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Financial management is the operational activity of a business that is responsible for obtaining and effectively
utilising the funds necessary for efficient operations
Joseph and Massie
Financial management is that managerial activity which is concerned with the planning and controlling of the firm’s financial resources
SCOPE AND FUNCTIONS OF FINANCIAL MANAGEMENT
First approach(Traditional approach)
Second Approach Third approach(Modern approach)
1. Investment decision2. Financing decision3. Dividend decision
Capital budgetingworking capital decision
OBJECTIVES OR GOALS OF FINANCIAL MANAGEMENT
I . Profit maximisation
Reasons
a. Profit is the test of economic efficiencyb. It is difficult to survive with out profitc. It leads to efficient allocation of resourcesd. Profit ensure maximum social welfare(i,e maximum
dividend to shareholders, timely payment to creditors, more and more wages to employees, more employment opportunities etc)
DISADVANTAGES OF PROFIT MAXIMISATION
I . PROFIT MAXIMISATION
1. AmbiguityIt is vague and ambiguous concept
2. Timing of benefitIt ignores the time pattern of benefit
Alternative (A) Alternative (B)
Period I 5000 -
Period II 10000 10000
Period III 5000 10000
Total 20000 20000
3. Quality of benefits
Alternative A AlternativeB
RecessionPeriod(I)
900 -
Normal Period (II)
1000 1000
BoomPeriod (III)
1100 2000
Total 3000 3000
II . WEALTH MAXIMISATION
TIME VALUE OF MONEY
A B10000 loan
One Year
Market value of interest 10%
Reasons
1. More purchasing power2. An investor can profitably invest which make him to give a higher value
TIME VALUE OF MONEY
Compounding value concept(Future value of present money)
Discounting orPresent value concept(Present value of future money)
RISK AND RETURN
The chance of future loss that can be foreseenRisk :
The unforeseen chance of future loss or damage
Eg : Earth quake, Coup
Uncertainty :
It represents the benefits derived by a business from its operations
Return:
METHODS OF RISK MANAGEMENT
Avoidance of risk
Prevention of risk
Transfer of risk
Retention of risk
Insurance
CAPITAL BUDGETING
Investment in fixed assets
Benefits derived in future which spreads over no: of years
NEED FOR CAPITAL BUDGETING
Large investments
Irreversible nature
Difficulties of investment decision
Long term effect on profitability
EVALUATION OF INVESTMENT PROPOSALS
Traditional methods Discounted cash flow method
1. Payback period method 2. Average rate of return method
1. Net present value (NPV method)2. Internal rate of return method (IRR)3. Profitability index (PI method)
I. TRADITIONAL METHOD
1. Pay back period method or pay out or pay off period method
Representing the no of years required to recover the original investment
Under this method projects are ranked on the basis of length of payback period
Payback period = Initial investment
annual cash inflow
Note: Annual cash inflow is the annual earnings (Profit before depreciation and after tax)
Payback period = Initial investment cumulated annual cash inflow
Un even cash inflow
Investment proposals are judged on the basis of their relative profitability
Projects with higher rate of return is accepted
ARR = Average income after tax and depreciation x100 Average investment
Average investment = Original investment
2
Average investment = original Cost - Scrap value
2
+ additional W.C +Scrap value
2. Average rate of return method or Rate of return method or Accounting rate of return method
II. DISCOUNTED CASH FLOW METHODS
OR TIME ADJUSTED TECHNIQUE
1 Net present value method
Best method for evaluating the capital investment proposals
It gives consideration to the time value of money
Formula=Discounted cash inflow-Discounted cash outflow
Note1 : If only in the beginning initial investment is made, then the discounted cash outflow will be the same i.e.,
initial investment
Note2 : Cash inflow means profit before depreciation and after tax
If NPV is zero or positive the project can be accepted
2. Profitability index method
This method is also called benefit cost ratio
PI = Present value of cash inflow Present value of cash outflow
PI is equal to or more than one the proposal can be accepted
3. Internal rate of return (IRR)
IRR is that rate at which the sum of discounted cash inflow equals the sum of discounted cash outflows
L = Lower discount rate P1 = Present Value at lower rateP2 = Present Value at higher rateQ = Actual investmentD = Difference in rate
P1 – Q IRR = L+
P1-P2 xD
COST OF CAPITAL
Rate of return expected by the suppliers of capital
Importance of cost of capital
Capital budgeting decision
(Business must earn at least a rate which is equal to its cost of capital in order to
make at least a break even)
Capital structure decision (Raise capital from different sources which optimizes the risk and cost factors)
COMPUTATION OF COST OF CAPITAL
I. COST OF DEBT (PERPETUAL OR IRREDEEMABLE)
a. Debt issued at par = Kd =(1-T)R
Kd =Cost of debt, T=Marginal Tax rateR= Debenture interest rate OR R= Annual Interest :- Net Proceeds of Loan or debentures
b. Debt issued at premium or discount
Formula = Kd = (1-T)R
Here R = I Where I = Annual interest payment NP
NP = Net proceeds of loan or debentures
II. COST OF REDEEMABLE DEBT
a. Issued at par redeemable at par
Kd= I+(Rv-Sv)/nm
(Rv +Sv)/2
I = annual interest Rv = Payable value at the time of maturitySv=Sales price or (face value of debt - Expenses)Nm = Term of debt or no: of years
b. Debt issued at premium redeemable at par
Kd = I + F - P Nm Nm
(Rv + Sv)/2
P = premium on debentureF=Flotation cost
c. Issued at discount redeemable at par
D = Discount on debentureF=Flotation cost
Kd = I + F + D Nm Nm
(Rv + Sv)/2
III. COST OF PREFERENCE SHARES
a. Cost of preference shares : Irredeemable
Kp= d
P0 (1-F)
WhereKp = Cost of preference sharesd = Constant annual dividend payment Po= Expected sales price of preference sharesF= Flotation cost
Kp= d+(Rv-Sv)/nm
(Rv+Sv)/2
b. Cost of preference share : Redeemable
IV. COST OF EQUITY CAPITAL
a. Dividend approach
P0 = face value or market price per share G=growth rate
Ke= D1
P0+g
b. Earnings approach
Ke = Cost of equityE0 = Current earnings per share or Total earnings
Share outstandingP0 = Current net proceeds per share or (net proceeds per share - flotation cost)
Ke= E0
P0
V. COST OF RETAINED EARNINGS
Kr = Ke(1-T) ( 1-B)
T= TaxB=Brokerage
Ke = Shareholders required rate of return
Or
Ke = D1 +g
P0
WEIGHTED AVERAGE COST OF CAPITALOR OVERALL COST OF CAPITAL
It involves the following steps
1. Calculation of the cost of each specific source of funds.
2. Assigning weights to specific costThis involves determination of the proportion of each source of
funds in the total capital structure of the company.
3. Adding of the weighted cost of all sources of funds to get an overall weighted average cost of capital.