CONCEPT OF FINANCIAL MANAGEMENT

What is Finance

1. SUB-SET OF ECONOMICS AND IN ESSENCE IS ALSO TERMED AS APPLIED MICRO-ECONOMICS.

2. IMPORTANT BUSINESS ACTIVITY.

3. FUND MANAGEMENT SCIENCE.

4. FOCUSES IN WEALTH MAXIMIZATION GOAL/ENHANCING FIRM’S VALUE.

5. FOCUSES ON FUTURE DECISION BASED ON ACCOUNTING FINANCIAL STATEMENTS.

6. ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE.

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BASIC CONCEPT OF NATIONAL INCOME AND ECONOMIC INDICATORS

1. GDP: A measure of the final goods and services, produced by the residents of the country with resources located in that country. GDP=(C+I+G)+(X-M) {Domestic Economy}; 5.3% India’s GDP growth during Jan-March 2011-12, slowest in 9 years.

2. GNP: The value measured at market prices, of all final goods and services produced by an economy in one year. GNP=(C+I+G)+(X-M)+(R+P) {Open Economy}

3. IIP: Index of Industrial production, released monthly, is a measure of capturing production across factories in India. It records output in factories across three categories-mining, electricity, manufacturing, IIP was flat at 0.1% in April.

4. WPI: Wholesale price Index; This is India’s most watched cost of living index. Calculated on a monthly basis, the index gives trends in inflation rate or the rate at which wholesale prices of goods such as vegetables, fuel, manufactured items and food grains are changing. It rose to worrisome 7.55% in May.

5. CPI: Consumer Price Index; released monthly, gives retail prices of almost all everyday products and services from food to footwear and movie tickets to medicine. It is more realistic cost-of-living index because it captures shop-end prices. It rose 10.36% in May, showing government inability to cool prices.

6. Sensex: The Bombay Stock Exchange’s (BSE) benchmark 30-share index (reflects the weighted arithmetic average of price relatives of 30 sensitive shares) is a barometer for equity markets, perhaps the first indicator (base year for calculation of sensex is 1978-79; value 100) about the health of the economy and investor sentiments. The Sensex closed up 76 pts. at 17,538.67 on Thursday (5 th July), a three-month high, amid strong expectations about reformist moves in the coming weeks.

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Defines the environment in which the firm operates i.e. key Macroeconomic factors such as:-

1.Growth Rate of Economy,

2.Domestic savings.

3. Tax Environment.

4.Inflation rate.

5.Real interest rate.

Finance in essence, is applied Micro-Economics

key Microeconomic tools

principal of marginal analysis according to which a decision should be guided by a comparison of incremental Benefits and Cost

ECONOMY

INDUSTRY

COMPANY BUSINESS FINANCE

1. Economics Focuses on optimization of Valued Goals.2. Finance Focuses on Wealth Maximization3. To Sum up, a basic knowledge of macro-economics is necessary for

understanding the environment in which company/firm operates.4. Good grasp of micro-economic principles is helpful in sharpening the tools of

financial decision making

The fundamental Approach says

SUB-SET OF ECONOMICS

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IMPORTANT BUSINESS ACTIVITIES

Major Business Activities in a Firm is categorized as:-

1.PRODUCTION

2.MARKETING

3.FINANCE

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FUND MANAGEMENT SCIENCE

1. CHOICE OF FINANCIAL MARKET

2. CHOICE OF FINANCIAL INSTRUMENT---FINANCING DECISION

3. OPTIMUM CAPITAL STRUCTURE DECISION

4. OPTIMIZATION OF COST OF CAPITAL

The BusinessProposal

Investors• Shareholders• Lenders

Financial Market

Investors provide the initial cash required to finance the business proposal

The proposal generates cash to investors

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FUND MANAGEMENT SCIENCE

FINANCE FUNCTION

FINANCING INVESTMENT LIQUIDITY

DECISION DECISION DECISION

1. Investment or Long Term Asset Mix Decision2. Financing or Capital Mix Decision3. Dividend or Profit Allocation Decision4. Liquidity or Short Term Asset Mix Decision

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•Economic conditions

•Political and social environments

Market structureFirm’s competitive position

SALES EBIT EAT EPS

Economic Risk + Operational Risk + Financial Risk

VALUE

CREATION

Business Risk

FOCUSES IN WEALTH MAXIMIZATION GOAL/ENHANCING FIRM’S VALUE -The process of value creation

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RISK-RETURN PARADOX

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Contradictory*

SurviveAvoid financial distress and bankruptcyBeat the competitionMaximize sales or market shareMinimize CostsMaximize profitsMaintain steady earnings growth

PROFITABILITYMaximize salesMaximize Market ShareMinimize Cost

MINIMIZING RISKBankruptcy avoidanceStabilitySafety

Capital Budgeting DecisionCapital Structure DecisionDividend DecisionWorking Capital ManagementRisk Management

RISK AND RETURN TRADE OFF

WEALTH MAXIMIZATION/ENHANCING VALUE OF THE FIRM (EVA)

*Pursuit of profit involves risk; it is not possible to maximize both safety and profit:- Need of goal that encompasses both factors

FOCUSES ON FUTURE DECISION BASED ON ACCOUNTING FINANCIAL STATEMENTS

Share Capital Equity Preference Reserve &Surplus Secured Loans Debentures Loans and advances Unsecured Loans Current Liabilities and Provisions Trade Creditors Provisions

Fixed Assets (net) Gross block Less: depreciation Investments Current Assets, loans and advances Cash and bank

Receivables

InventoriesMiscellaneous expenditure and losses

Capital structure and Cost of Capital

Working Capital financing policy

Capital Budgeting

Portfolio Management

Cash Management

Credit Management

Inventory Management

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ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE The Role of The Financial Manager

The Balance-Sheet Model of the Firm-Traditional Approach

The Net Working Capital Investment Decisions

Current Assets

Investment Decisions

“Capital

Budgeting”

Fixed Assets

1 Tangible

2 Intangible

Current Liabilities

Long-Term Debt

Shareholders’ Equity

Net WorkingCapital

Financing Decisions

“Capital Structure”

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FOCUSES ON FUTURE DECISION BASED ON ACCOUNTING FINANCIAL STATEMENTS

Net Sales

Cost of goods sold stocks Wages and salaries Other manufacturing expenses Gross Profit Operating expenses Selling & Administration expenses Depreciation

Operating Profit

Non-operating surplus/deficit

Earnings before income and tax

Interest

Profit before tax

Tax

Profit after Tax

Dividends

Retained earnings

Revenue Risk

Depreciation Policy

Business Risk

Tax Planning

Return on Equity

Dividend Policy

Gross Profit Margin

Financial Risk

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Financial

managers

Firm's

operations

Financial

markets

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors(5) Taxes

(4b)

ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE

The Role of The Financial Manager

GovernmentGovernment

(5)

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ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE The Role of The Financial Manager

Contemporary Approach Concern on Institutional Imperatives referred as the focus which lead

to divergence between the goals of Managers and Shareholders. Instead of merely focusing on the efficient allocation of funds among various assets and the acquisition of funds on favorable terms.

A fundamental change in financial management is the direct result of two recent trends: the Globalization of Competition and the Integration of World financial markets facilitated by Improved ability to collect and analyze information.

A common element, which distinguishes the recent Financial Management tools from the earlier ones have emerged predominantly from practice and from consultants. The modern approaches also have developed concerning the pursuit of shareholder value.

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ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE The Role of The Financial Manager

Business Knowledge

Effective Costing, Planning & Evaluation

Risk Management

Standards Compliance

Effective Communication

Performance Management

Forecasting, Planning and Budgeting

Accounting/ Financial Knowledge

Valued-added Advice

Value-for-

Money

StrategicFocus

Competencies

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CONCEPT OF ECONOMIC VALUE ADDED1. Traditional approaches to measuring ‘Shareholders’ Value Creation used

parameters such as earnings capitalisation, market capitalisation and present value of estimated future cash flows.

2. Extensive equity research has now established that it is not earnings per se, but value which is important.

3. A new measure called “Economic Value Added” (EVA) is increasingly being applied to understand and evaluate financial performance.

4. EVA = NOPAT – COCE (Net operating profit after taxes – Cost of Capital Employed)

NPOAT = Profits after depreciation and taxes but before interest costs. NOPAT thus represents the total pool of profits available on an ungeared basis to provide a return to lenders and shareholders;

COCE = Weighted average cost of capital (WACC x Average capital employed)

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CONCEPT OF ECONOMIC VALUE ADDED

What does EVA show ?

EVA is residual income after charging the Company for the cost of capital provided by lenders and shareholders. It represents the value added to the shareholders by generating operating profits in excess of the cost of capital employed in the business.

When will EVA increase ?

(a)Operating profits can be made to grow without employing more capital, i.e. greater efficiency.

(b)Additional capital is invested in projects that return more than the cost of obtaining new capital, i.e., profitable growth.

(c)Capital is curtailed in activities that do not cover the cost of capital, i.e., liquidate unproductive capital.

Utility of EVA

(i) EVA represents the value added to the shareholders by generating operating profits over and above the cost of capital employed in the business. Hence it is a measure of financial performance.

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CONCEPT OF ECONOMIC VALUE ADDED

Utility of EVA Continued

(ii) EVA is a management tool that discloses the impact of both strategic as well as operational decision of the management. The examples of strategic decisions are: what investment to make, which business to exist, which financial structure is optimal, etc. While operational decision include, whether to make in house or out source, repair or replace equipment or, make short or long production runs, etc.

(iii) EVA can prove as an effective tool for increasing shareholders’ wealth, through integrating EVA framework in four key areas, viz., to measuring business performance, guiding managerial decision-making, aligning managerial incentives with shareholder interests and improving the financial and business literacy throughout the organisation.

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The Foreign Exchange MarketThe foreign exchange market is the market where the

currency of one country is exchanged for the currency of another country. Most currency transactions are channelled through the world-wide interbank market. Interbank market is the wholesale market in which major banks trade with each other.

Participants Speculators ArbitrageursTraders Hedgers

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Foreign Exchange Rates A foreign exchange rate is the price of one currency quoted in terms of

another currency. When the rate is quoted per unit of the domestic currency, it is referred

to as direct quote. Thus, the US$ and INR exchange rate would be written as US$ 0.02538/INR.

When the rate is quoted as units of domestic currency per unit of the foreign currency, it is referred to as indirect quote.

A cross rate is an exchange rate between the currencies of two countries that are not quoted against each other, but are quoted against one common currency.

Suppose that German DM is selling for $ 0.62 and the buying rate for the French franc (FF) is $ 0.17, what is the DM/FF cross-rate? It is:

$ 0.62 3.65

$ 0.17

US FF FF

DM US DM

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Foreign Exchange Rates The spot exchange rate is the rate at which a currency can be bought or

sold for immediate delivery which is within two business days after the day of the trade.

Bid-ask spread is the difference between the bid and ask rates of a currency.

The forward exchange rate is the rate that is currently paid for the delivery of a currency at some future date.

The forward rate may be at a premium or at a discount. For a direct quote, the annualised forward discount or premium can be

calculated as follows:

Spot rate – Forward rate 360Forward premium (discount)

Spot rate Days

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International Parity Relationships

There are the following four international parity relationships:Interest rate parity (IRP)Purchasing power parity (PPP)Forward rates and future spot rates parityInternational Fisher effect (IFE).

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Currency Appreciation and Depreciation

“We frequently hear things like “the dollar strengthened (or weakened) in financial Markets today” or the dollar is expected to appreciate (or depreciate) relative to the Rupee.” When we say that the dollar strengthens or appreciates, we mean that the value of a dollar rises, so that it takes more foreign currency to buy a dollar.

What happens to the exchange rates as currencies fluctuate in value depends on how exchange rates are quoted. Since we are quoting them as units of foreign currency per Rupee, the exchange rate move in the same direction as the value of the Rupee: it rises as the rupee strengthens, and it falls as the rupee weakens.

Relative PPP tells that the exchange rate will rise if the India’s inflation rate is lower than the foreign country’s. This happens because the foreign currency depreciates in value and therefore weakens relative to the Rupee.

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Depreciation of Rupee against US Dollar

1. Rupee has depreciated a record low of Rs. 57.32 on June 22-2012 against US dollar.

2. Loss of potential European export market. Due to Euro-zone debt crises. Financial crunch and insolvency. The main countries are Greece, Ireland, Portugal, Spain and Italy and France.

3. Export leads to foreign exchange inflow.

4. Huge oil bills due to import of crude oil.

5. FII’s turned bearish due to implementation of GAAR* retroactively.

6. The above mentioned reasons lead to scarcity of US dollar and depreciated partially convertible rupee to a record low.

7. Gradual strengthening of Rupee started form 4th July 2012.

8. Offloading of dollars by banks and exporters.

9. The government increased foreign investment limits in government debt by $ 5 billion to $ 20 billion.

10. FII’s turned bullish due to announcement that application of GAAR will not be retrospectively.

*General Anti Avoidance Rule aimed at preventing deals or incomes that are structured to avoid taxes

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GAAR jarrs

1. What is GAAR? General Anti Avoidance Rule is aimed at preventing deals or incomes that are structured only to avoid paying taxes.

2. Why is GAAR Required? Isn’t Tax Planning and Tax Savings Legitimate ; In India the courts have ruled that savings of taxes through permissible instruments of Tax planning is legitimate. But Tax Avoidance is illegal.

3. Why are Anti-Avoidance measures necessary? According to some expert in an environment of moderate rates of tax, it is necessary that the correct tax base be used for calculating taxes in the face of aggressive planning and use of opaque low tax jurisdictions for residents as well as for sourcing capital.

4. Whom does GAAR Affect ? Almost anybody and everybody. Corporations may be forced to re-structure salaries of employees if Taxmen conclude that these were structured only to avoid Taxes. (FII’s) who invest through countries such as Mauritius to exploit bilateral Tax Treaties will be effected after GARR comes into force. It’s feared that once GAAR is invoked FII’s will have to pay capital gain tax for their investment in Indian equities.

5. The committee has proposed to implement GARR on P-Notes. (Participatory Notes are offshore derivative instruments issued by foreign broking houses to overseas investors who wish to invest in the Indian stock market without registering themselves with the market regulator, SEBI.

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Critical Policies Awaiting Approval

1. India’s is suffering from stagflation of its own version; Morgen and Stanley

2. P.M. is rated as under-achiever; Times Magazine.

3. Indian economy downgraded from stable to negative; Standard & Poors.

4. Raising FDI Limit in insurance sector from 29% to 49%.

5. Introduce the Direct Tax Code (DTC) to overhaul archaic income tax laws.

6. Banking laws (Amendment) Bill to empower RBI to supersede banks’ boards; grant license to new private sector banks.

7. Introduce a uniform Goods and Services (GST).

8. Legislate the Pension Fund Regulatory and Development Authority (PFRDA) Bill to ensure social security for employees.

9. Allow FDI in multi-brand retail.

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PERPLEXING FACTS

1. PM promises in G20 summit at Los Cabos, Mexico, to provide $ 10 billlion (Appx Rs 56,000 crore) under deficit economy when the people are subjected to growing economic burdens.

2. The three major rating agencies forced India to allow International Capital flows by the recent reform witnessed. There is a strong suspicions that these agencies promote agenda of international finance capital by manipulating their ratings.

3. These agencies had earlier given AAA rating to mortgage-based debt of companies like Enron.

4. In 2008, on the eve of the global financial meltdown, they had given a similar rating to Lehman Brothers and the insurance giant AIG-the main players in the Wall street collapse.

5. Reforms undertaken; opening Retail trade sector, reducing subsidy, decontrolling fuel prices, increase foreign investment ceiling in thr insurance sector, allowing foreign banks to take over Indian private banks, allowing foreign investment in pension funds to go in for maeket investment i.e., speculation

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PERPLEXING FACTS

1. The retail sector in India conservatively contributes 11% of the GDP and employs over 40 million people. According to the 4th Economic census, 38.2% of rural and 46.4% of urban employment is generated in this sector.

2. Permitting multinational giants in retail will only displace these millions into poverty and misery.

3. India to a large extent protected itself from the global financial meltdown because it did not allowed its financial sector to be open to international speculation.

4. After the proposed reforms, India may subject itself to international volatility and thus, become extremely vulnerable.

5. Allowing international speculation in pension funds and the insurance sector will ruin the lives of millions of working people.

THANK YOU

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