Presentation financial management lecture

Financial management notes

1. Government of Karnataka Department of Collegiate Education Government First Grade College, Ainapur (NAAC Accredited “B” Grade) IQAC And Department of Commerce jointly organized E- Workshop on Financial Management Welcome To Presentation

2. UNIT – I FINANCIAL MANAGEMENT – MEANING – It refers to that part of management activity, which is concerned with planning and controlling of financial resources of organization . DEFINITION – Soloman Ezra - “Financial Management is concerned with the efficient use of an important economic resource, namely capital fund” Howard and Upton defined – “Financial Management is the application of planning and controlling function to the finance.

3. NATURE OF FINANCIAL MANAGEMENT Nature of financial management refers to its objectives, scope and functions. Objectives of Financial Management   I) Profit maximization II) Wealth Maximisation

4. I) Profit maximization – Arguments in favour of profit maximization – 1.Profit – Natural objective of business. 2.Profit – an economic obligation. 3.Profit – a measure of efficiency. 4.Profit – ensures welfare. 5.Profit – attracts investors. 6.Profit – helps for growth and development of organization. Arguments against of profit maximization – 1.Ambiguity/ Vague . 2.Ignored time value of money. 3.Ignored uncertainty and risk factor. 4.Neglects social responsibility of business. 5.The term “maximum” is also ambiguous.

5. II) Wealth Maximisation – Advantages of Wealth Maximisation – Avoids ambiguity. Considers time value of money. Regular payment of dividend. Promotes economic welfare of shareholders. Considers risk factor. Based on precise concept of cash flows. Disadvantages of Wealth Maximisation – Ignored firms wealth. Equality of wealth is not maintained. Ignored social welfare. Government restrictions. Ignores social responsibility of business.

6. Sl No. Profit Maximization Sl No. Wealth Maximization 01 It is a narrow concept. 01 It is a broad concept. 02 Calculation of profit is not clear. i.e whether short term or long term, Gross profit or Net profit, Profit before tax or after tax. 02 Calculation of wealth is clear. The calculation is for long term 03 Ignores time value of money. 03 Considers time value of money. 04 The main goal is maximization of profit. 04 The main goal is maximization of wealth. 05 Ignored risk and uncertainty. 05 Considered risk and uncertainty. 06 Financial decisions are taken on the basis of Profit Maximization. 06 Financial decisions are taken on the basis of Wealth Maximization. 07 No balance between expected returns and risk because higher expected returns involves more risk and uncertainty. 07 Balance between expected returns and risk. 08 It is not balanced. Wide gap between expected and actual earnings. 08 It is balanced. PROFIT MAXIMIZATION V/S WEALTH MAXIMIZATION

7. SCOPE OF FINANCIAL MANAGEMENT – Scope of Financial Management means what exactly we study in financial management. Scope of financial management can be studied under two headings – Traditional Approach. Modern Approach.

8. Traditional Approach- Under this approach , the term Corporate Finance Was used for Financial Management. The role of Financial Management was limited to raising and administering of funds by corporate enterprise to meet their financial needs. This approach was popular between 1920 -1949. Criticism – Ignored non-corporate enterprises ( like sole trading and partnership). Outsider looking in approach. Ignored allocation of funds. Ignored routine financial problems. Ignored working capital financing.

9. Modern Approach – Since 1950 onwards popularity of traditional approach is reduced and contributed to the emergence of the modern approach. Under this approach, the Financial Management has a vast scope or coverage. According to modern approach, Financial Management is concerned with both acquisition and allocation of funds. According to modern approach, Financial Management is related to four decisions – Funds requirement decision. Financing decision. Investment decision Dividend decision.

10. AGENCY PROBLEM (OR) MANAGERS VS SHAREHOLDERS GOALS . (AGENCY THEORY) – In large companies, ownership and management are separated. The decision – taking authority in a company lies in the hands of managers. Shareholders as owners of a company are the principals and managers are their agent. Thus there is a principal – agent relationship between shareholders and managers.

11. Agency problem The conflict between the interest of shareholders and managers is referred to as Agency problem and it is resulted in agency cost. Agency costs include the less than optimum share value for shareholders and costs incurred by them to monitor the actions of managers and control their behavior. (Or) Agency costs may be defined as, the difference between the value of an actual firm and value of a hypothetical firm in which management and shareholder interests are perfectly aligned.

12. UNIT - II CAPITAL BUDGETING UNIT – II CAPITAL BUDGETING INTRODUCTION – Firms Invest Funds in to I. Current Assets II. Fixed Assets Short Term Investment Long Term Investment Decision Decision ‘Working Capital Management’ Capital Expenditure Decision (or) Capital Budgeting. Capital budgeting decisions relate to fixed assets or long term assets that yield benefits over a long period of time, exceeding a year.

13. MEANING – The term capital budgeting refers to, Planning for expenditures, whose results or benefits extend over the period of time. Charles. T.Horngreen defined capital budgeting as “Long term planning for making and financing proposed capital out lay”. Keller and Ferrara , “Capital Budgeting represents the plans for the appropriation and expenditure for fixed asset during the budget period”.

14. NEED OF CAPITAL BUDGETING DECISION – a) Expansion: b) Replacement: c) Diversification: d) Buy or Lease: e) Research and Development:

15. METHODS (or) TECHNIQUES OF CAPITAL BUDGETING I)Traditional or Non-discount II) Discounted cash flow cash flow Techniques Techniques 1. Pay-Back period 1) Net Present Value (NPV) 2. Accounting or Average 2) Internal Rate of Return Rate of Return (ARR) (IRR) 3) Profitability Index 4) Discounted Pay Back Period      

16. Traditional (or) Non-discount cash flow Techniques:   1. Pay Back Period: Pay-back period refers to the number of years required to recover the initial outlay of investment in a project. When cash flows are uniform: If the proposed project’s cash inflows are uniform the following formula can be used to calculate the payback period. Initial Investment Pay-Back Period = Annual cash inflow (Before Depreciation but after Taxes)

17. b) When cash flows are not uniform When the project’s cash inflows are not uniform, but vary from year to year pay back period is calculated by the process of cumulating cash inflows till the time when cumulative cash flows become equal to the original investment outlay. Accept/Reject Rule: If Pay-Back Period< Standard Pay-Back set by Management- Accept If Pay-Back Period > Standard Pay-Back Set by Management- Reject (OR) Out of two projects, project with Lesser pay back period should be preferred.

18. Example - The following is the annual cash flow of two projects. The cost of both the projects is Rs. 50000. Project X Project Y 10000 20000 40000 10000 30000 20000 60000 80000 10000 70000 Calculate Pay Back Period and suggest which project to be selected. Project X Project Y Pay Back Period = 2 years 3 years Project X should be preferred because the cost of the project can be covered within 2 years.

19. MERITS: Easy to understand and simple to calculation. Emphasis is on early recovery of the investment. Less costly. It reduces the possibility of loss through obsolesce. It is suitable especially for short term capital projects. DEMERITS: Ignores returns after Pay-Back period. Ignores time value of money. Ignores scrap value of asset. No relation with the wealth maximization principle.

20. 2. Accounting or Average Rate of Return (ARR)- ARR is also known as Return on Investment (ROI). This method is based on conventional accounting concept. This method takes into consideration the total earnings over the life of the project. It uses accounting information available in financial statement. Average Annual income after Tax and Depreciation ARR = Average Investment    Accept/Reject Rule: If ARR > Minimum Rate set by Management – Accept If ARR < Minimum Rate set by Management – Reject

21. II ) Discounted Cash-Flow Techniques (DCF Techniques) This technique is an improvement on the Pay-Back Period method. It considers interest factor as well as return after Pay-Back period. “Discounted cash flow technique recognizes that Rs 1 of today (The cash outflow) is worth more than Rs 1 received at a future date (cash inflow). The following are important DCF techniques-

22. Net Present Value (NPV) Method: “The NPV is the difference between the total present value of future cash inflows and the total present value of future cash outflows.” NPV = Present Value of Future Cash Inflows – Present value of future cash Outflows

23. Steps in Calculation of NPV: Forecast correctly future cash outflow and cash inflow. Select appropriate rate of interest to discount cash inflow and cash outflow (Generally cost of capital is used as rate of interest) Calculate present value of cash inflow and outflow. Formula - 1 Where Present value = r = Rate of interest p.a. (1+r) n n = Number of years iv. Find out NPV by using below formula. NPV = Present value of future - Present value of future cash inflow cash outflow

24. ACCEPTANCE RULES: If NPV > 0 (i.e. NPV is Positive) - Accept If NPV < 0 (i.e. NPV is Negative) – Reject If NPV = 0 - May be Accepted (firm is indifferent between the projects) MERITS: Considers total earnings in the project life. Based on Time Value of Money. Consistent with the shareholders wealth maximization principle.   DEMERITS: Difficult to use. Requires estimation of future cash inflows and cash outflows. This is complicated. It is very difficult to calculate required rate of return. The NPV method may also prove wrong in case of two projects having different effective lives.

25. 2. Internal Rate of Return (IRR) of Trial and Error Method:   IRR is that rate at which the sum of discounted cash inflows equals the sum of discounted cash outflows. In other words, it is the rate which discounts the cash flows to “zero” .   R I = 1+ r Where I= Cash Outflow (or) Initial investment R= Cash Inflow r= Rate of return yielded by investment (or IRR)   Thus, in case of this method the discount rate is not known but the cash outflows and cash inflows are known.

26. Acceptance Rules:   If IRR > K - Accept K= Cost of capital If IRR < K - Reject If IRR = K - Project may be Accepted   MERITS: Considers Time Value of Money. Considers cash flows over the entire life of project. Calculation of cost of capital is not pre- requisite to use of this method. Consistent with wealth maximization principle.   DEMERITS: Requires estimation of cash flows which is a tedious task. At times of mutually exclusive projects it fails to indicate correct choice.

27. UNIT - III WORKING CAPITAL MEANING – Working capital is that part of capital, which is required for the day to day operations of the business. Working capital is regarded as the life blood of the business. It is also called as ‘circulating capital or revolving capital’. DEFINATIONS – Shubin – “working capital is the amount of funds necessary to cover the cost of operating the enterprise”. Gerstenberg – “working capital has been defined as the excess of current assets over current liabilities”. In other words – “working capital refers to the difference between current assets and current liabilities”.

28. CONCEPT OF WORKING CAPITAL – I) Gross Working Capital – It refers to the firms total investment in “current assets”. Gross Working Capital = Total Current Assets II) Net Working Capital – It refers to the difference between current assets and current liabilities. Generally Net Working Capital concept is preferred. Net Working Capital = Current Assets – Current Liabilities Generally Net Working Capital concept is preferred.

29. Components of Working Capital – According to Net concept working capital has two components viz, Current Assets and Current Liabilities . Components Of Working Capital Current Assets Current Liabilities Components of Current Assets Components of Current Liabilities. Cash in hand. 1. Creditors. Cash at bank. 2. B/P. Stock (Raw-material and W-I-P). 3. Bank Overdraft (BOD). B/R. 4. Outstanding expenses. Advance given. 5. Short term borrowings. Prepaid expenses. 6. Dividend payable. Debtors. Outstanding incomes.

30. Classification or Types of Working Capital – Gross Working Capital – It refers to the firm’s total investment in “current assets”. Net Working Capital – It refers to the difference between current assets and current liabilities. Permanent Working Capital – It is the amount of working capital which remains in the business permanently, in one form or another. Variable or Temporary Working Capital - The working capital which changes, with the volume of production, is called as variable working capital.

31. 5 . Negative Working Capital – It refers to excess of current liabilities over current assets. It is nothing but deficit working capital. Variable working capital Fixed working Amount of capital working capital Time

32. Method Of Estimating Working Capital – Estimation of components of working capital method. Operating cycle method. Percentage of sales method. Projected balance sheet method. Cash forecasting method.

33. Approaches of estimating working capital - Total Approach – In this method of estimation all costs including depreciation and profit margin are included. Unless it is asked specifically, the estimation of working capital total approach is suggested.   Cash Cost Approach – Under this approach, working capital is estimated on the basis of cash cost. Depreciation is excluded from the cost of sales. The profit margin is also not considered while estimating of debtors.

34. Thank you