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COURSE NO 203-Financial Management Financial Management: Definition, Aims, Scope and Functions

Financial management includes adoption of general management principles for financial implementation. collection of funds and their effective utilisation for efficient running of and organization is called financial management. Financial management has influence on all activities of an organisation.

The implication of financial management is not only attaining efficiency and getting profits but also maximising the value of the firm. It facilitates to protect the interests of various classes of people related to the firm. Aims of FM : 1. Rice in profits 2. Reduction in cost 3. Sources of funds: 4. Reduce risks: 5. Long run value: Scope FM: 1. relating to finance and cash, 2. rising of fund and their administration, 3. along with the activities of rising funds, Main Roles: 1. participating in funds utilisation and controlling productivity, 2. Identifying the requirements of funds and selecting the sources for those funds. Functions Of FM: 1.Liquidity, 2. profitability and 3.management 1.Liquidity: i) Forecasting of cash flow: ii) Rising of funds: iii) Managing the flow of internal funds: 2. Profitability: 1) Cost of control: ii) Pricing: iii) Forecasting of future profits: iv) Measuring the cost of capital: 3. Management. Objectives of FM: (a) To ensure availability of sufficient funds at reasonable cost (liquidity). (b) To ensure effective utilisation of funds (financial control). (c) To ensure safety of funds by creating reserves, re-investing profits, etc. (minimisation of risk). (d) To ensure adequate return on investment (profitability).

(e) To generate and build-up surplus for expansion and growth (growth). (f) To minimise cost of capital by developing a sound and economical combination of corporate securities (economy). (g) To coordinate the activities of the finance department with the activities of other departments of the firm (cooperation).

Profit Maximisation: It is said that profit maximisation is a simple and straightforward objective. It also ensures the survival and growth of a business firm. But modern authors on financial management have criticised the goal of profit maximisation. Wealth Maximisation: wealth maximisation as the goal of financial decision-making. “The gross present worth of a course of action is equal to the capitalised value of the flow of future expected benefits, discounted (or as capitalised) at a rate which reflects their certainty or uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in current assets is also a part of investment decisions called as working capital decisions.

2. Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby.

3. Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two:

a. Dividend for shareholders- Dividend and the rate of it has to be decided. b. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the

enterprise. Objectives of FM 1. To ensure regular and adequate supply of funds to the concern. 2. To ensure adequate returns to the shareholders this will depend upon the earning capacity, market price of the share, expectations of

the shareholders. 3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost. 4. To ensure safety on investment, i.e., funds should be invested in safe ventures so that adequate rate of return can be achieved. 5. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt

and equity capital. Functions of FM: 1.Estimation of capital requirements: 2.Determination of capital composition: 3.Choice of sources of funds: (i) Issue of

shares and debentures (ii) Loans to be taken from banks and financial institutions (iii) Public deposits to be drawn like in form of bonds. Choice of factor will depend on relative merits and demerits of each source and period of financing. 4. Investment of funds: 5.Disposal of surplus (i) Dividend declaration (ii) Retained profits 6.Management of cash: 7.Financial controls

Financial Analysis and Control Management accounting reports are built around the information needs of managers, who must define specific objectives of the enterprise. Different institutions have different objectives, and management accounting focuses on the financial dimensions of how and why institutional objectives are achieved. Unlike audited financial reports, managerial financial reports are more subjective and less rigid in form. The form or content may vary and can include graphs or charts to supplement the statements. Moreover, these reports can encompass nonfinancial elements such as the size and quality of enrolment, faculty size, the condition of physical facilities, and the scope of administrative staff.

Nearly all facilities management problems involve alternatives, and resolution of these problems requires consideration and comparison of the costs of alternatives. What levels of electric power should be purchased and produced? Should a heating or power plant be converted to a different type of fuel? Should building cooling systems be converted to a central chillier plant with a chilled water distribution system? Control and Analysis Concepts Planning is the process of deciding what needs to be done and anticipating the steps needed to produce the desired outcome. Control involves implementing the planning decision, comparing actual results with what was planned, and taking corrective action if there is an unacceptable deviation. This close relationship is illustrated by the planning and control cycle, which continues until goals are achieved:

Goals are set.

Steps to achieve the goals are chosen.

Actual performance occurs, either according to plan or with variation.

Performance is monitored through feedback mechanisms.

Adjustments are made to goals, plans, or actions.

Additional feedback is received.

Additional adjustment takes place.

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Control To control, it is necessary to have a way of measuring performance and a standard to which that performance will be compared. The cost accounting system, when properly structured, provides a means of measuring cost performance. The standards for comparison can take many forms. The two most common comparisons are present versus past and actual versus budget. Present-Versus-Past Comparison Even the most rudimentary accounting systems permit a comparison of present to past costs for the same time period. If conditions are generally the same and the account breakdown is sufficiently detailed, this can be an effective control method. Even in the presence of other, more sophisticated techniques, a present-versus-past comparison is usually useful. Its usefulness is enhanced if trend lines are established that depict performance over a series of time periods. The chief difficulty with using past performance as a standard is that there is no indication of what performance should have been. Historical data could represent excellent or poor performance. Unless past conditions are known, a standard may be adopted that contains inefficiency and extraordinary costs. Although present-versus-past comparisons should not be dismissed entirely, they must be used with extreme caution and scepticism. They are most valuable when used in conjunction with other indicators. Actual-Versus-Budget Comparison Comparison of actual costs to budget is perhaps the most important technique available to the facilities manager. It is generally superior to comparisons against past performance because of the characteristics of budgets in general and the unique role they play in non-profit organizations. When properly prepared, budgets represent the plan, stated in monetary terms, that has been formulated to meet the objectives of the organization. As such, they force the manager to anticipate changes. In non-profit organizations, budgets play an even more important role in management control. In such organizations, control is generally viewed to be more difficult because of the absence of profit as an objective, as a criterion for appraising alternative courses of action, and as a measure of performance. This shifts the focus from profits to plans and budgets and makes the budget the principal means of overall control. When budgets are used, cost control will be much more effective if the cost accounting system is designed to be consistent with the budget, and vice versa. Unless the two are stated in the same terms and structured similarly, there is no way of determining whether spending occurred according to the budget plan. This does not mean that a budget should be set for each detail account, but it does mean that there should be accounts in the cost accounting system that match each line item in the budget so that a direct comparison can be made. Types of Analysis: 1.Comparative Analysis : Every two years, APPA: The Association of Higher Education Facilities Officers surveys its members and publishes the results in its Comparative Costs and Staffing Report for College and University Facilities . The information reported by each participating institution includes the following:

Full-time equivalent (FTE) student enrolment

Total gross square footage of all buildings

Gross square footage maintained in facilities budget

Ground acreage

Administrative cost per gross square foot

FTE administrators

Engineering cost per gross square foot

FTE engineering personnel

Maintenance cost per gross square foot

FTE maintenance employees

Custodial cost per gross square foot

FTE custodial personnel

Landscape and grounds cost per gross square foot

FTE landscape and grounds personnel

Custodial salaries, stated in dollars per student and per square foot

Financial Analysis and Control Page 5 Copyright APPA 2009

Custodial salaries, stated in dollars per student and per square foot

Maintenance salaries, stated in dollars per student and per square foot

Heat, other utilities, and other costs, stated in dollars and per square foot

Average custodial and maintenance salaries

Square feet per custodian

The above data are presented for each of ten regions of the United States, including Alaska

and Hawaii

2.Constant-Dollar Analysis 3.Performance Analysis 4.Ratio Analysis Following are some examples of these ratios:

Current asset/current liability

Long-term asset/long-term liability

Fund balances/debt

Fund balances/types of expenditures and mandatory transfer

Credit worthiness ratios

Return-on-investment ratios

5.Variance Analysis 6.Exception Analysis Operating and Financial Leverage Comparison Chart

BASIS FOR COMPARISON

OPERATING LEVERAGE FINANCIAL LEVERAGE

Meaning Use of such assets in the company's operations for which it has to pay fixed costs is known as Operating Leverage.

Use of debt in a company's capital structure for which it has to pay interest expenses is known as Financial Leverage.

Measures Effect of Fixed operating costs. Effect of Interest expenses

Relates Sales and EBIT EBIT and EPS

Ascertained by Company's Cost Structure Company's Capital Structure

Preferable Low High, only when ROCE is higher

Formula DOL = Contribution / EBIT DFL = EBIT / EBT

Risk It give rise to business risk. It give rise to financial risk.

Time Value of Money Definition Time Value of Money is a concept that recognizes the relevant worth of future cash flows arising as a result of financial decisions by considering the opportunity cost of funds. Concept Money loses its value over time which makes it more desirable to have it now rather than later. There are several reasons why money loses value over time. Most obviously, there is inflation which reduces the buying power of money. The present or future value of cash flows are calculated using a discount rate (also known as cost of capital, WACC and required rate of return) that is determined on the basis of several factors such as: ● Rate of inflation Higher the rate of inflation, higher the return that investors would require on their investment.

● Interest Rates Higher the interest rates on deposits and debt securities, greater the loss of interest income on future cash inflows causing investors to demand a higher return on investment.

● Risk Premium Greater the risk associated with future cash flows of an investment, higher the rate of return required by

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an investors to compensate for the additional risk. Consider a simple example of a financial decision below that illustrates the use of time value of money.

Interest

Simple

Compound

Interest is a charge for borrowing money, usually stated as a percentage of the amount borrowed over a specific period of time. Simple interest is computed only on the original amount borrowed. It is the return on that principal for one time period. In contrast, compound interest is calculated each period on the original amount borrowed plus all unpaid interest accumulated to date. Compound interest is always assumed in TVM problems.

Number of Periods Periods are evenly-spaced intervals of time. They are intentionally not stated in years since each interval must correspond to a compounding period for a single amount or a payment period for an annuity.

Payments

Payments are a series of equal, evenly-spaced cash flows. In TVM applications, payments must represent all outflows (negative amount) or all inflows (positive amount).

Present Value

Single Amount

Annuity

Present Value is an amount today that is equivalent to a future payment, or series of payments, that has been discounted by an appropriate interest rate. The future amount can be a single sum that will be received at the end of the last period, as a series of equally-spaced payments (an annuity), or both. Since money has time value, the present value of a promised future amount is worth less the longer you have to wait to receive it.

Future Value

Single Amount

Annuity

Future Value is the amount of money that an investment with a fixed, compounded interest rate will grow to by some future date. The investment can be a single sum deposited at the beginning of the first period, a series of equally-spaced payments (an annuity), or both. Since money has time value, we naturally expect the future value to be greater than the present value. The difference between the two depends on the number of compounding periods involved and the going interest rate.

Loan Amortization A method for repaying a loan in equal installments. Part of each payment goes toward interest and any remainder is used to reduce the principal. As the balance of the loan is gradually reduced, a progressively larger portion of each payment goes toward reducing principal.

Cash Flow Diagram A cash flow diagram is a picture of a financial problem that shows all cash inflows and outflows along a time line. It can help you to visualize a problem and to determine if it can be solved by TVM methods.

Capital Structure - Meaning and Factors Determining Capital Structure Meaning of Capital Structure Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance. The capital structure involves two decisions- a. Type of securities to be issued are equity shares, preference shares and long term borrowings (Debentures). b. Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies are divided into two- i. Highly geared companies - Those companies whose proportion of equity capitalization is small.

ii. Low geared companies - Those companies whose equity capital dominates total capitalization. Factors Determining Capital Structure : 1.Trading on Equity 2. Degree of control 3.Flexibility of financial plan 4.Choice of investors 5.Capital market condition 6.Period of financing 7.Cost of financing 8.Stability of sales 9.Sizes of a company Instruments of Long Term Finance. Financial instruments are tradable assets of any kind. They can be cash, evidence of an ownership interest in an entity, or a contractual right

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to receive or deliver cash or another financial instrument. "any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity". Cost of Different Sources of Rising - Type of cost (A)Actual Cost (B) Opportunity Cost (C) Sunk Cost (D) Incremental Cost (E) Explicit Cost (F) Implicit Cost (G) Book Cost (H) Out Of Pocket Costs (I) Accounting Costs (J) Economic Costs (K) Direct Cost (L) Indirect Costs (M) Controllable Costs (N) Non Controllable Costs (O) Historical Costs and Replacement Costs. (P) Shutdown Costs (Q) Abandonment Costs (R) Urget Costs and Postponable Costs (S) Business Cost and Full Cost (T) Fixed Costs (U) Variable Costs (V) Total Cost, Average Cost and Marginal Cost (W) Short Run Cost and Long Run Cost (i) Short Run Cost: (ii) Long Run Cost: Sources of finance Sourcing money may be done for a variety of reasons. Traditional areas of need may be for capital asset acquirement - new machinery or the construction of a new building or depot. The development of new products can be enormously costly and here again capital may be required. Normally, such developments are financed internally, whereas capital for the acquisition of machinery may come from external sources. In this day and age of tight liquidity, many organisations have to look for short term capital in the way of overdraft or loans in order to provide a cash flow cushion. Interest rates can vary from organisation to organisation and also according to purpose. Objectives • An introduction to the different sources of finance available to management, both internal and external

• An overview of the advantages and disadvantages of the different sources of funds • An understanding of the factors governing the choice between different sources of funds. Sources of funds 1. Bank lending 2. Capital markets 3. Debentures 4. Deferred ordinary

shares 5. Franchising 6. Government assistance 7. Hire purchase 8. Loan stocks

9. New share issue 10. Ordinary shares 11. PARTS 12. Preference shares 13. Retained earnings 14. Rights issue 15. Sources of funds 16. Venture capital

Weighted average cost of capital

Weighted average cost of capital (WACC) is the average of the minimum after-tax required rate of return which a company must earn for all of its security holders (i.e. common stock-holders, preferred stock-holders and debt-holders). It is calculated by finding out cost of each component of a company’s capital structure, multiplying it with the relevant proportion of the component to total capital and then summing up the proportionate cost of components. WACC is a very useful tool because it tells whether a particular project is increasing shareholders’ wealth or just compensating the cost. The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm’s cost of capital. Importantly, it is dictated by the external market and not by management. The WACC represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and

other providers of capital, or they will invest elsewhere. Companies raise money from a number of sources: common stock, preferred stock, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities,executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC. Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.

[2]

Importance of WACC Weighted average cost of capital is the discount rate used in calculation of net present value (NPV) and other valuations models such as free cash flow valuation model. It is the hurdle rate in the capital budgeting decisions. WACC represents the average risk faced by the organization. It would require an upward adjustment if it has to be used to calculate NPV of projects which are riskier than the company's average projects and a downward adjustment in case of less risky projects. Further, WACC is after all an estimation. Different models for calculation of cost of equity may yield different values. Limitations of Weighted Average Cost of Capital (WACC) The WACC formula seems easier to calculate than it really is. Because certain elements of the formula, like cost of equity, are not consistent values, various parties may report them differently for different reasons. As such, while WACC can often help lend valuable insight into a company, one should always use it along with other metrics when determining whether or not to invest in a company. Uses of Weighted Average Cost of Capital (WACC) Securities analysts frequently use WACC when assessing the value of investments and when determining which ones to pursue. For example, in discounted cash flow analysis, one may apply WACC as the discount rate for future

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cash flows in order to derive a business's net present value. WACC may also be used as a hurdle rate against which to gauge ROIC performance. WACC is also essential in order to perform economic value added (EVA) calculations. Optimal Capital Structure The concept of optimal capital structure has drawn a great deal of attention in accounting and finance literature. Capital structure means the proportion of debt and equity in the total capital of a firm. The objective of a firm is to maximize the value of its business. This is done by maximizing market value of the shares and minimizing the cost of capital of a firm. An optimal capital structure is that proportion of debt and equity, which fulfils this objective of a firm. Thus an optimal capital structure tries to optimize two variables at the same time: cost of capital and market value of shares. Optimal capital structure may be defined as that relationship of debt and equity which maximizes the value of company’s share in the stock exchange. Kulkarni and Satyaprasad defined optimum capital structure as ‘the one in which the marginal real cost of each available method of financing is the same’. They included both the explicit and implicit cost under the term real cost. According to Prof Ezra Solomon, ‘Optimal capital structure is that mix of debt and equity which will maximize the market value of a company’. Hence there should be a judicious combination of the various sources of long-term funds which provides a lower overall cost of capital and so a higher total market value for the capital structure. Optimal capital structure may thus be defined as, the mixing of the permanent sources of funds used by the firm in a manner that will maximize the company’s common stock price by minimizing the firm’s composite cost of capital. Features of Optimal Capital Structure: a) The relationship of debt and equity in an optimal capital structure is made in such a manner that the market value per equity share becomes maximum. b) Optimal capital structure maintains the financial stability of the firm. c) Under optimal capital structure the finance manager determines the proportion of debt and equity in such a manner that the financial risk remains low. d) The advantage of the leverage offered by corporate taxes is taken into account in achieving the optimal capital structure. e) Borrowings help in increasing the value of company leading towards optimal capital structure. f) The cost of capital reaches at its minimum and market price of share becomes maximum at optimal capital structure. Constraints in Designing Optimal Capital Structure: The capital structure of a firm is designed in such a manner that the cost of capital is kept at its lowest and the value of the firm reaches its maximum. The firm manoeuvers its debt-equity proportion to reach the optimum level. However in practice, reaching the level of optimum capital structure is a difficult task due to several constraints that appear on the way of implementing that structure. The main constraints in designing the optimum capital structure are: 1. The optimum debt-equity mix is difficult to ascertain in true sense. 2. The concept of appropriate capital structure is more realistic than the concept of optimum capital structure. 3. It is difficult to find an optimum capital structure as the extent to which the market value of an equity share will fall due to increase in risk of high debt content in capital structure, is very difficult to measure. 4. The market price of equity share rarely changes due to changes in debt-equity mix, so there cannot be any optimum capital structure. 5. It is impossible to predict exactly the amount of decrease in the market value of an equity share because market factors that influence market value of equity share are highly complex. Valuation and Rates of Return In finance, return is a profit on an investment.[1] It comprises any change in value and interest or dividends or other such cash flows which the investor receives from the investment. It may be measured either in absolute terms (e.g., dollars) or as a percentage of the amount invested. The latter is also called the holding period return. A loss instead of a profit is described as a negative return. Rate of return is a profit on an investment over a period of time, expressed as a proportion of the original investment.[2] The time period is typically a year, in which case the rate of return is referred to as annual return. To compare returns over time periods of different lengths on an equal basis, it is useful to convert each return into an annual equivalent rate of return, or annualised return. This conversion process is called annualisation, described below. Return on investment (ROI) is return per dollar invested. It is a measure of investment performance, as opposed to size (c.f. return on equity, return on assets, return on capital employed). Capital Budgeting Capital budgeting, which is also called "investment appraisal," is the planning process used to determine which of an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is to budget for major capital investments or expenditures (Capital budgeting is the planning process used to determine which of an organization's long term investments are worth pursuing.) 5 Techniques used in Capital Budgeting (with advantages and limitations)| Financial Management Some of the major techniques used in capital budgeting are as follows: 1. Payback period 2. Accounting Rate of Return method 3. Net present value method 4. Internal Rate of Return Method 5. Profitability index. IMPORTANCE OF CAPITAL BUDGETING 1) Long term investments involve risks: 2) Huge investments and irreversible ones: 3) Long run in the business SIGNIFICANCE OF CAPITAL BUDGETING Capital budgeting is an essential tool in financial management

Capital budgeting provides a wide scope for financial managers to evaluate different projects in terms of their viability to be taken up for investments

It helps in exposing the risk and uncertainty of different projects

It helps in keeping a check on over or under investments

The management is provided with an effective control on cost of capital expenditure projects

Ultimately the fate of a business is decided on how optimally the available resources are used What Are Short-Term Investments : Short-term investments are any assets that are anticipated to expire or to be liquidated within the course of one to three years. The goal of this type of asset is to protect capital with low-risk investments. However, with low risk, the return on short-term investments is very low.

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There are thousands of different types of short-term investment opportunities. Listed below are some of the most common types that many people use: 1.Savings Accounts 2. Certificates of Deposit (CD) 3. Money Market Funds 4.Treasury Bills and Bonds 5.Long-Term vs. Short-Term Financing Long-Term Financing - Businesses need long-term financing for acquiring new equipment, R&D, cash flow enhancement and company expansion. Major methods for long-term financing are as follows: 1.Equity Financing 2.Corporate Bond 3.Capital Notes Short-Term Financing : Short-term financing can be used over a period of up to a year to help corporations increase inventory orders, payrolls and daily supplies. Short-term financing includes the following financial instruments: 1.Commercial Paper 2.Promissory Note 3.Asset-based Loan 4.Repurchase Agreements 5.Letter of Credit WORKING CAPITAL MANAGEMENT Meaning and Types of Finance: - Finance is the Art & Science of Managing Money . It is the Art of passing currency from hand to hand until it finally disappears Types & Sources of Finance Long Term Sources of Finance - Finance required to meet Capital Expenditure. Also, known as Fixed Capital Finance Short Term Sources of Finance - Finance required to meet day-to-day Business requirements. Also, known as Working Capital Meaning of Working capital - Working Capital is the amount of Capital that a Business has available to meet the day-to-day cash requirements of its operations - Working Capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities) .It refers to the amount of Current Assets that exceeds Current Liabilities (i.e. CA - CL) - Working Capital refers to that part of the firm’s Capital, which is required for Financing Short-Term or Current Assets such as Cash, Marketable Securities, Debtors and Inventories. -Working Capital is also known as Revolving or Circulating Capital or Short-Term Capital Concepts of Working Capital:- There are two concepts of working capital- (1) Gross Working Capital Concept (2) Net Working Capital Concept. Classification of Working Capital (1) On the Basis of Concept: - (i) Gross Working Capital

(ii) Net Working Capital (2) On the Basis of time or Need:-

(i) Permanent Working Capital (ii) Temporary Working Capital

(1) Gross working capital: Gross working capital; refers to firm's investment in currentassets. Current assets are the assets which can be converted into cash within an accounting year and include cash, short-term securities, debtors, bill receivables and stock. According to this concept, working capital means Gross working Capital which is the total of all current assets of a business. It can be represented by the following equation: Gross Working Capital = Total Current Assets Definitions favoring this concept are:- According to Mead, Mallot and Field : "Working Capital means total of Current Assets". (2) Net Working Capital Concept: Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors, bills payables, and outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise when current assets exceed current liabilities. A negative Net working capital occurs when current liabilities are in excess of current assets. Net Working Capital = Current Assets - Current Liabilities Definitions Favoring Net Working Capital Concept:- According to C.W.Gestenbergh "It has ordinarily been defined as the excess of current assets over current liabilities". According to Lawrence. J. Gitmen " The most common definition of net working capital is the difference of firm's current assets and current liabilities". (3) On the basis of time or need (1) Permanent or Fixed Working Capital:- The need for working capital fluctuates from time to time. However, to carry on day-to-day operations of the business without any obstacles, a certain minimum level of raw materials, work-in-progress, finished goods and cash must be maintained on a continuous basis. The amount needed to maintain current assets on this minimum level is called permanent or regular working capital. The amount involved as permanent working capital has to be meet from long-term sources of finance, e.g. (i) Capital (ii) Debentures (iii) Long-term loans. (2) Temporary or Variable or Fluctuating Working Capital:- Depending upon the changes in production and sales, the need for working capital, over and above the permanent level of working capital is called temporary, fluctuating or variable working capital. It may be two types:- (a)Seasonal-Due to seasonal changes, level of business activities is higher than normal during some months of year and therefore additional working capital will be required along with the permanent working capital. It is so because during peak season, demand rises and more stock is to be maintained to meet the demand . (b) Special- Additional doses of working capital may be required to face cut throat competition in the market or other contingencies like strikes, lock outs, theft etc. ADEQUATE WORKING CAPITAL: The firm should maintain a sound working capital position. It should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous from firm's point of view. Excessive working capital means holding costs and idle funds which earn no profit for the firm. Paucity of working capital not only impairs the firm's profitability but also results in production interruptions and inefficiencies and sales disruption Importance/Need/Advantage of Adequate Working Capital:

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(1) Availability of Raw Materials Regularly:- (2) Full Utilization of Fixed Assets (3) Cash Discount:- (4) Increase in Credit Rating:- 5) Exploitation of Favourable Market conditions:- (6) Facility in Obtaining Bank Loans (7) Increase in Efficiency of Management:- (8) Ability to face crisis: - (9) Solvency of the business:- (10) Good will EXCESSIVE AND INADEQUATE WORKING CAPITAL: A business enterprise should maintain adequate working capital according to the needs of its business operations. The amount of working capital should neither be excessive nor inadequate. If the working capital is in excess if its requirements it means idle funds adding to the cost of capital but which earn nom profits for the firm. On the contrary, if the working capital is short of its requirements, it will result in production interruptions and reduction of sales and, in turn, will affect the profitability of the business adversely. Disadvantage of Excessive Working Capital:- (1) Excessive Inventory:- (2) Excessive Debtors:- (3) Adverse Effect on Profitability:- (4) Inefficiency of Management:- Disadvantage of Inadequate Working Capital: (1) Difficulty in Availability of Raw-Material:- (2) Full Utilization of Fixed Assets not Possible:- (4) Decrease in Credit Rating:- (5) Non Utilization of Favorable Opportunities: (6) Decrease in Sales: (7) Difficulty in the Distribution of Dividends: (8) Decrease in the Efficiency of Management: DETERMINANTS OF WORKING CAPITAL: (1) Nature of Business (2) Size of Business (3) Growth and Expansion (4) Production cycle (5) Business Fluctuations (6) Production Policy (7) Credit Policy Relating to Sales (8) Credit Policy Relating to Purchase (9) Availability of Raw Material (10) Availability of Credit from Banks (11) Volume of Profit (12) Level of Taxes (13) Dividend Policy (14) Depreciation Policy (15) Price Level Changes (16) Efficiency of Management Working Capital Management Introduction - Businesses require adequate capital to succeed in business environment. There are two types of capital required by business; fixed capital and working capital. Businesses require investment in asset, which has to be utilized over a longer period of times. These long-term investments are considered as fixed capital, e.g. plant, machinery, etc. Another type of finance required is short term in nature. This short term finance or capital is required to undertake day to day operation. Such short capital is called current capital or working capital. Working capital refers to company’s investment in short term asset such as cash, inventory, short term marketable securities and account receivable. Information technology is playing a big part in today’s working capital management. Several aspects of working capital management like the cash management, inventory management, account receivables/payable management, etc. are managed through enterprise resource planning modules. Cash Management System - The cash management module within the working capital management system should be fully integrated with other modules like account receivable/payable, payroll and general ledger. The main features of cash management tools are as follows: The module tracks complete audit trails of all transactions and

adjustment for controls. It highlights current and future balances for all cash accounts. The module has the capability for complete drill down to the

source of all transactions.

The module provides full bank reconciliation. It allows export of information for analysis, forecasting,

presentation, reports, etc.

Inventory Management System - Inventory management and control module is utilized by companies to avoid product overstock and outages. There are several components of an inventory management tool such as order management, asset tracking, product identification, etc. The main purpose within the inventory management system is to reduce the overall costs of carrying. An inventory management tool helps in:

Sustain a balance between too less and too much inventory. Track inventory between locations.

Track inventory been received at warehouse. Track product sales and finished goods inventory.

The main advantage of an inventory management tool is cost savings, increased efficiency, warehouse management, etc. Account Receivable Management - An account receivable management tool helps solve critical question like when payment is due, how much payment is due, etc. The main features of account receivable tool are as follows: Permits transfer of account receivable information for analysis, forecasting, presentation, reports, etc. Maintain complete customer information, including sales history, current balance, open deposit, last payment, etc. Minimize data entry errors and permit print invoice, credit memos, debit memos, etc.

Appropriate credit policy is essential to maintain the cash flow cycle and return on capital. Short Term Financing - Another important aspect of working capital management is short term financing. The short term financing tool based on cash flow cycle, inventory position and requirement helps in deciding the quantity of capital required. It also helps identify the term of financing and track payment. Working capital management decision directly affects day to day business operations. One of such factors is the cash conversion cycle which immediately affects the liquidity of the organization. Management of Cash, Receivables, Inventory and Current Liabilities Management of Cash Cash is considered as vital asset and its proper management support company development and financial strength. An effective cash management program designed by companies can help to realise this growth and strength. Cash is vital element of any company needed to acquire supply resources, equipment and other assets used in generating the products and services. Marketable securities also come under near cash, serve as back pool of liquidity which provides quick cash when needed. Cash management is the stewardship or proper use of an entity's cash resources. It assists to keep an organization functioning by making the best use of cash or liquid resources of the organization. Cash management is associated with management of cash in such a way as to realise the generally accepted objectives of the firm, maximum productivity with maximum liquidity. It is the management's capability to identify cash problems before they ascend, to solve them when they arise and having made solution available to delegate someone carry them out. Objective of Cash Management 1. To make Payment According to Payment Schedule: Firm needs cash to meet its routine expenses including wages, salary, taxes etc.

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2. To minimise Cash Balance: The second objective of cash management is to reduce cash balance. Excessive amount of cash balance helps in quicker payments, but excessive cash may remain unused & reduces profitability of business. Contrarily, when cash available with firm is less, firm is unable to pay its liabilities in time. Therefore optimum level of cash should be maintained (Excel Books India, 2008).

An effective management is considered to be important for the following reasons: 1. Cash management guarantees that the firm has sufficient cash during peak times for purchase and for other purposes. 2. Cash management supports to meet obligatory cash out flows when they fall due. 3. Cash management helps in planning capital expenditure projects. 4. Cash management helps to organize for outside financing at favourable terms and conditions, if necessary. 5. Cash management helps to allow the firm to take advantage of discount, special purchases and business opportunities. 6. Cash management helps to invest surplus cash for short or long-term periods to keep the idle funds fully employed.

General Principles of Cash Management 1. Contingency Cash Requirement: 2.Availability of External Cash: 3.Maximizing Cash Receipts: Some techniques proved helpful in this context are mentioned below: i.Concentration Banking: ii. Local Box System: iii. Reviewing Credit Procedures: iv. Minimizing Credit Period: v. Others:

4.Minimizing Cash Disbursements 5.Maximizing Cash Utilization: Function of Cash Management - 1.Cash Planning: 2.Managing Cash Flows: 3. Controlling the Cash Flows: 4. Optimizing the Cash Level: 5. Investing Idle Cash: Benefits of Cash Management System In the period of technology progression, the Cash Management System provides following Benefits to its customers: 1. Funds availability as per need on day zero, day one, day two, day three etc. i.e. Corporate can plan their cash flows. 2. Bank interest saved as instruments are collected faster. 3. Affordable and competitive rates.

4. Single point enquiry for all queries. 5. Pooling of funds at desired locations.

To summarize, Cash Management denotes to the concentration, collection and disbursement of cash. The major role for managers is to maintain the flow of cash. Cash Management include a series of activities aimed at competently handling the inflow and outflow of cash. This mainly involves diverting cash from where it is to where it is needed. It is established that cash management is the optimization of cash flows, balances and short-term investments. Management of Receivable The term receivables is described as debt owed to the firm by the customers resulting from the sale of goods or services in the ordinary course of business. There are the funds blocked due to credit sales. Receivables management denotes to the decision a business makes regarding to the overall credit, collection policies and the evaluation of individual credit applicants. Receivables Management is also known as trade credit management. Robert N. Anthony, explained it as "Accounts receivables are amounts owed to the business enterprise, usually by its customers. Sometimes it is broken down into trade accounts receivables; the former refers to amounts owed by customers, and the latter refers to amounts owed by employees and others". Receivables are forms of investment in any enterprise manufacturing and selling goods on credit basis, large sums of funds are tied up in trade debtors. When company sells its products, services on credit, and it does not receive cash for it immediately, but would be collected in near future, it is termed as receivables. However, no receivables are created when a firm conducts cash sales as payments are received immediately. A firm conducts credit sales to shield its sales from the rivals and to entice the potential clienteles to buy its products at favourable terms. Generally, the credit sales are made on open account which means that no formal reactions of debt obligations are received from the buyers. This enables business transactions and reduces the paperwork essential in connection with credit sales. Receivables have vial function in quickening distributions. As a middleman would act fast enough in mobilizing his quota of goods from the productions place for distribution without any disturbance of immediate cash payment. As, he can pay the full amount after affecting his sales. Likewise, the customers would panic for purchasing their needful even if they are not in a position to pay cash immediately. It is for these receivables are regarded as a connection for the movement of goods from production to distributions among the ultimate consumer. Maintenance of receivable Objectives of receivables management: The objective of Receivables Management is to promote sales and profits until that point is reached where the return on investment in further funding receivables is less than the cost of funds raised to finance that additional credit i.e. cost of capita. Management of Accounts Receivables is quite expensive. The following are the main costs related with accounts receivables management: Cost of Management of Accounts Receivables 1. Opportunity cost. 2. Collection cost. 3. Bad debts Advantages of accounts receivable management: 1. Increased Sales: 2.Increased Market Share: 3. Increase in profits Management of Inventory Inventory management is basically related to task of controlling the assets that are produced to be sold in the normal course of the firm's procedures. In supply chain management, major variable is to effectively manage inventory. The significance of inventory management to the company depends on the extent of its inventory investment. The objectives of inventory management are of twofold: 1. The operational objective is to uphold enough inventories, to meet demand for product by efficiently organizing the firm's production and

sales operations. 2. Financial interpretation is to minimize unproductive inventory and reduce inventory, carrying costs.

Effective inventory management is to make good balance between stock availability and the cost of holding inventory. Components of inventory management 1.Raw materials: 2.Work-in-process: 3.Finished products: 4.Stores and spares Types of Inventory- 1. Raw-Materials Inventory: 2.Work-in-Process Inventory: 3.Finished-Goods Inventory:

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Motives of inventory management: 1.The transaction motive: 2.The precautionary motive: 3.The speculative motive: Merits of Inventory Management 1. Inventory management guarantees adequate supply of materials and stores to minimize stock outs and shortages and avoid costly

interruption in operations. 2. It keeps down investment in inventories, inventory carrying costs, and obsolescence losses to the minimum. 3. It eases purchasing economies throughout the measurement of requirements on the basis of recorded experience. 4. It removes duplication in ordering stock by centralizing the source from which purchase requisition emanate. 5. It allows better utilization of available stock by enabling inter-department transfers within a firm. 6. It offers a check against the loss of materials through carelessness or pilferage. 7. Perpetual inventory values provide a stable and reliable basis for preparing financial statements a better utilization.

Demerits of Holding Inventory 1.Price decline: 2.Product deterioration: 3.Product obsolescence: Managing Current Liabilities A current liability is an obligation that is payable within one year. The collection of liabilities comprising current liabilities is closely watched, a business must have enough liquidity to guarantee that they can be paid off when due. In accounting area, current liabilities are often understood as all liabilities of the business that are to be settled in cash within the financial year or the operating cycle of a given firm, whichever period is longer. o Current ratio. This is current assets divided by current liabilities. o Quick ratio. This is current assets minus inventory, divided by current liabilities. o Cash ratio. This is cash and cash equivalents, divided by current liabilities.

Common examples of Current Liabilities Accounts payable: These are the trade payables due to suppliers, usually as evidenced by supplier invoices. Sales taxes payable: This is the obligation of a business to remit sales taxes to the government that it charged to customers on behalf of the government. Payroll taxes payable: This is taxes withheld from employee pay, or matching taxes, or additional taxes related to employee compensation. Income taxes payable: This is income taxes owed to the government but not yet paid. Interest payable: This is interest owed to lenders but not yet paid. Bank account overdrafts: These are short-term advances made by the bank to offset any account overdrafts caused by issuing checks in excess of available funding. Accrued expenses: These are expenses not yet payable to a third party, but already incurred, such as wages payable. Customer deposits: These are payments made by customers in advance of the completion of their orders for goods or services. Dividends declared: These are dividends declared by the board of directors, but not yet paid to shareholders. Short-term loans: This is loans that are due on demand or within the next 12 months. Current maturities of long-term debt: This is that portion of long-term debt that is due within the next 12 months. To summarise, financial experts defined current liabilities as "obligations whose liquidation is reasonably expected to require the use of existing resources properly categorized as current assets or the certain of current liabilities." Internal financing In the theory of capital structure, internal financing is the name for a firm using its profits as a source of capital for new investment, rather than a) distributing them to firm's owners or other investors and b) obtaining capital elsewhere. It is to be contrasted with external financing which consists of new money from outside of the firm brought in for investment. Internal financing is generally thought to be less expensive for the firm than external financing because the firm does not have to incur transaction costs to obtain it, nor does it have to pay the taxes associated with paying dividends. Many economists debate whether the availability of internal financing is an important determinant of firm investment or not. A related controversy is whether the fact that internal financing is empirically correlated with investment implies firms are credit constrained and therefore depend on internal financing for investment. Advantages- 1.Capital is immediately available 2.No interest payments 3.No control procedures regarding creditworthiness 4.Spares credit line 5.No influence of third parties 6.More flexible 7.More freedom given to the ownerDisadvantages

Expensive because internal financing is not tax-deductible

No increase of capital

Losses (shrinking of capital) are not tax-deductible

Limited in volume (volume of external financing as well is limited but there is more capital available outside - in the markets - than inside of a company)

Concept And Meaning Of Dividend Policy Dividend refers to the portion of net income paid out to shareholders. It is paid in cash and/or stock for making

investment and bearing risk. Dividend decision of the firm is yet another crucial area of financial management as it affects shareholders wealth and value of the firm. The percentage of earning paid out in the form of cash dividend is known as dividend payout ratio. A company may retain some portion of its earnings to finance new investment. The percentage of retained in the firm is called retention ratio. Dividend policy is an integral part of the firm's financing decision as it provides internal financing. Dividend policy is concerned with determining the proportion of firm’s earnings to be distributed in the form of cash dividend and the portion of earnings to be retained. A firm has three alternatives regarding the payment of cash dividends:

1. It can distribute all of its earnings in the firm of cash dividends, 2. It can retain all of its earnings for reinvestment, 3. It can distribute a part of earnings as dividend and retain the rest for reinvestment purpose. Dividends - Dividend Policy- Dividend policy is the set of guidelines a company uses to decide how much of its earnings it will pay out to shareholders. Some evidence suggests that investors are not concerned with a company's dividend policy since they can sell a portion of their portfolio of equities if they want cash. This evidence is called the "dividend irrelevance theory," and it essentially indicates that an issuance of dividends should have little to no impact on stock price. That being said, many companies do pay dividends, so let's look at how they do it. There are three main approaches to dividends: residual, stability or a hybrid of the two. Residual Dividend Policy - Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met. These companies usually attempt to maintain balance in their debt/equity ratios before making any dividend distributions, deciding on dividends only if there is enough money left over after all operating and expansion expenses are met. Dividend Stability Policy The fluctuation of dividends created by the residual policy significantly contrasts with the certainty of the dividend stability policy. With the stability policy, quarterly dividends are set at a fraction of yearly earnings. This policy reduces uncertainty for investors and provides them with

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income.

Hybrid Dividend Policy The final approach is a combination between the residual and stable dividend policy. Using this approach, companies tend to view the debt/equity ratio as a long-term rather than a short-term goal. In today's markets, this approach is commonly used by companies that pay dividends. As these companies will generally experience business cycle fluctuations, they will generally have one set dividend, which is set as a relatively small portion of yearly income and can be easily maintained. On top of this set dividend, these companies will offer another extra dividend paid only when income exceeds general levels.

Valuation for Mergers and Acquisitions Mergers and acquisitions are both aspects of strategic management, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity or using a joint venture.

a merger is a legal consolidation of two companies into one entity, whereas an acquisition occurs when one company takes over another and completely establishes itself as the new owner (in which case the target company still exists as an independent legal entity controlled by the acquirer). Either structure can result in the economic and financial consolidation of the two entities. In practice, a deal that is a merger for legal purposes may be euphemistically called a "merger of equals" if both CEOs agree that joining together is in the best interest of both of their companies, while when the deal is unfriendly (that is, when the management of the target company opposes the deal) it is almost always regarded as an "acquisition". Several valuation methods are available, depending on a company’s industry, its characteristics (for example, whether it is a start-up or a mature company), and the analyst’s preference and expertise. In this chapter and the rest of the book, we focus on the mainstream valuation methods. These methods are classified into four categories, based on two dimensions. The first dimension distinguishes between direct (or absolute) valuation methods and indirect (or relative) valuation methods; the second dimension separates models that rely on cash flows from models that rely on another financial variable, such as sales (revenues), earnings, or book value. As their name indicates, direct valuation methods provide a direct estimate of a company’s fundamental value. In the case of public companies, the analyst can then compare the company’s fundamental value obtained from that valuation analysis to the company’s market value. The company appears fairly valued if its market value is equal to its fundamental value, undervalued if its market value is lower than its fundamental value, and overvalued if its market value is higher than its fundamental value. In contrast, relative valuation methods do not provide a direct estimate of a company’s fundamental value: They do not indicate whether a company is fairly priced; they indicate only whether it is fairly priced relative to some benchmark or peer group. Because valuing a company using an indirect valuation method requires identifying a group of comparable companies, this approach to valuation is also called the comparables approach. Exhibit 1.1 provides an overview of the mainstream valuation methods. Exhibit 1.1. Overview of Valuation Methods Direct (or Absolute) Valuation Methods Relative (or Indirect) Valuation Methods

Valuation methods that rely on cash flows

Discounted cash flow models: Free cash flow to the firm model Free cash flow to equity model Adjusted present value model Option-pricing models: Real option analysis

Price multiples: Price-to-cash-flow ratio

Valuation methods that rely on a financial variable other than cash flows

Economic income models: Economic value analysis

Price multiples*: Price-to-earnings ratios (P/E ratio, P/EBIT ratio, and P/EBITDA ratio) Price-to-sales ratio Price-to-book ratio Enterprise value multiples: EV/EBITDA multiple EV/Sales multiple

* E stands for earnings; EBIT for earnings before interest and taxes; EBITDA to earnings before interest, taxes, depreciation, and amortization; and EV for enterprise value.

1. Relative Valuation Methods-i. Price Multiples. ii. Enterprise Value Multiples 2. Direct Valuation Methods. i. Discounted Cash Flow Models ii. Non Discounted Cash Flow Models 3. other i.Real option analysis ii. Economic income models, 5.3. The Use of Valuation Methods

The two most widely used valuation methods are the P/E ratio and the FCF to the firm model. In contrast, few analysts used economic value analysis, multiples based on book values (whether price or enterprise value multiples), or the P/Sales ratio.

Approximately 60 percent of the analysts expressed a strong preference for cash flow–based valuation methods, particularly buy-side analysts. However, most analysts admit that they often complement their cash flow–based analysis with a multiples-based analysis.

Some valuation methods are sector specific. For example, the P/B ratio and EV/Sales ratios are rarely used, except to value financial institutions and retailers, respectively.

Process of Merger and acquisition - 1.Business Valuation 2.Proposal Phase 3.Planning Exit 4.Structuring Business Deal 5.Stage of Integration 6.Operating the Types of merger & acquisitions 1.Horizontal Merger 2.Vertical Merger 3.Co-Generic Merger 4.Conglomerate Merger