Financial management is that specialized activity which is responsible for obtaining and affectively utilizing the funds for the efficient functioning of the business and, therefore, it includes financial planning, financial administration and financial control.

To maximize the shareholders wealth.

a) Investment decision b) Financing decision c) Dividend decision

Financial planning means deciding in advance, the financial activities to be carried on to achieve the basic objective of the firm. The basic objective of the firm is to get maximum profits out of minimum efforts.

a) to ensure availability of fund whenever

b) to see that the firm does not raise funds

The capital required for day to day operations of the business is called Working capital.

Gross working capital is the sum/ aggregate of the current assets, whereas

Net working capital = Current assets – current liabilities.

A long term Investment decision is called capital budgeting decision.

Financial leverage is considered favorable when return on investment is higher than the cost of debt.

Working capital requirement is higher with longer production cycle.

Cost incurred for raising funds.

Capital structure is the relative proportion of different sources of long term finance. In other words Capital structure of a company refers to the make up of its capitalization

The shareholders of a company are very likely to gain with debt component in the capital employed by way of trading

On equity as it increases the earning per share(EPS) of the share holders.

The shareholders of a company are very likely to gain with debt component in the capital employed by way of trading

On equity as it increases the earning per share(EPS) of the share holders.

Current assets also called as floating assets or fluctuating assets are short term assets whose value fluctuates in the short period. These assets are required to pay off the current liabilities. For e.g. cash in hand/Bank, Inventory, Debtors. Bills receivable, Marketable securities etc.

Financial Planning is required to avoid shortage or surplus of finance.

Importance of financial planning is:

1. By planning utilization of finance, it reduces waste ,duplication of efforts and

         gaps in the planning.

     b. It helps in coordinating the various business activities such as sales, purchases, production, finance

     c. It is a technique of It helps in setting up standard and compare with the actual performance. The deviations, if any are then analysed. Causes found out and corrective measures are taken.

     d. It helps in avoiding shocks and surprises as proper provision regarding Shortage or surplus is made in       advance by anticipating future receipts and Payments.

The firm with a better operational efficiency has to invest less in working capital because-

1. they convert raw materials quickly into finished goods, and sell them at their i.e. converts stock into sales quickly.
2. Promptly collects debts from debtors and bills

Short term Investment decisions are concerned with the decisions about the level of cash, inventory and debtors etc. (working capital)

Efficient cash management, Inventory management and receivable management are essential ingredients of sound working capital management.

The working capital should be neither more or less than required. Both the situations are harmful. If the amount of working capital is more than required, it will no doubt increase the liquidity but decrease the profitability. Similarly if there is a shortage of working capital, it will face the problem of meeting day to day requirements.

Thus optimum amount of current assets and current liabilities should be determined so that the profitability of the business remains intact and there is no fall in the liquidity.

The interest coverage ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligations.

Interest coverage ratio = EBIT/Interest

Higher the ratio, better is the position of the firm to pay its interest obligations, so

it should issue debt. On the other hand if it is low, the firm should avoid using debt as

interest is to be paid irrespective of profits.

The long term Investment decision is called capital budgeting. It is more important due to the following reasons-

1. Long term growth and affects : As capital budgeting decisions involve investment in long term fixed assets, it affects the long term
2. Large amount of funds involved : As huge amount of fund is blocked for a long period, the decision should be taken rationally.
3. Risk involved : As such a decision affects the returns of the firm as a whole, it involves more
4. Irreversible decisions : These long term decisions taken once cannot be reversed back, without incurring heavy losses. It will lead to waste of fund, if

Thus capital budgeting decisions should be taken after careful study and deep analysis.

It refers to the risk of the company not being able to cover its fixed financial cost. Fixed financial cost includes payment of interest that is to be paid irrespective of profit.

The higher level of risk are attached to higher degrees of financial leverage. If EBIT(Earnings before interest and tax) decreases, financial risk increases as the firm is not in a position to pay its interest obligations. Thus the risk of default is called Financial risk. The firm should overcome the situation accordingly or will be forced towards liquidation.

It will be operating activities in case of a finance company and investing activities in case of non-Financing Company.

Cash Flow statement is prepared on cash basis of accounting but profit is calculated on accrual basis.So cash flow statement is not a judge of profitability.

Under accounting standard-3(Revised).

Non cash items reduce the net profit without reducing the cash balance.

As Operating Activities.

Operating Activities

As Outflow under Investing Activities.

Give any two examples-

1. Acquisition of fixed asset by issue of debentures or
2. Conversion of debentures into

Cash deposited into bank, Cash withdrawn from bank for office use, purchase of short term marketable securities, , sale of short term marketable securities

Examples of extraordinary items under:-

• 1. Examples of extraordinary items under:-

      

     • Operating activity – claim received from insurance company against loss of
     • Investing activity – amount of compensation received against acquisition of land belonging to the
     • Financing activity – payment for buy-back of equity shares of the

Activities = Net Increase /Decrease in cash and Cash Equivalents.

The two methods which can be employed to calculate net cash flow from operating activities are:

1. Direct Method and
2. Indirect Method

The cost of capital to a company is the rate of return it must earn in order to satisfy the expectation of investors who provide long term funds to the firm. Cost of capital is a concept in financial management linking the investment and financing decisions.

It is important for three reasons:

1. For proper analysis of capital expenditure decisions, which are of prime importance to a firm, an estimate of cost of capital is required. The cost of capital is the discount rate used in NPV calculations and also the financial yardstick against which rate of return is evaluated.

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2. Several other decisions like leasing, long ten, financing and working capital policy, require estimates of cost of capital.
3. In order to maximize the value of the firm the costs of all inputs, including capital input, must be minimum and in this context the should be able to measure the cost of capital.

1.  It is still larger, academic term and the problem of measuring it in operational terms is a recent development. Earlier, the problem was either ignored or bypassed.
2.  Measurement of cost of capital, specifically for equity capital, is very complex subject.

A firm’s cost of capital is the weighted arithmetic average of the cost of different sources of long term finance used by it. Let us assume a company uses equity costing 16% and debt costing 9%. If the proportions in which debt and equity are used are respectively 40% and 60% the cost capital would work out to:

Cost of capital = Proportion of equity x Cost of equity + Proportion of debt x Cost of debt

= 0.40 x 16% + 0.60 x 9%

= 6.4% + 5.4% = 11.80%

Generalising, if the firm uses different sources of capital then the Average cost of capital would be:

K_a = S P_i K_i

where

K_a = Average cost of capital

P_i = Proportion of the i th sources of finance

K_i = Cost of the i th source of finance.

The cost of debentures and long term loans is the contractual interest rate adjusted for the tax liability of the company or put simply,

K = (1 – T) R

where, K = Cost of debt capital

T = Tax rate

R = Contractual interest rate

As interest is tax deductible, it is customary to compute the cost of borrowed funds as an after effective rate of tax

One can adjust the cost of debt only if the EBIT (Earning Before Interest and Taxes) is equal to or more than the interest rate. If, on the other hand, EBIT is less than the interest rate then the actual interest payable becomes the cost of capital effectively.

The method of computing cost of preference shares is similar to that of debentures. If 11 % preference share is sold at Rs. 100 par value, and the issue expenses incurred by the company amount to Rs. 2 per share then the cost of preference capital would be:

Preference Dividend/ Net Price of Preference shares = D/P

11/100-2 = 11/98 = 11.22%

Determining the cost of equity capital enables the corporate management to make decision in the best interests of the equity share holders. In theory, management strives to maximize the returns to the equity share holders and these effort involves many decisions in respect of capital expenditures and financing.

The cost of equity capital indicates the minimum rate which must be earned on the projects, before their acceptance and the raising of equity capital to finance them, i.e. it should lead to an increase in the net present value of their wealth.

1. Dividend price ratio
2. Earnings price ratio
3. Dividend price + growth rate of earnings
4. Realised yield approach

The correct capital structure for obtaining the weights to work out the weighted average, theoretically it is the optimal capital structure of the company. An optimal structure should take into account the following factors:

1. Accounting for the effect of risk

2. Leverage

3. Management control

However, in practice one can never achieve the optimal capital structure, as it can be seldom determined precisely. As a result, what is really sought is a capital structure that can permit the computation of the cost of capital that is not too far from the optimum rate/value.

A firm’s cost of capital is the weighted arithmetic average of the cost of various sources of long term finance used by it. Therefore, to calculate the cost of capital we should know (a) the specific cost of each source of capital (b) the proportion of different sources of financing in the capital structure.

Evaluation of capital expenditure, which are basically decisions of selecting long term projects proposals for investment, is called budgeting. The process of capital budgeting is quite complex, involving the following:

1. Identifying the potential investment opportunities.

2. Assembling the proposed investments.

3. Making the decision,

4. Capital budget proportion

5. Implementation

6. Performance review.

1. They have long term implications on the company.

2. Capital investment decisions are irreversible. This is owing to the fact that the markets for used capital equipment is not an organized one. Further, the capital equipments ordered and bought may have special tailor made specifications of the customer.

3. Capital investment decisions involve substantial outlays

Any delays in implementation can cause cost over-runs. The following points are relevant and should be adopted while implementing a project.

1. For project planning and control one must adopt the Program Evaluation Review Technique or . the Critical Path Method to facilitate monitoring the project on a continuous basis while under implementation.

2. Assigning specific responsibilities to project managers to implement their part of the project within specific time and cost limits is helpful while expediting execution of the project.

Post completion audit is a feedback device. It is a means for comparing the actual performance with the anticipated/planned performance. It should be undertaken once the plant overcomes initial teething problems and stabilizes in operations. Such an audit gives an insight into many aspects.

(a) How realistic were the assumptions at the time the project was taken up for discussion and approval

(b) induces a degree of caution among those who put forth proposals.

The capital budgeting process requires an estimate of future events to be translated into a schedule of cash flows. At a given point of time, a company may be having a number of alternative investment proposals and obviously the objective of the capital budgeting analysis is to obtain an indication of the value each might contribute to the company.

Before applying any method to evaluate the relative acceptability of a project it is necessary to analyse to components which affect cash flows related to the projects over the life of the project. The basic components of investment analysis are: 1 Amount of net capital investment, 2. Operating cash flows, 3. Choice of a horizon.

Net capital investment represents the amounts of funds committed to a project. It may include not only the cost of land, building, plant and machinery but also the increase in working capital required to support larger operations.

If a project results in the replacement of an existing capital asset, which has not been fully depreciated, there is a tendency to include the remaining value of the old asset in the amount of the investment.

However, the book value of the replaced asset should be of no consequence to the investment analysis of the new proposal as it pertains to an earlier investment proposal and should be accounted in that proposal. The only relevant factor to be considered is the salvage value of the old asset, which can be reduced from the investment required for the new project.

Initial flows represent the cash outflows associated with investment in various project components These can be: Outlays on plant, machinery, and other fixed assets, tax shields relating to above investments plus outlays on new working capital.

Operational flows are cash inflows expected during the operational phase of the project. The operational inflow for a particular year is equal to:

Profit after tax + Depreciation and any other non cash changes

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

Post tax salvage value of fixed assets + Post tax salvage value of working capital

Payback period represents the length of time required for the stream of cash proceeds generated by the investment, to be equal to the original investment. In other words this is the time required for the project to pay itself. The formula is

Payback period = Original investment/Annual cash flow

According to the payback criteria the shorter the pay back period the more desirable the project. Firms using this method specify the maximum payback period acceptable. If the specified payback is n years then projects with payback of n years or less than n years are accepted.

1. It is very simple—both in concept and application. It has no dubious assumptions nor any cumbersome calculations.

2. It favours projects which generate substantial cash flows in the initial years and discriminates against projects which bring substantial cash flows in the later years. Thus the payback method can be used to weed out risky propositions

3. As it emphasizes faster/earlier cash flows it is desirable for a company with a liquidity crunch.

1. It fails to take into account the time value of money. Cash inflows are added without any discounting. This violates the most basic principle of financial accounting which stipulates cash flows accruing at different points of time can be added or subtracted after suitable discounting/compounding.

2. It does not take into account the cash flows after the payback period This leads to discrimination against projects which generate cash flows in later years

The average rate of return, also called the accounting rate of return, is defined as

Average rate of return = Profit after tax/Book value of fixed assets

In the ratio, the numerator is the annual average post tax profit over the life of the investment and the denominator, the average book value of the fixed assets committed to the project.