior management, shared values and ethics, communication and organizational learning.

Ø Comply with authorities and safeguard assets. Financial management is essential to ensuring that an organization carries out its transactions in accordance with applicable legislation, regulations and executive orders; that spending limits are observed; and that transactions are authorized. It also provides an organization with a system of controls for assets, liabilities, revenues and expenditures. These controls help to protect against fraud, financial negligence, violation of financial rules or principles and losses of assets or public money.

Lecture no.: 5
Topic : Time Value of Money

Time value of money
What is the time value of money?
The time value of money serves as the foundation for all other notions in finance. It impacts business finance, consumer finance and government finance. Time value of money results from the concept of interest.
This overview covers an introduction to simple interest and compound interest, illustrates the use of time value of money tables, shows a approach to solving time value of money problems and introduces the concepts of intra year compounding, annuities due, and perpetuities. A simple introduction to working time value of money problems on a financial calculator is included as well as additional resources to help understand time value of money.
The concepts of present and future value hinge upon the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal. In particular, the time value of money represents the interest one might earn on a payment received today, if held, earning interest, until that future date.
All of the standard calculations derive from the most basic algebraic expression for the present value of a future sum, "discounted" to the present by an amount equal to the time value of money. For example, a sum of FV to be received in one year is discounted (at the rate of interest r) to give a sum of PV at present: PV = FV — r·PV = FV/(1+r).
Some standard calculations based on the time value of money are:
Present Value (PV) of an amount that will be received in the future.
Present Value of a Annuity (PVA) is the present value of a stream of (equally-sized) future payments, such as a mortgage.
Present Value of a Perpetuity is the value of a regular stream of payments that lasts "forever", or at least indefinitely.
Future Value (FV) of an amount invested (such as in a deposit account) now at a given rate of interest.
Future Value of an Annuity (FVA) is the future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest.

Calculations
There are several basic equations that represent the equalities listed above. The solutions may be found using (in most cases) the formulas, a financial calculator or a spreadsheet. The formulas are programmed into most financial calculators and several spreadsheet functions (such as PV, FV, RATE, NPER, and PMT)[1].
For any of the equations below, the formulae may also be rearranged to determine one of the other unknowns. In the case of the standard annuity formula, however, there is no closed-form algebraic solution for the interest rate (although financial calculators and spreadsheet programs can readily determine solutions through rapid trial and error algorithms).
These equations are frequently combined for particular uses. For example, bonds can be readily priced using these equations. A typical coupon bond is composed of two types of payments: a stream of coupon payments similar to an annuity, and a lump-sum return of capital at the end of the bond's maturity - that is, a future payment. The two formulas can be combined to determine the present value of the bond.
An important note is that the interest rate i is the interest rate for the relevant period. For an annuity that makes one payment per year, i will be the annual interest rate. For an income or payment stream with a different payment schedule, the interest rate must be converted into the relevant periodic interest rate, For example, a monthly rate for a mortgage with monthly payments requires that the interest rate be divided by 12 (see the example below). See compound interest for details on converting between different periodic interest rates.
The rate of return in the calculations can be either the variable solved for, or a predefined variable that measures a discount rate, interest, inflation, rate of return, cost of equity, cost of debt or any number of other analogous concepts. The choice of the appropriate rate is critical to the exercise, and the use of an incorrect discount rate will make the results meaningless.
For calculations involving annuities, you must decide whether the payments are made at the end of each period (known as an ordinary annuity), or at the beginning of each period (known as an annuity due). If you are using a financial calculator or a spreadsheet, you can usually set it for either calculation. The following formulas are for an ordinary annuity. If you want the answer for the Present Value of an annuity due simply multiply the PV of an ordinary annuity by (1 + i).

Lecture No.:6

Topic: Sources of Long Term Finance

Sources of Long Term Finance

It is required for investments in fixed assets like land and building, plant and machinery and for financing expansion programmes. In other words, long term finance is required to meet fixed capital requirements. Fixed capital is the core of the business.

The sources for raising long term finance are the following:

1. Issue or sale of Shares.
2. Sale of debentures.
3. Financial Institutions.
4. Retained Earnings or ploughing back of Profits.

1. Issue of Shares:
Issue of share is the best method for the procurement of fixed capital requirements because it has not to be paid back to shareholder within the life time of the company. Funds raised through the issue of shares provides a financial floor to the capital structure of a company. A share may be defined as a unit of measure of a shareholder's interest in the company. "A share is a right to participate in the profits made by a company while it is a going concern and in the assets of the company when it is wound up."
(Bachan Cozdar Vs. Commissionor of Income tax). The share capital of company is divided into a large number of equal parts and each part is individually called a share. Under the provisions of Section 86 of the Indian Companies Act, 1956, a public company or a private company which is subsidiary of a public company can issue only two types of shares i.e. equity shares and preference-shares. However, an independent private company can issue deferred shares as well .

->Preference Shares:
Preference Shares are those shares which carry priority rights with regard to
payment of dividend and return of capital. According to Sec. 85 of the Indian Companies
Act, preference share is that part of the share capital of the company which is endowed
with the following preferential rights :
(1) Preference with regard to the payment of dividend at fixed rate; and
(2) Preference as to repayment of capital in the event of company being wound up.

Thus, Preference shareholders enjoy two preferential rights over the equity shares.
Firstly, they are entitled to receive a fixed rate of dividend out of the net profits of
the company prior to the declaration of dividend on equity shares. Secondly, the assets
remaining after the payment of debts of the company under liquidation are first distributed
for returning preferential capital (contributed by the preference shareholders).

Advantages of preference shares

(1) Suitable to Cautions Investors. Preference shares mobilize the funds from such investors who prefer safety of their capital and want to earn income with greater certainty.

(2) Retention of Control. Control of the company is vested with the management by issuing preference shares to outsiders because such share-holders have restricted voting rights.

(3) Increase in the Income of Equity Shareholders. Preference shares bear a fIxed yield and enable the company to adopt the policy of "trading on equity" to increase the rate of dividend on equities out of profIts remaining after paying fixed rate of dividend on preference shares.

(4) Flexibility in the Capital Structure. In case of redeemable preference shares, company may feel at ease to bring flexibility in the fInancial structure as they can be redeemed whenever a company desires.

(5) No charge on Assets of the Company. The company can raise capital in the from of preference shares for a long term without creating any charge on its assets.

Disadvantages of preference shares
(1) Permanent Burden. Preference Shares impose permanent burden on the company to pay fixed dividend prior to its disbursement among other types of shareholders.

(2) No Voting Right. The preference shares may not be advantageous from the point of view of investors because they do not carry voting rights.

(3) Redemption during the period of Depression. Preference shareholders will suffer the loss, if the company exercises its discretion to redeem the debentures during the periods of depression.

(4) Costly. Compared to debentures and Govt. securities, the cost of raising the preference share capital is higher.

(5) Income Tax. Since preference dividend is not an admissible deduction for income tax purposes, the company has to earn more. Otherwise the dividend on equity shareholders will be affected.

EQUITY SHARES
Equity shares or ordinary shares are those ownership securities which do not carry any special right in respect of annual dividend or the return of capital in the event of winding up of the company.
According to Sec. 85(2) of the Indian Companies Act.” Equity shares (with reference to any company limited by shares) are those which are not preference shares". A substantial part of risk capital of a company is raised from this source, which is of permanent nature. Equity shareholders are the real owners
of the company. They get dividend only after the dividend on preference shares is paid out to the profits of the company. They may not receive any return, if there are no profits. At the time of winding up of the company equity capital can be paid back after every claim including that of preference shareholders has been settled.

Advantages of Equity Shares

(1) No Charge on Assets. The company can raise the fIxed capital without creating any charge over the assets.

(2) No-Recurring Fixed Payments. Equity shares do not create any obligation on the part of company to pay fixed rate of dividend.

(3) Long term Funds. Equity capital constitutes the permanent source of finance and there is no obligation for the company to return the capital except when the company is liquidated.

(4) Right to Participate in Affairs. Equity shareholders, being the real owners of the company, have the right to participate in the affairs of the company.

(5) Appreciation in the value of Assets. Investors in equity shares are rewarded by handsome dividends and appreciation in the value of their shareholdings under boom conditions.

(6) Ownership. Equity shareholders are the real owners of the company. They alone have voting rights. They elect the directors to manage the company.

Disadvantages of Equity Shares

(1) Difficulty in Trading on Equity. The company will not be in a position to adopt the policy of trading on equity if all or most of the capital is raised in the form of equity shares.

(2) Speculation. During the period of boom, higher dividends on equity shares results in the appreciation of the value of shares which in turn leads to speculation.

(3) Manipulation. As the affairs of the company are controlled by equity shareholders on the basis of voting rights, there are chances of manipulation by a powerful group.

(4) Concentration of Control. Whenever the company intends to raise capital by new issues, priority is to be given to existing shareholders. This may lead to concentration of power in few hands.

(5) Less Liquid. Since equity shares are not refundable they are treated as illiquid.

(6) Not always Acceptable. Because of the uncertainty of the return on the equity shares, conservative investors will hesitate to purchase them.

DEFERRED SHARES
The shares which are issued to the founders or promoters are called deferred shares or founders shares. The promoters take these shares for enabling them to control the company. These shares have extra ordinary rights though there face value is very low. The holders of deferred shares clln get dividend only after preference and equity shareholders shall have received their dividend. Now-a-days, these shares have last their popularity. At present in India public companies cannot issue deferred shares.

2. DEBENTURES
A company can raise finances by issuing debentures. A debenture may be defined as the acknowledgement of debt by a company. Debentures constitute the borrowed capital of the company and they are known as creditor ship securities because debenture holders are regarded as the creditors of the company. The debenture holders are entitled to periodical payment of interest at a fixed rate and are also entitled to redemption of their debentures as per the terms and conditions of the issue. The word debenture is derived from the Latin word 'Lebere' meaning 'to owe'. In its simplest sense it means a document which either creates or acknowledges a debt.

A debenture may be defined broadly, as "an instrument in writing, issued by a company under its seal and acknowledging a debt for a certain sum of money and giving an undertaking to repay that sum on or after a fixed future date and meanwhile to pay interest thereon at a certain rate per annum of stated intervals."
.
Advantages of debentures

(1) Preferred by Investors. A company can raise large amount by issue of debentures because investors give weight age to safety of capital on fixed rate of return.

(2) Maintenance of Control. No voting rights are conferred on the debenture-holders and as a result they cannot weaken the control of existing shareholders.

(3) Reliable Source. The debentures can be issued for long periods as a result of which the company can take up the projects for further expansion.

(4) Trading on Equity. The company can adopt the policy of trading on equity and there by increasing the return of equity shareholders.
(5) Interest charged against Profits. For the purpose of income-tax, company enjoys the benefit by issuing debentures as the interest paid on debentures is deductible from the profits of the company.

(6) Less Costly. Usually the rate of interest is lower than the rate of dividend payable on preference shares and equity shares. So raising of capital through debentures is less costly.

(7) Remedy against over capitalization. Whenever the company is over capitalized, it can redeem debentures.

Disadvantages of debentures
(1) Permanent Burden. The company is obliged to bear a fixed burden of interest, irrespective of the profits earned by the company.

(2) Danger of Liquidation. There is the ligancy fails to pay interest at th stipulated time.

(3) Affecting the capacity to raise Loans. If the capital structure is heavily loaded with debentures, much of the company's earnings will be absorbed in the payment of interest and as a result, the financial institutions may disfavor lending.

(4) Loss of Credit worthiness in Stock Market. Due to one or more mortgage charges on the assets of the company (necessary to issues debentures), debentures cause the loss of credit in the stock market.

(5) Costly. Debentures are expensive source of financing due to high stamp duty. A company has to fix Rs. 15stamps for bearer debenture and Rs. 7.50 for registered debentures of Rs. 1,000 each.

C) PLOUGHING BACK OF PROFITS OR REINVESTMENT OF EARNINGS

The 'Ploughing Back of Profits' is a management policy under which all profits are not distributed amongst the shareholders, but a part of the profit is 'Ploughed back' or retained in the company. These retained earnings are utilised in future for financing modernization and expansion programmes and for meeting the fixed or working capital needs ofthe company. Since it means dependence on internal sources for meeting
the financial needs ofthe company. It is also called 'Internal Financing' or 'Self Financing'. It creates no legal formalities as do borrowing either from the public or from the banks. The policy of ploughing back is a sound method of funding the projects of established concerns without disturbing their capital structure.
Retained earnings or profits are ploughed back for the following purposes.

(1) purchasing new assets required for betterment, development and expansion
of the company.
(2) Replacing the old assets which have become obsolete.
(3) Meeting the working capital needs of the company.
(4) Repayment of the old debts of the company.

Merits of "Ploughing Back of Profits"

Advantages to the company:

From the point of view of company, the policy of retained earnings results into
the following advantages :

1. A cushion to absorb the shocks of depression. The paramount advantage of the policy of ploughing back of profit is that such a company is well armed to fight out depressions and seasonal changes in demand. It acts as a cushion to absorb the shocks of business cycles.

2. Ease in financing schemes of modernization and expansion. When a concern expands its business or when any scheme of modernization, mechanization or automation is to be implemented, the retained earnings can be profitably used. There are two additional benefits of internal financing:

(i) There is no dependence on any outside resource; and
(ii) No charge or encumbrance is created on the property of the company.

3. Follow a stable dividend policy. If a company has retained its earnings in the form of Dividend Equalization Fund, it is in a position to follow a stable dividend policy. Otherwise high rate of dividend in one year and lower rate in another year would bring about fluctuations in the market value of its shares.

4. No dependence on 'fair-weather friends'. Public deposits, banks, issues of shares or debentures are like fair weather friends. Dependence on them is risky. Companies with retained earnings are free from such risk or uncertainty.

5. Deficiencies of depreciation can be made good. Companies with retained surpluses can set right any shortfalls in provision for depreciation, bad and doubtful debts etc.

6. Easy repayment of bonds or debentures. The undistributed income can also be used for retiring the bonds or debentures and thus a company is relieved of the fixed burden of interest charges.

(b) Advantages to shareholders.

The shareholders of the companies which have accumulated surplus also stand
to gain by this policy. The advantages from their view point are as follows :

(1) Safety of investment. The policy of ploughing back of profits assures the investors (i) their investment is quite safe and sound, (ii) the dividend rate will not decrease, and (iii) company can easily face seasonal reactions and business fluctuations.

(2) Increase in the market value of shares. Due to stable dividend payment regularly, the company earns reputation and the market value of its shares goes up. Hence, the shareholders can profitably dispose of their holdings or can use them as
collateral securities for borrowing from banks etc.
(3) Enlarged earning capacity. Internal financing is an economical method. It leads to lower cost, higher business, quicker improvements and enhanced profits. Obviously, the shareholders stand to gain by the enhanced earning capacity of the company.

(4) Evasion of Super-tax. Where the numbers of shareholders are few, the retained earnings provide an opportunity for the evasion of super-tax. The amended Indian Income tax law provides sufficient safeguard against this practice.

(C) Advantages to the Society or Nation.
The society as a whole is also gainer due to the following points.
(1) Speedy capital formation. The policy of retained earnings accelerates the rate of capital formation, which is necessary for the economic development of a country. Hence, plouging back of profits, which is an important form of capital formation, indirectly stimulates the rapid industrialization of a country.

(2) Higher standard of living. The self-financing is an economical device of financing the scheme of modernisation and automation which facilitates greater, better and cheaper production of goods and services. Consumers stand to gain in the form of improved quality of the goods and their relatively reduced prices. "Society at large, would be the beneficiary by an increased standard of living " wrote Husband
and Dockery.

(3) Smooth and continuous functioning of the enterprises. Retained earnings provide the financial stability and flexibility which are indispensable for the successful operation of business enterprises. Without this artificial cushion (in the form of corporate savings) the rate of industrial failure and other financial embarrassment, undistributed profits are a vital factor in relieving society from possible chaos and
confusion.

(4) Quick financing of modernization schemes. For financing improvement or modernization schemes, corporate savings are the reliable resources. Rationalization or productivity movement can be strengthened out of the retained surpluses. The society as a whole secures the benefit of better industrial productivity.

Dangers of ploughing back of profits
If the policy of ploughing back is ill-planned and irrational, it may lead to the following disadvantages:

1. Creation of monopolies. By continuous ploughing back of profits over a long period of time, concern may expand to a limit when it may become uncontrollable to manage its affairs. Thus, re-investment of earnings may lead a company to grow into monopoly, with all the inherent evils.

2. Manipulation in the share values. Sometimes, by retaining earned profits, lower dividends may be declared. When the share values fall in the market, the management may purchase them at lower prices. Later, they increase the dividend rate out of the past profits and try to share the increased prosperity or gain by disposing off the shares at a higher price.

3. Mis -utilization of savings. Management may not always use the retained earnings to the advantages of the shareholders. Accumulated surpluses may be invested in other concerns under the same management, bringing no gain to the shareholders.

4. Over-capitalization If accumulated reserves are used for the issue of bonus shares, it may result in over-capitalization later on.

5. Interfering with the freedom of the investors. Since the profits are retained in the same business the investors' freedom employing their savings in industries of their choice is restricted. This results into the hindrance of natural growth of capital market.

6. Evasion of tax. Sometimes earnings are retained to minimise the corporate profits so that the tax liability may be reduced. Now the Income-tax law has been amended in such a way that evasion of tax may not be possible by the companies.

7. Dissatisfaction among the shareholders. An over-enthusiastic policy of retaining profits into the business may lead to dissatisfaction among the shareholders. They may feel that the directors are ignoring their interest, by paying them a rate of dividend lower than that can be paid out of the available profits.

(E) SPECIAL FINANCIAL INSTITUTIONS

Special financial institutions often play a vital role in the industrial growth of developing nations like India. Such institutions are operating in many developed countries. Although these were in existence prior to World War-II, they are mostly a post-war phenomenon. Soon after independence, it was felt that fast industrial growth in the country cannot take place without cheapening and widening channels of industrial
finance. A notable step towards this was the establishment of special financial institutions both at the national level and state level. National level special financial institutions set up the Central Government includes the Industrial Finance Corporation of India, the Industrial Credit and Investment
Corporation of India, National Industrial Development Corporation of India, the Industrial Development Bank of India and the Industrial Reconstruction Corporation of India. Such institutions at the state level
include the State Financial Corporations and State Industrial Development Corporations. These institutions are, mainly financing agencies, providing medium and long-term capital, generally to the private sector, although public sector is not. excluded. Their operations also include conducting of market surveys, preparation of project report, provision of technical advice and management services, and establishment
and management of industrial units. They help in the development of the capital market by providing direct financial assistance to industrial enterprises and by helping them to raise long-term loans from the market. They underwrite the new issues of industrial securities and also subscribe to them. They are working as an instrument of balanced economic development by focusing their efforts on less developed industries and backward regions of the country. They mobilise the resources of the country into the profitable channels taking in view the goal of balanced development of the country. They also provide guarantee of deferred payment against imports of capital goods and thus bring together local and foreign entrepreneurs.
Generally speaking, they are multipurpose institutions in the sense of financing projects in the various sectors of the economy. A brief discussion of these various special financial institutions with particular
reference to their incorporation, purpose, source of funds, management and operations is attempted below:

Lecture no.8 & 9

Topic: Investment Decision

Investment Decision

Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future. Two important aspects of the investment decision are:

(a) the evaluation of the prospective profitability of new investments, and
(b) the measurement of a cut-off rate against that the prospective return of new investments could be compared.
Future benefits of investments are difficult to measure and cannot be predicted with certainty. Because of the uncertain future, investment decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision for investment managers do see where to commit funds when an asset becomes less productive or non-profitable.
There is a broad agreement that the correct cut-off rate is the required rate of return or the opportunity cost of capital. However, there are problems in computing the opportunity cost of capital in practice from the available data and information. A decision maker should be aware of capital in practice from the available data and information. A decision maker should be aware of these problems.

Investments decisions of a firm are generally known as Capital Budgeting or Capital expenditure decisions

various forms of investment decisions:

1. Replacement projects: Firms routinely invest in equipments meant to replace obsolete and inefficient equipments, even though they may in serviceable condition. The objective of such investments is to reduce costs (of labour, raw material, and power), increase yield, and improve quality. Replacement projects can be evaluated in a fairly straightforward manner; though at times the analysis may be quite detailed.

2. Expansion projects: These investments are meant to increase capacity and/ or widen the distribution network. Such investments call for an explicit forecast of growth. Since, this can be risky and complex, expansion projects normally warrant more careful analysis than replacement projects. Decisions relating to such projects are taken by the top management.

3. Diversification projects: These investments are aimed at producing new products or services or entering into entirely new geographical areas. Often diversification projects entail substantial risks, involve large outlays, and require considerable managerial efforts and attention. Given their strategic importance, such projects call for a very thorough evaluation, both quantitative and qualitative. Further, they require a significant involvement of the board of directors.

4. Research and development projects: Traditionally, R%D projects absorbed a very small proportion of capital budget in most Indian companies. Things however are changing. Companies are now allocating more funds to R&D projects, more so in knowledge intensive industries. R&D projects are characterized by numerous uncertainties and typically involve sequential decision-making. Hence the standard DCF analysis is not applicable to them. Such projects are decided on the basis of managerial judgment. Firms, which rely more on quantitative methods, use decision tree analysis and option analysis to evaluate R&D projects.

5. Mandatory investments: These are expenditure required to comply with statutory requirements. e.g., pollution control equipment, medical dispensary, fire fitting equipment etc. These are often non-revenue producing investments. In analysing such investments the focus is mainly on finding the most cost-effective way of fulfilling a given statutory need.

Importance of Investment Decision are as follows:

1.They influence the firm’s growth in the long run :
A firm’s decision to invest in long-term assets has a decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On the other hand, inadequate investment in assets would make it difficult for the firm to compete successfully and maintain its market share.

2. They affect the risk of the firm :
A long-term commitment of funds may also change the risk complexity of the firm. If the adoption of investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky.

3. They involve commitment of large amount of funds:
Investment decisions generally involve large amount of funds, which make it imperative for the firm to plan its investment programmes very carefully and make an advance arrangement for procuring finances internally or externally.

4. They are irreversible, and if reversible it is at substantial loss:
Most investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped.

5. They are among the most difficult decisions to make:
Investments decisions are the most complex ones. They are an assessment of future events, which are difficult to predict. It is really a complex problem to correctly estimate the future cash flow of an investment. Economic, social, & technological forces cause the uncertainty in cash flow.

Investment Decision – Difficulties:
1. Measurement problems
2. Uncertainty
3. Temporal spread.

Lecture no. 11

Topic: Methods of Capital Budgeting

Capital budgeting
Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research and development projects are worth pursuing.
Capital Budgeting Techniques

TRADITIONAL OR NON-DISCOUNTING –TECHNIQUES
As the name itself suggests, these techniques do not discount the cash flows to find out their present worth
.
There are two such techniques available i.e,

(i) The Payback period method, and
(ii) The Accounting rate of return.

I. PAYBACK PERIOD
The payback period as name suggest is defined as the number of years required for the proposal's cumulative cash inflows to be equal to it cash outflows. In other words, the payback period is the length of time required to recover the initial cost of the project. The payback period therefore, can be looked upon, as the-length of time required for a proposal to 'break even' on its net investment.

Advantages of payback method:

1. The payback period is simple and easy, in concept as well as in its applications. In particular, a small firm having limited manpower, which does not have any special skill to apply other sophisticated techniques, can adopt it.

2. It gives an indication of liquidity. In case a firm is having liquidity problems, then the payback period is a good method to adopt as it emphasizes the earlier case inflows.

3. In a broader sense, the payback period deals with the risk also. The project with a shorter payback period will be less risky as compared to project with a longer payback period, as the cash inflows which arise further in the future will be less certain and hence more risky. So, the payback period helps in weeding out the risky proposals by assigning lower priority.

Disadvantages of payback method:

1. The payback period entirely ignores many of the cash inflows, which occur after the payback period. This could be misleading and could lead to discrimination against the proposal, which generates substantial cash inflows in later years. By restricting itself to
answering the question ‘when will this project make it initial investment?’ it ignores what happens after the initial investment is recouped.

II. ACCOUNTING RATE OF RETURN OR AVERAGE RATE OF
RETURN (ARR)

The ARR is based on the accounting-concept of return on investment or rate of return. The ARR may be defined as the annualized net income earned on the average funds invested in a project. In other words, the annual returns of a project are expressed as a percentage of the net investment in the project.

Computation of ARR:
Symbolically,

ARR= Average Annual-Profit (after tax) /Average investment in the project

This clearly shows that the ARR is a measure based on the accounting profit rather than the cash flows and is very similar to the measure of rate of return on capital employed, which is generally used to measure the over all profitability of the firm.

ARR has certain limitations and drawbacks when used as a technique of project evaluation as follows.

1. It ignores the time value of money and considers the profit earned in the 1st year as equal to the profits earned in later years. It does not discount the future profits.

2. The ARR is based on the accounting profits rather than the cash flows. It has already been noted in the previous chapter that accounting profits are affected by different accounting policies. It has also been noted earlier that a sound evaluation technique should be based on the cash flows rather than the accounting profits.

3. The ARR also ignores the life of the proposal. A proposal with a longer life may have the same ARR as another proposal with a shorter life has. On the basis of ARR, both the proposals may be placed at par, but the proposal with a longer life should be preferred over the proposal with a shorter life (as the former proposal will generate the returns for a longer period). However, the ARR method fails to distinguish between the two.
4. The ARR technique also ignores the salvage value of the proposal. In real sense, the salvage value is also a return from the proposal and should be considered.

5. The ARR also fails to recognize the size of the investment required for the project. Particularly, in case of mutually exclusive proposals, the two projects having significantly different initial costs may have same ARR.

Discounted cash flow techniques

I.NET PRESENT VALUE (NPV) METHOD:

The NPV is the first and the foremost of the discounted cash flow techniques. NPV is used simply to weigh the elements of trade-off between investment outlays and the future benefits in equivalent terms, and to determine whether the net balance of the present values is favorable or not. The NPV of an investment proposal may be defined as the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows associated with a proposal. In other words, the NPV of any proposal, that involves cash inflows and outflow over a period of time, is equal to the net present value of all the cash flows. Thus, the NPV is the sum of the discounted values of the cash flows of a proposal. In case, the cash outflows i.e. the investment in the proposal occur only in the beginning at time 0, then NPV may be defined as the sum, of the present values of cash inflows less the initial investment.

The merits of the NPV technique can be enumerated as follows.

1. It recognizes the time value of money. It helps evaluation of proposals involving cash flows over a period of several years. The cash flows occurring at different point of time are not directly comparable, but they can be made comparable by the application of the discounting procedure.

2. The NPV technique considers the entire cash flow stream and all the cash inflows and outflows, irrespective of the timing of their occurrence, are incorporated in the calculation of the NPV.

3. The NPV technique is based on the cash flows rather than the accounting profit and thus helps in analyzing the effect of the proposal on the wealth of the shareholders in a better way.

4. The discount rate, k, applied for discounting the future cash flows is in fact, the minimum required rate of return, which incorporates both the pure return as well as the premium required to set off the risk.

II.PROFITABILITY INDEX (PI):

This technique which is a variant of the NPV technique, is also known as Benefit- cost ratio, or preset Value index. The PI is also based upon the basic concept of discounting the future cash flows and is ascertained by comparing the present value of the future cash inflows with the present value of the future cash outflows.

PI = Total present value of cash inflows
Total Present Value of cash outflows

III. Internal Rate of Return (IRR):

Like the NPV, the IRR is also based on the discounting technique. In the IRR technique, the future cash inflows are discounted in such a way that their total present value is just equal to the present value of total cash outflows. The time-schedule of occurrence of the future cash flows is known but the rate of discount is not. Rather this discount rate is ascertained, by the trial and error procedure. This rate of discount so calculated, which equates the present value of future cash inflows with the present value of outflows, is known as the IRR.

Lecture no.: 12

Topic: Risk Analysis

RISK ANALYSIS

The cash flows from an investment are estimated when the proposal is evaluated, however, the returns are not known until the cash flows actually occur. The uncertainty of returns from the moment, the funds are invested until management and investor know how much the projects has earned, is a primary determinant of a proposal's risk. The owner of a firm are ordinarily concerned with the riskiness of their capital, and management must therefore, take risk into account in evaluation of capital budgeting proposals.

1. Project Specific Risk:

This type of risk is project specific i.e., an individual project may have higher or lower cash flows than expected, either because of the wrong estimation or because of factors specific to that project. When firms takes a large number of similar projects, it may be argued that much of this project specific risk would be diversified away The project specific risk affects only the project under consideration and may arise from factors specific to project or estimation error.

2. Competition Risk:

The second type of risk is competition risk where the cash flows of a project are affected by the actions of the competitors. Although, a good project analysis might consider the reactions of the competitors, the actual actions taken by the competitors may be different from those expected. In most of the cases, this risk will affect more than one project and is therefore difficult to be diversified away in the normal course of business.

3. Industry Specific Risk:

The third type of risk is the industry specific risk i.e., the risk that primarily affects the earnings and cash flows of a specific industry only. This risk may arise because of three factors. The first is technology risk, which reflects the effects of technologies that change or evolve in ways different from those expected when the project was originally analyzed. The second is legal risk, which reflects the effect of changing laws and
regulation affecting a particular industry only. The third may be the commodity risk, which reflects the effects of price changes in goods and services that are used or produced.

4. International Risk:

A firm faces this type of risk when it takes on projects outside its domestic market. In such cases, the earnings and cash flows might be different than expected owing to exchange rate movements or political changes. Some of this risk may be diversified away by a firm in the normal course of business by taking on projects in different countries whose currencies may not all move in the same direction. Multinational firms who hold projects in number of countries are able to diversify away this risk.

5. Market Risk:

The last type of risk arises by the factors that affect essentially all companies and all projects, of course in varying degrees. For example, changes in interest rate structure will affect the projects already taken as well as those yet to be taken, both directly through the discount rate and indirectly through cash flows. Other factors that affect all the projects may be inflation, economic conditions etc. Although the expected values of these entire variables may be considered in the capital budgeting analysis, changes in these variables will affect their values. Firms cannot diversify away this risk in the normal course of business, although may be considered to some extent only.

Financial Management

Tuesday, January 27, 2009

Assignments

Thursday, January 22, 2009

course plan

Wednesday, January 21, 2009

Lecture notes 1-12

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