Financial Management Material I and II Units

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Financial ManagementUnit - I

Introduction: Financial Management is that managerial activity which is concerned with the planning and

controlling of the firms financial resources. Financial management is a process of identification, accumulation,analysis, preparation, interpretation and communication of financial information to plan, evaluate and control a

business firm. Financial management is a specialized function of general management which is related to the

procurement of finance and its effective usage for the achievement of the goals of an organization. It wasbranch of economics till 1890, and as separate discipline it is of recent origin still, the theoretical concepts are

drawn from economics.

Definition: Finance can be defined as the art and science of managing money. Finance is concerned with the

process, institutions, markets and instruments involved in the transfer of money among individuals, business

and government.

Financial Management is the process of decision making and controlling business operations. Western Bringham

Nature and scope of Financial Management:

Financial Management as an academic discipline has undergone fundamental changes with regard to its scope

and coverage. In the earlier years, it was treated synonymously with the raising of funds. In the later years, its

broader scope, included in addition to the procurement of funds, efficient use of resources.Firms create manufacturing capacities for production of goods; they sell their goods or services to earn profit.

They raise funds to acquire manufacturing and other facilities. The three most important activities of a business

firm are:- Production- Marketing

- Finance

A firm secures whatever sources it needs and employs it in activities which generate returns on invested capital.

Real and financial assets: A firm requires real assets to carry on its business. Tangible real assets are physical

assets that include plant, machinery, office, factory, furniture, and building. Intangible real assets are technical

know how, technological collaboration, patents and copyrights. Financial assets include shares, bonds anddebentures.

Equity and borrowed Funds: There are two types of funds that a firm can raise: Equity funds and borrowed

funds. A firm sells shares to acquire equity funds. Share holders invest their money in the shares of a companyin the expectation of a return on their invested capital. The return of share holders consists of dividend.

Another important source of securing capital is creditors or lenders. Loans are generally furnished for a

specified period at a fixed rate of interest. For lenders, the return on loans comes in the form of interest paid by

the firm.

Financial management is broadly concerned with the acquisition and use of funds by a business firm. The

important tasks of financial management are,

1. Financial analysis, planning and control

a) Analysis of financial conditionb) Profit planning

c) Financial forecasting

d) Financial control

2. Investinga) Management of current assets

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b) Capital budgeting

c) Managing of mergers, reorganizations and divestments3. Financing

a) Identification of sources of finance and determination of financing mix

b) Cultivating sources of funds and raising funds.c) Allocation of profits

Evolution of Financial Management:

The need for formation of large scale business enterprises and consolidation movements in the early stages of

the 20th century gave rise to the emergence of financial management as a distinct field of study. It was branch

of economics till 1890, and as separate discipline it is of recent origin still, the theoretical concepts are drawnfrom economics.

During the initial stages of the evolution of financial management, more focus was placed on the study of

sources and different forms of financing business enterprises. Business enterprises faced difficulties in raisingfinance from banks and other financial institutions in 1930s due to economic recession. Hence, the areas such

as sound financial structure and liquidity position of the firm were emphasized. New methods of planning and

control were concerned. The ways and means for assessing the credit worthiness of the firms were developed.The consequences of World War II facilitated the business enterprises to adopt sound financial structure and

reorganization. In the early 50s emphasis was laid upon liquidity and day to day operations of the firm ratherthan on profitability and institutional finance. Therefore the extent of financial management was broadened to

include the process of decision making within the firm.The modern phase began in the mid 1950s, and the concept of financial management became more analytica

and qualitative, with the application of economic theories and quantitative methods of finance analysis. 1960s

witnessed phenomenal advances in the theory of portfolio analysis. CAPM (capital asset pricing model) wasdeveloped in 1970s, which suggested that investment in diversified portfolio of securities can neutralize the

risks faced in financial investments. In 1980s taxation policies in personal and corporate finance played a vital

role. During this period the option pricing theory was also developed. Globalization of markets led to theemergence of Financial Engineering which involves formation of optimal solutions to problems confronted in

corporate finance

Financing Functions:

The functions of raising funds investing them in assets and distributing returns earned from assets to

shareholders are respectively known as financing decision, investment decision and dividend decision. A firmattempts to balance cash inflows and outflows while performing these functions. This is called liquidity

decision.

- Long term asset mix or Investment decision- Capital mix or Financing decision

- Profit allocation or Divided decision

- Short term asset mix or Liquidity decision

A firm performs finance functions simultaneously and continuously in the normal course of the business.Finance functions call for skillful planning, control and execution of a firms activity.

Investment decision: A firm investment decision involves capital expenditures. They are referred as capitalbudgeting decisions. A capital budgeting decision involves the decision of allocation of capital and also the

evaluating of the prospective profitability of new investment. Future benefits of investments are difficult to

measure and cannot be predicted with certainty. Risk in investment arises because of the uncertain returns.Hence, investment proposals are to be evaluated in terms of both expected return and risk. Capital budgeting

also involves replacement decisions.

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Financing decision: Financing decision is the second important function in finance department. It is to decide

where from and how to acquire funds to meet the firms investment needs. The central issue here is to determinethe appropriate proportion of equity and debt. The mix of debt and equity is known as the firms capita

structure. The firms capital structure is considered optimum when the market value of shares is maximized.

Dividend decision: Dividend decision is the third major financial decision. The finance manager has to decide

in what proportion the firm has to distribute the dividends. The proportion of profits distributed as dividends is

called the dividend payout ration and retained portion of the profits is known as the retention ratio. The

optimum dividend policy is one that maximizes the market value of the firms shares.

Liquidity decision: Investment in current assets affects the firms profitability and liquidity. Current assets

management that affects a firms liquidity is yet another important finance function. Current assets should bemanaged efficiently for safeguarding the firm against the risk of illiquidity. Lack of liquidity in extreme

situations can lead to the firms insolvency. A high rate of investment in current assets would provide liquidity

but it would lose profitability. As, the current assets would not earn anything thus, profitability liquiditytradeoff must be maintained.

Finance functions are said to influence production, marketing and other functions of the firm. Hence, financefunctions may affect the size, growth, profitability and risk of the firm and ultimately value of the firm.

Role of a Financial Manager:

A financial manager is a person who is responsible, in a significant way, to carry out the finance functions. It

should be noted that, the financial manager occupies a key position. Finance managers functions not confined to

preparing, maintaining records and raising funds when needed. He is now responsible for shaping fortunes ofthe enterprise, and is involved in the most vital decision of the allocation of capital. He needs to have broader

outlook and must ensure the funds of the enterprise are utilized in the most efficient manner.

The main functions of financial manager are,

Funds raising: During the major events, such as promotion, reorganization, expansion or diversification in the

firm that the financial manager was called upon to raise funds.

Funds allocation: A number of economic and environmental factors, such as the increasing pace o

industrialization, technological innovations, intense competition, increasing intervention of government on

account of management inefficiency and failure, have necessitated efficient and effective utilization of financialresources. The development of a number of management skills and decision-making techniques facilitated the

implementation of a system of optimum allocation of firms resources. As a result, the emphasis shifted from

raising of funds to efficient and effective use of funds.

Profit planning: The functions of the financial manager may be broadened to include profit planning function

Profit planning refers to the operating decisions in the area of pricing costs, volume of output and the firms

selection of product lines. Profit planning is a prerequisite for optimizing investment and financing decisions.

Understanding capital markets: Capital markets bring investors and firms together. Hence, the financia

manager has to deal with capital markets. He should understand the operations of capital markets and the way inwhich it values the securities. He should also know how risk is measured and how to cope up with the risk in

investment and financing decisions.

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Relation between finance and other management functions:

Finance is the life blood of an organization. It is a common thread, which binds all the organizational functions

There is an inseparable relationship between finance and other functions. All most all business activities

directly or indirectly, involve the acquisition and use of funds. For ex: recruitment and promotion of employeesin production is clearly a responsibility of production department, but it requires payment of wages and salaries

and other benefits, and thus, involves finance. Sales promotion activity come with in the purview of marketing,

but advertising and other sales promotion activities require investment of cash and therefore, affect financial

resources.We do not find an answer to the question where do the production and marketing functions end and finance

function begin? The finance function of raising and using money will have a significant effect on other

functions.

Manufacturing - Finance:

1. Manufacturing function needs a large investment. Productive use of resources ensures a cost advantage forthe firm.

2. Optimum investment in inventories improves profit margin.

3. Many parameters of the production cost having effect on production cost are possible to control throughinternal management thus improving profits.

4. Important production decisions like make or buy can be taken only after financial implications have beenconsidered.

Marketing Finance:

1. Many aspects of marketing management have financial implications eg: hold inventories to provide

uninterrupted service to customers, extension of credit facility to customers in order to increase the sales.2. Marketing strategies to increase sales have additional cost impact.

Personnel Finance:

1. In the global competitive scenario, business firms are moving to leaner and flat organizations. Investments in

human resource development are also bound to increase.

2. Providing remuneration and other incentives.3. Restructuring of remuneration structure, voluntary retirement scheme, sweat equity, etc., has become majorfinancial decisions in the area of human resource management.

Strategic planning Finance:

Finance function is an important tool in the hands of management for strategic planning and control on two

counts:

1. The decision variables when converted into monetary terms are easier to grasp.2. Finance function has strong inter-links with other functions. Controlling other functions is possible through

finance function.

The changing role of financial management in India:

Modern financial management has come a long way form the traditional corporate finance. The finance

manager is working in a challenging environment, which changes continuously. As the economy is opening upand global resources are being tapped, the opportunities available to finance manager have no limits. At the

same time, one must understand the risk in the decisions. Financial management is passing through an era of

experimentation, as a large part of the finance activities carried out today were not heard of a few years ago.

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1. Interest rates have been deregulated. Further, interest rates are fluctuating, and minimum cost of capital

necessitates anticipating interest rate movements.2. The rupee has become freely convertible in current account of international market.

3. Optimum debt equity mix is possible. Firms have to take advantage of the financial leverage to increase the

shareholders wealth. However, financial leverage entails financial risk. Hence a correct trade off between riskand improved rate of return to share holders is a challenging task.

4. With free pricing of issues, the optimum price of new issue is a challenging task, as overpricing results in

under subscription and loss of investor confidence, whereas under pricing leads to unwarranted increase in a

number of shares and also reduction of earnings per share.5. Maintaining share prices is crucial. In the liberalized scenario, the capital markets are important avenue of

funds for business.

6. The dividend and bonus policies framed have a direct bearing on the share prices.7. Ensuring management control is vital, especially in the light of foreign participation in equity, making the

firm an easy takeover target. Financial strategies to prevent this are vital to the present management.

Approaches to Finance Function:

The different approaches associated with finance function can be broadly categorized into two types. They areas follows,

1. The Traditional Approach2. The Modern Approach

1. The Traditional Approach: The term financial management used in this modern era was known as

corporate finance under traditional approach. This approach to financial management was popular in the initial

stages of its evolution as a separate branch of academic study. Under this approach the role of financial managerwas limited to raising and administering of funds needed by corporate enterprises to meet their financial needs.

It broadly covers the following three aspects.

1. Arrangement of funds from financial institutions.2. Arrangement of funds through instruments, viz. shares, bonds, etc.

3. The legal and accounting relationships between a firm and its sources of funds.

The scope of traditional approach to financial management was mainly concerned with raising of fundsexternally. The finance manager had a limited role to perform. He was expected to keep accurate financialrecords, prepare reports on the enterprise status, performance and manage funds in such a way that the firm

could meet its maturing obligations.

The traditional approach evolved during 1920s and 1930s and dominated academic thinking during the 1950sand through early 1940. It has now been discarded as it suffers from serious limitations.

Limitations of Traditional Approach:1. Outsider Looking Approach: This approach is concentrated only on raising and administering of funds from

the view point of suppliers of funds i.e., bankers, financial institutions. It completely ignored the view point of

those who had to take internal financing decisions.

2. Ignored working capital problems: This approach emphasized on events like mergers, consolidation andreorganizations of enterprises, the result of which is that the day to day financial problems of business

undertakings were ignored. This approach focused on long term financing of the business enterprises. The

problems relating to short term funds of working capital were ignored.3. No emphasis on allocation of funds: The approach was confined to issues involving procurement of funds. It

did not emphasize on allocation of funds, which is a matter of concern today.

2. The Modern Approach: The narrow scope of traditional approach led to the emergence of modern approach

in the mid 1950s. The modern approach ahs a broader aspect of financial management which provides

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conceptual and analytical framework for financial decision making, by including both areas of finance, raising

of funds as well as their effective utilization. The new approach is an analytical way of viewing the financialproblems of firms.

Features of Modern Approach:

1. The approach emphasizes not only on sources of raising funds but also their effective and optimum

utilization.

2. The cost of raising finance and the return on their investment are compared. The investment should yield

more returns than the cost of raising finance.3. Financial management according to this approach covers the areas of financial planning and control, raising

of corporate finance, effective utilization of funds, etc.

4. The techniques of models, linear programming, simulations, queuing and financial engineering are used tosolve problems of financial management.

Thus, the modern approach widens the scope of financial management considering the major management

decisions such as financing decision, investment decision and dividend policy decision.

Goals of financial management:

1. Maintenance of liquid assets: In order to meet the day to day operation, every firm should maintain necessary

liquid assets.2. Maximization of Profitability: The immediate objective of any business is to earn profits and to maximize the

profit as much as possible. Without profit objective no businessman starts business at all.3. Ensuring fair return to share holders

4. Building up reserves for growth and expansion.

5. Ensuring maximum operational efficiency by efficient and effective utilization of funds.6. Ensuring financial discipline in the organization.

Profit Maximization:

Maximization of profits is generally regarded as the main objective of a business enterprise. Each company

collects its finances by way of issue of shares to the public. Investors invest in shares with the hope of gettingmaximum profits from the company in the form of dividend.Price system is the most important organ of a market economy indicating what goods and services society

wants. Goods and services in great demand command higher prices. This result in higher profit for firms more

of such goods and services are produced. Higher profit opportunities attract other firms to produce such goodsand services. Ultimately, with intensifying competition, an equilibrium price is reached at which demand and

supply match. In the case of goods and services, which are not required by society, their prices and profits will

fall.In the economic theory, the behavior of a firm is analyzed in terms of profit maximization. Profit maximization

implies that a firm either produces maximum output for a given amount of input or uses minimum input for

producing a given output. The underlying logic of profit maximization is efficiency. It is assumed that profit

maximization causes the efficient allocation of resources under the competitive market conditions and profit isconsidered as the most appropriate measure of a firms performance.

On the other hand, higher profits are the barometer of its efficiency on all fronts, i.e., production, sales and

management. A few replace the goals of maximization of profits to fair profits.Fair profits mean the general rate of profit earned by similar organizations in a particular area. The main

objective of financial management is to safeguard the economic interest of the persons who are directly or

indirectly connected with the company i.e., shareholders, creditors and employees.

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All such interested parties must get the maximum return for their contribution. But this is possible only when

the company earns higher profits or sufficient profits to discharge its obligations to them. Therefore the goal ofmaximization of profits is said to be best criterion of the decision making.

Arguments in favour of profit maximization:

1. Profit is the test of economic efficiency: It is a measuring rod by which the economic performance of the

company can be judged.

2. Efficient allocation of fund: Profit leads to efficient allocation of resources as resources tend to be directed to

uses which in terms of profitability are the most desirable.3. Social welfare: It ensures maximum social welfare i.e., maximum dividend to shareholders, timely payments

to creditors, more and more wages and other benefits to employees, better quality at cheaper rate to consumers,

more employment society and maximization of capital to the entrepreneur.4. Internal resources for expansion: It will consume a lot of time to raise equity funds in a primary market

Retained profits can be used for expansion and modernization.

5. Reduction in risk and uncertainty: Once after availing huge profits the company develops risk bearingcapacity. The gross present value of a course of action is found by discounting and low capitalizing is benefits

at a rate which reflects their timing and uncertainty. A financial action which has positive net present value

creates wealth and therefore is desirable. The negative present value should be rejected.6. More competitive: More and more profits enhance the competitive spirit thus, under such conditions firms

having more and more profits are considered to be more dependable and can survive in any environment.7. Desire for controls: More and more profits are desirable and imperative for the management t make optimum

use of available financial resources for continued survival.

Objections to Profit Maximization:

1. It is argued that profit maximization assumes perfect completion, and in the face of imperfect modernmarkets, it cannot be a legitimate objective of the firm.

2. It is also argued that profit maximization, as a business objective, developed in the early 19 th century for

single entrepreneurship. Only aim of single owner was to enhance his individual wealth. But the modernbusiness environment is characterized by limited liability and a difference between management and ownership

Share holders and lenders today finance the firm but it is controlled and directed by professional management

In the new business environment, profit maximization is regarded as unrealistic, difficult, inappropriate andimmoral.3. It is also feared that profit maximization behavior in a market economy may tend to produce goods and

services that are wasteful and unnecessary from the societys point of view.

4. Firms producing same goods and services differ substantially in terms of technology, costs and capital. Inview of such conditions, it is difficult to have a truly competitive price system, and thus, it is doubtful if the

profit maximizing behavior will lead to the optimum social welfare.

5. Profit cannot be ascertained will in advance to express the probability of return as future is uncertain. It is notpossible to maximize something that is unknown. Moreover the term profit is vague and not clearly expressed.

6. The executive or the decision maker may not have enough confidence in the estimates of future returns so

that he does not attempt further to maximize. It is argued that a firms goal cannot be, to maximize profits but to

attain a certain level or certain share of the market or certain level of sales.7. The criterion of profit maximization ignores the time value factor it considers the total benefits or profits into

account while considering a project whereas the length of time in earning that profits is not considered at all.

Wealth Maximization:

Wealth maximization (shareholders wealth maximization) means maximizing the net present value of a courseof action to shareholders. Net present value or wealth of a course of action is the difference between the present

value of its benefits and the present value of its costs.

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A financial action that has a positive NPV creates wealth for shareholders and, therefore, is desirable. A

financial action resulting in negative NPV should be rejected since it would destroy shareholders wealth.The objective of shareholder wealth maximization takes care of the timing and risk of the expected benefits.

These problems are handled by selecting an appropriate rate for discounting the expected flow of future

benefits. It is important to emphasize that benefits are measured in terms of cash flows. In investment decisionsit is the flow of cash that is important, not the accounting profits.

The objective of shareholders wealth maximization is an appropriate and operationally feasible criterion to

choose among the alternative financial actions. It provides unambiguous measure of what financial manager

should seek to maximize in making investment and financing decisions on behalf of shareholders.Wealth maximizing objectives is consistent with the objective of maximizing the business economic welfare

i.e., their wealth. The wealth of owner is reflected by the market value of companys shares.

Thus, it implies that the fundamental principle of the company is to maximize the market value of the shares inthe long run. Long run means a considerably long period in order to work out a normalized market price, the

management can make decision to maximize the value of its shares on the basis of the day to day fluctuation in

the market price.

Features of Wealth maximization:

1. Protection of interest of shareholders: Shareholders interest is protected by increased market value of their

holdings in the firm.2. Security to financial lenders: It provides security to short term and long term financial lenders, who supply

funds to the business enterprise. Short term lenders are interested in the firms liquidity position, whereas longterm lenders enjoy priority over shareholder at the time of return of funds besides getting fixed rate of interest.

3. Protection of interest of employees: Employees contribution is a primary consideration in raising the wealth

of an enterprise. Their productivity and efficiency ultimately leads to fulfilling companys objective of wealthmaximization.

4. Survival of Management: Management is a representative body of shareholders. When shareholders interest

is protected, they may not wish to change the management and hence it can survive for a longer period of time.5. Interest of society: When all the available productive resources are put to optimum and efficient use,

economic interest of the society is served.

Profit Maximization Vs. Wealth Maximization:

Profit Maximization Wealth Maximization

1. Profit cannot be ascertained well in advance to

express the probability of return. The term profit hasno clear meaning.

1. There is no vagueness in wealth maximization goal

It represents the value of benefits minus the cost ofinvestment.

2. The executive or the decision maker may not haveenough confidence in the estimates of future returns so

he does not attempt to maximize further.

2. It is argued that a firms goal cannot be, tomaximize profits but to attain a certain level or share

of the market or certain level of sales.

3. The risk variations and related capitalization rate is

not considered in the concept of profit maximization.

3. In wealth maximization, it is considered that there

should be balance between expected return and risk.4. The goal of profit maximization is considered to bea narrow outlook.

4. The goal of wealth maximization is considered to bea broad outlook.

5. It ignores the interests of the community. 5. Its objective is to enhance the shareholders wealth.

6. The criterion of profit maximization ignores the

time value factor for the profits of a project.

6. Wealth maximization concept fully considers the

time value factor of cash inflows.

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In large companies, there is a difference between management and ownership. The decision taking authority ina company lies in the hands of managers. Shareholders as owners of a company are the principals and managers

are their agents. Thus there is a principal agent relationship between them. In theory, managers should act in the

best interests of shareholders i.e., their actions and decisions should lead to shareholders wealth maximizationIn practice, managers may not necessarily act in the best interest shareholders, and they may pursue their own

personal goals. Managers may maximize their own wealth in the form of high salaries at the cost o

shareholders.

Such satisfying behaviour of mangers will frustrate the objective of shareholders wealth maximization. It is inthe interests of managers that the firm survives over the long run. Managers also wish to enjoy independence

and freedom from outside interference, control and monitoring. Thus their actions are very likely to be directed

towards the goals of survival and self sufficiency. Managers in practice may perceive their role as reconcilingconflicting objectives of stakeholders.

Shareholders continuously monitor modern companies that would help them to restrict managers freedom to

act in their own self interest at the cost of shareholders. Emplo9yees, creditors, customers and government alsokeep an eye on managers activities. Thus the possibility of managers pursuing exclusively their own personal

goals is reduced. Managers can survive only when they are successful and they are successful when they

manage the company better than someone else. Every group connected with the company will, however,evaluate management success from the pint of view of the fulfillment of its own objective. The survival of

management will be threatened if the objective of any of these groups remains unfulfilled.The wealth maximization objective may be generally in harmony with the interests of the various groups such

as owners, employees, creditors and society and thus, it may be consistent with the management objective ofsurvival. Still, there are many situations where a conflict may occur between the shareholders and managers

goals.

The conflict between the interests of shareholders and managers is referred as agency problem and it results inagency costs. Agency costs include the less than optimum share value for shareholders and costs incurred by

them to monitor the actions of mangers and control their behavior.

The optimal solution to shareholders management conflicts is to monitor the managerial actions to some extentand the managerial compensation should be based upon the performance. Specific mechanisms, should be used

to motivate management to act in the shareholders interest are,

1. Management compensation plans: Managerial compensation should be designed in a way that it attracts andretains desired management and managerial actions are close to shareholders interests. Different companysfollows different compensation policies such as apart form specified annual salary, a senior executive can be

provided with cash or bonus shares at the end of financial year.

2. Intervention of shareholders in decision making: Shareholders, being the owners of the company enjoy votingrights and right to attend the annual general meetings of the company. Today majority ownership lies with

corporate investors like insurance companies, mutual funds. They can suggest to the management on ways to

operate the business.3. Threat of firing: If the shareholders are not satisfies with the managements performance, they can exercise

voting rights and replace the management at the annual general meeting.

4. Hostile takeover: Hostile takeovers are likely to occur when firms shares are undervalued because of the

poor performance of the management. In such takeovers, the management of subsidiary company is replaced bythe management of the holding company.

Risk Return Trade-off

Financial decisions incur different degree of risk. Your decision to invest your money in government bonds has

less risk as interest rate is known and the risk of default is very less. On the other hand, you would incur morerisk if you decide to invest your money in shares, as return is not certain. However, you can expect a lower

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return from government bond and higher from shares. Risk and expected return move in one behind another

The greater the risk, the greater the expected return.Financial decisions of a firm are guided by the risk-return trade-off. These decisions are interrelated and jointly

affect the market value of its shares by influencing return and risk of the firm. The relationship between return

and risk can be simply expressed as:Return = Risk free rate + Risk Premium

Expected ReturnRisk Premium

Risk-free Return

Risk

Risk free rate: Risk free rate is a rate obtainable from a default risk free government security. An investorassuming risk from his investment requires a risk premium above the risk free rate. Risk free rate is a

compensation for time and risk premium for risk. Higher the risk of an action, higher will be the risk premiumleading to higher required return on that action. A proper balance between return and risk should be maintained

to maximize the market value of a firms share. Such balance is called risk return trade off and every financiadecision involves this trade off.

Trade-off

The financial manager in order to maximize shareholders wealth should strive to maximize returns in relation tothe given risk. He should seek courses of actions that avoid unnecessary risks. To ensure maximum return

funds flowing in and out of the firm should be constantly monitored to assure that they are safeguarded and

properly utilized. The financial reporting system must be designed to provide timely and accurate picture of thefirms activities.

10

Financial Management

Maximization of share value

Financial Decisions

Investment

LiquidityManageme

Financing

DividendDecisions

Return Risk


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Unit II

Introduction: An efficient allocation of capital is the most important finance function in the modern times. It

involves decisions to commit the firms funds to the long term assets. Capital budgeting or investment decisions

are of considerable importance to the firm since they tend to determine its value by influencing its growth,profitability and risk.

Capital Budgeting: The investment decisions of a firm are generally known as the capital budgeting or capital

expenditure decisions. A capital budgeting decision may be defined as the firms decision to invest its currentfunds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of

years. The long term assets are those that affect the firms operations beyond the one year period. The firms

investment decisions would generally include expansion, acquisition, modernization and replacement of thelong term assets.

Capital budgeting may also be defined as The decision making process by which a firm evaluates the purchase

of major fixed assets.

Opportunity cost of capital: The investments should be evaluated on the basis of a criterion, which is

compatible with the objective of the shareholders wealth maximization. An investment will add to the

shareholders wealth if it yields benefits in excess of the minimum benefits as per the opportunity cost of capital.

Importance of Investment Decisions / Capital Budgeting Decisions:

1. They influence the firms growth in the long run2. They affect the risk of the firm

3. They involve commitment of large amount of funds

4. They are irreversible, or reversible at substantial loss5. They are among the most difficult decisions to make

Growth: The effects of investment decisions extend into the future and have to be endured for a longer periodthan the consequences of the current operating expenditure. Unwanted or unprofitable expansion of assets wil

result in heavy operating costs to the firm.

Risk: A long term commitment of funds may also change the risk complexity of the firm. If the adoption of aninvestment increases average gain but causes frequent fluctuations in its earnings, the firm will become morerisky.

Funding: Investment decisions generally involve large amount of funds which make it necessary for the firm to

plan its investment programmes very carefully and make an advance arrangement for procuring financesinternally or externally.

Irreversibility: 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. Investment decisionsonce made cannot be reversed or may be reversed but at a substantial loss.

Complexity: Another important characteristic feature of capital investment decision is that it is the most

difficult decision to make. Such decisions 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.

Types of Investment Decisions:

1. Expansion of existing business

2. Expansion of new business

3. Replacement and modernizationExpansion and Diversification: Generally expanding the firms capacity to produce more output will

accommodate high operational efficiency.

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Related expansion / diversification: A company may add capacity to its existing product lines to expand existingoperations.

Unrelated diversification: A firm may expand its activities in a new business. Expansion of a new business

requires investment in new products and a new kind of production activity within the firm.Revenue expansion investments: Sometimes a company acquires existing firms to expand its business. In either

case, the firm makes investment in the expectation of additional revenue.

Replacement and Modernization: The main objective of modernization and replacement is to improve operatingefficiency and reduce costs. Cost savings will reflect in the increased profits, but the firms revenue may remain

unchanged. Assets become outdated and obsolete with technological changes. The firm must decide to repalcee

those assets with new assets that operate more economically.If a certain company changes form semi automatic equipment to fully automatic drying equipment, it is an

example of modernization and replacement. These are also called cost reduction investment.

Mutually exclusive investments: Mutually exclusive investments serve the same purpose and compete with each

other. If one investment is undertaken, others will have to be excluded. A company may, for example, either use

a labour intensive production method or capital intensive production method choosing capital intensiveproduction method will preclude labour intensive production method.

Independent investments: Independent investments serve different purposes and do not compete with each

other. Depending on their profitability and availability of funds, the company can undertake both investments.For example, Mahindra & Mahindra can manufacture two wheelers as well as four wheelers.

Contingent Investments: Contingent investments are dependent projects the choice of one investmentnecessitates undertaking one or more other investments.

For example, if a company decides to build a factory in a remote, backward area, it may have to invest in

houses, roads, hospitals, schools etc. for employees to attract the work force.

Investment Decision Process

The allocation of investible funds to different long term assets is known as capital budgeting decisions. Capitalbudgeting is a complex process which may be divided into five broad phases.

1. Project generation

2. Project evaluation3. Project selection

4. Project implementation

5. Controlling and review

1. Project generation: The planning phase of a firms capital budgeting process is concerned with the

circulation of its broad investment strategy and the generation and preliminary screening project proposals.

The investments strategy of the firm delineates the broad areas or types of investments the firm plans toundertake. This provides the framework which shapes and guides the identification of individual project

opportunities.

2. Project evaluation: If the preliminary screening suggests that the project is prima facie worth while, adetailed analysis of the marketing technical, financial, economic and ecological aspects is undertaken. The

questions and issues raised in such a detailed analysis are described in the following section.

The focus of this phase of capital budgeting is on gathering, preparing and summarizing relevant informationabout various project proposals which are being considered for inclusion in the capital budget. Based on the

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information developed in this analysis, the stream of costs and benefits associated with the project can be

defined.

3. Project selection: Selection follows an often overlaps, analysis. It addresses the questions. Is the project

worth while? A wide range of appraisal criteria have been suggested to judge to worth while of a project. They

are divided into two broad categories: Non discounting criteria and Discounting criteria.The principle in non discounting criteria is the pay back period and the accounting rate of return.

The key discounting criteria are the net present value, the internal rate of return and profitability index.

To apply the various appraisal criteria suitable cut off values have to be specified. These are essentially a

function for the fix of financing and the level of project risk while the former can be defined with relative case;the latter truly tests the liability of the project evaluation.

4. Project implementation:

The implementation phase for an industrial project which involves setting up of manufacturing facilitiesconsists of several stages.

Stage Concerned with

Project and engineeringdesign

Site probing and prospecting, preparation of blue prints and plant designs, plantengineering selection of specific machines and equipment.

Negotiation and contracting Negotiating and drawing up of legal contracts with respect to project financing

acquisition of technology, supply of machinery and know how and marketing

arrangements.Construction Site preparation, construction of buildings and civil work, erection and

installation of machinery and equipment.

Training Training of engineers, technicians and workers.

Plant commissioning Start up of the plant.

5. Project Review: Once the project is commissioned the review phase has to be set in motion. Performance

review should be done periodically to compare actual performance with projected performance. A feedback

device, it is useful in several ways,1. It throws light on how realistic were the assumptions underlying the project.

2. It provides a documented long of experience that is highly valuable in future decision making.

3. It suggests corrective action to be taken in the light of the actual performance.

Steps involved in Feasibility study

The available capital must be used in a manner which is consistent with the over all socio economic objectives.

This becomes more difficult when there are several competing projects, each giving a rate of return higher than

the minimum cut off rate.Project appraisal may be defined as a detailed evaluation of the project to determine the technical feasibility,

economic feasibility, financial feasibility and managerial competence.

Project feasibility study or appraisal consists of the following:

1. Technical feasibility

2. Economic feasibility3. Financial feasibility

4. Managerial competence5. Market feasibility

1. Technical feasibility:A project must be technically feasible. This can be judged by a detailed assessment of the following factors.

a. Technology used: The technology used has been tested and suits the local conditions. The technical study

helps us to know how is available and technical collaborators are persons of good reputation.13


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b. Plant and equipment: The supplier of plant equipment needed for the projects are of experience and

reputation. Plant layout is in accordance with the production flow programme.

2. Economic and social feasibility:

Economic feasibility analysis is also referred to as a social cost benefit analysis which is concerned with

judging a project from the larger social point of view but not in monetary terms. In such an evaluation, the focusis on the social costs and benefits of a project which may often be different from the monetary costs and

benefits to the firm.

a. The extent to which, the project is expected to contribute to national development.

b. The project can bring about the development in that area.c. The project will crate more employment.

d. The atmospheric and other pollutants could be contained.

3. Financial Feasibility:

Financial appraisal is done to ascertain whether the proposed project will be financially viable in the sense of

being able to meet the burden of servicing debt and whether the proposed project will satisfy the return

expectations of those who provide capital. While appraising a project financially, the following aspects shouldbe kept in mind.

a. Cost of project: The estimates of the project should cover all items expenditure and should be realistic.

b. Sources of finance: Sources of finance contemplated by the promoters should be adequate and necessaryfinance should be available during installation. Factors to be considered while evaluating project on financia

criteria:1. Investment outlay or cost of project

2. Means of financing3. Projected profitability

4. Break even point

5. Cash flows of the project6. Level of risk

4. Managerial competence:

The technical competence, administrative ability, integrity and resourcefulness of borrowing concerns topmanagerial personnel determines to a great extent the willingness of a financial institutional to accept a term

loan proposal.

The loan application from firms having competent and honest management finds favourable considerations. Itcan therefore be stated that the appraisal of the managerial competence is of primary importance in the overallappraisal of a project.

5. Market feasibility:

Market appraisal is concerned with two questions.1. What would be the aggregate demand of the proposed product/service in future?

2. What would be the market share of the project under appraisal?

In order to answer these questions a market analyst requires a wide variety of information and suitableforecasting methods.

The information required includes,

a. Past and present consumption trends, consumer behavior and preferences.

b. Past and present supply positionc. Production constraints

d. Imports and exports

e. Structure of competitionf. Cost structure and marketing policies

Capital Budgeting Techniques:

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The most important techniques used in capital budgeting are,

Traditional Methods:

1. Pay back Period Method

2. Accounting Rate of Return or Average Rate of Return MethodDiscounted Cash Flow Methods:

3. Net Present Value Method

4. Internal Rate of Return Method

1. Pay back Period Method: Pay back period method is the simplest method of evaluating investment

proposals. Payback period represents the number of years required to recover the original investment. The

payback period is also called payoff or payout. This period is calculated by dividing the cost of the project bythe annual earnings after tax but before depreciation. Under this method project with shortest pay back period

will be given the highest rank and taken as best investment.

Original cost of the project

Payback period = _______________________

Annual cash inflow

Advantages:1. Simple to understand and easy to calculate.

2. It reduces the chance of loss. As the project with a short payback period is preferred.3. A firm which has shortage of funds finds this method very useful.

4. This method costs less as it requires only very little effort for its computation.

Disadvantages:1. This method does not take into consideration the cash inflows beyond the pay back period.

2. It does not consider the time value of money.

3. It gives over emphasis to liquidity.

2. Accounting Rate of Return or Average Rate of Return Method:

This method is based on accounting profit, takes into account the earnings expected from the investment overthe entire lifetime of the asset. The various projects are ranked in the order of the rate of returns. The projectwith the higher rate of return is accepted.

Average annual earningsARR = _______________________ X 100

Average investment

Advantages:

1. It is easy to understand and calculate.

2. It can be compared with the cut off point of return and hence the decision to accept or reject is made easier.

3. It considers all the cash inflows during the life of the project, not like payback method.4. It is a reliable measure because it considers net earnings.

Disadvantages:1. The concept of time value of money is ignored.

2. The average concept is not reliable, particularly in the times of high fluctuation in the returns.

3. The average concept dilutes the profitability of the project.4. The method of computation of ARR is not standardized.

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Discounted Cash Flow: Discounted cash flows are the future cash inflows reduced to their present value based

on a discounting factor. The process of reducing the future cash inflows to their present value based on adiscounting factor or cutoff return is called discounting.

3. Net Present Value Method:

The net present value method considers the time value of money. The cash flows of different years are valued

differently and made comparable in terms of present values. The net cash inflows of various periods are

discounted using required rate of return which is predetermined. Taking into conside3ration the scrap value, if

the present value of as cash inflows exceeds the initial cost of the project, the project is accepted otherwiserejected. If there are two projects giving net present value, the project with the higher net present value is

selected.

NPV = Present value of cash inflows Investment

4. Internal Rate of Return Method:

The internal rate of return for an investment proposal is that discount rate which equates the present value of

cash inflows with the present value of cash outflows of an investment. When compared the internal rate of

return with a required rate of return, if the internal rate of return is more than required rate of return then, theproject is accepted else rejected. Incase of more than one project; the project with highest IRR is selected.

P1 - Q

IRR = L + ___________ x DP1 - P2

L = Lower discount rate; P1= Present value of earnings at lower rate; P2= Present value of earnings at higherrate; Q= Actual investment; D= Difference in rate of return.

Net Present Value Vs. Internal Rate of Return

Net Present Value Internal Rate of Return

1. NPV is expressed in terms of currency. 1. IRR is expressed in terms of percentage.2. NPV calculates additional wealth. 2. IRR does not calculate additional wealth.

3. NPV can deal with changing cash inflows. 3. IRR method cannot be used to evaluate where the

cash flows are changing (i.e. initial outlay followed bycash flows and later outlay)

4. This is an easy method which can be understoodeven by a layman because the NPV is expressed in

terms of money.

4. A manager can better understand the concept oreturns stated in percentages and find it easy to

summarize and compare to the required cost of capital.

5. NPV suggests larger projects which generates more

cash inflows.

5. IRR suggests smaller projects with shorter life and

earlier cash inflows.

6. In NPV using different discount rates will result in

different recommendations.

6. In IRR method what ever the discount rate we use, it

gives the same result.

Developing cash flows

Capital expenditures typically involve current and near future costs that are expected to generate benefits in the

future. While measuring the costs and benefits of a capital expenditure proposal, you must bear in mind thefollowing guidelines:

1. Focus on cash flows: Costs and benefits must be measured in terms of cash flows. Costs are cash outflows

and benefits are cash inflows. Cash flows matter because they represent the purchasing power. Since accounting

figures are based on the accrual principle, they have to be adjusted to derive the cash flows. For example,16


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depreciation and other non cash charges, which are deducted in computing profits from the accounting point of

view, have to be added back as they do not entail cash outflows.Estimate cash inflows on a post-tax basis. Some firms look at pre-tax cash flows and, to compensate that, apply

a discount rate greater than the cost of the capital. However, there is no reliable basis for making such

adjustments.

2. Consider all incidental effects: In addition to its direct cash flows, a project may have incidental effects on

the rest of the firm. It may enhance the profitability of some of the existing activities of the firm as it has a

complementary relationship with them or it may detract from the profitability of some of the existing activitiesas it has a competitive relationship with them all these must be taken into account.

3. Ignore sunk costs: Sunk costs represent past outlays that cannot be recovered and hence, are not relevant fornew investment decisions.

4. Include opportunity cost: If a project requires the use of some resources already available with a firm, theopportunity cost of the resources should be charged to the project. The opportunity cost of a resource is the

value of net cash flows that can be derived from it if it were put to its best alternative use.

5. Networking capital: Apart from investment in fixed assets like land, machinery, building and technical know

how, a project also requires investment in current assets like cash receivables (debtors), and inventories. Aportion of current assets is supported by non interest bearing current liabilities accounts payable (creditors) and

provisions. The difference between current assets and non interest bearing current liabilities is the net workingcapital. It is financed by equity, preference and debt.

Components of cash flow stream:The cash flows stream of a project may be divided into three parts as follows:

Initial Outlay: These represent the cash outflows associated with investment in various project components.Initial outlay = Outlay on fixed assets + Outlay on net working capital

Operational Flow: These are cash inflows expected during the operational phase of the project.Operational flow = Profit + Depreciation Tax

Terminal Flow: Cash flows expected from the disposal of assets when the project is terminated are referred to as

terminal flows.Terminal flow = Post tax salvage value of fixed asset + Post tax salvage value of net working capital

Approaches for Reconciliation

The conflicts in project rankings may arise because of size disparity, time disparity and life disparity.

Size DisparityA source of ranking conflict may be the disparity in the size of initial outlays. Such conflicts may arise mainly

because NPV represents an absolute magnitude whereas the IRR is a relative measure. The resolution of

conflict depends on the following circumstances of the firm.1. If the firm has enough funds available to it at a given cost of capital, a project with bigger size is preferable as

it contributes more to the NPV of the firm.

2. If the firm has limited availability of the funds and acceptance of big sized project means the rejection ofsome other projects, then the NPV of big project must be compared with the sum of NPV of other projects and

alternative with higher NPV is to be accepted.

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Time Disparity

Projects may differ with respect to the sequence of the pattern of cash inflows associated with that and such

time disparities of cash inflows may lead to conflicts in ranking.

This conflict can be resolved by defining the reinvestment rates that are applicable to cash flow and calculationmodified versions of NPV and IRR. This method is known as terminal value method and it involves the

following two steps.

Life Disparity

In some cases the mutually exclusive alternatives have varying times and it may lead to conflict in rankings

One approach to resolve this conflict is by comparing the alternatives on the basis of their Uniform AnnualEarnings (UAE) and selects the alternative with highest UAE.

The UAE of a project is equal to the project of NPV and CRF

UAE = NPV X CRFWhere capital recovery factor (CRF) is simply the inverse of the present value interest factor for annuity.

The UAE method appears appealing because it expresses the gains from the project in an annualized form and

hence renders easy comparison between projects with different expected lives.

Unit III

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In evaluating a capital budgeting proposal, the firm should recognize that the forecasted return may or may not

be achieved. This is the element of risk in the decision making process.

Risk

Risk may be defined as the likelihood that the actual return from an investment will be less than the forecastreturn. Stated differently, it is the variability of return form an investment.

Different types of risks / Sources of risks

All projects face certain risks. Some of the main risks are elaborated below.1. Project specific risk: Revenue as well as cash flows from the project could be lower than estimated due to

inaccurate forecasts or poor management.

2. Risk from competition: Again, revenue and cash flows could be influenced by sudden, unexpected action bythe competition.

3. Industry specific risk: Government legislation or the introduction of new technology could have its effect

on the industry to which the project belongs.

4. Market risk: Once more, developments of an unexpected nature like a slow down in market growth or even

bank interest increase will take in toll on the project. Other factors in market risk are changing needs of

consumers, changes in demand and supply.

5. International risk: Projects abroad could face political risks or lower currency exchange rates which would

lower revenue and cash flows.

Business Risk

Business risk refers to the variability in the operating profit (EBIT) due to change in sales. In such a change that

the firm will not have ability to compete successfully with the assets that it purchases. Any operationa

problems are classified as business risk.

Financial Risk

Financial risk refers to a risk on account of pattern of capital structure i.e., Debt-Equity mix. At this point theinvestment will not generate sufficient cash flows either to cover interest payments on money borrowed to

finance it or principal repayments on the debt or to provide profits to the firm. Simply it is the variability of

return from an investment.

Incorporation of risk into business decisions:

The decision situation as to risk may be broken down into three types,1. Certainty (no risk)

2. Uncertainty

3. Risk

The risk situation is one in which the probabilities of particular event occurring are known while an uncertain

situation is one where these probabilities are not known. In other words in case of risk chance of future loss can

be foreseen because of past experience. Risk of an investment proposal can be judged from variability of itspossible returns. Risk with reference to capital budgeting decision may be defined as the variability that is likely

to occur in future between estimated and actual return.

Greater the variability, the greater will be the risk and vice versa. Therefore, the risk situation is one in whichthe probabilities of the particular event occurring are known.

While uncertainty is a situation where the probabilities of the particular event are not known, in such a case risk

chances of future loses can be foreseen because of past experience. In case of uncertainty the future cannot beforeseen.

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Risk has been always involved in all the capital budgeting decisions. So, there is a need to consider risk at the

time of evaluating various investment proposals. In order to control risk, there are several techniques whichdiffer in their approach and methodology. These techniques are divided into two types. They are,

a) Conventional techniques

- Payback period method- Risk adjusted discount rate

- Certainty equivalents

- Sensitivity analysis

- Financial break evenb) Statistical techniques

- Probability distribution approach

- Decision tree approach

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Documents

Financial Management Material I and II Units