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Unformatted text preview: Financial Management This document is authorized for internal use only at IBS Campuses Batch of 2013-2015, Semester-I. No part of this publication may be reproduced, stored in a retrieved system, used in a spreadsheet, or transmitted in any form or by any means - electronic, mechanical, photocopying or otherwise. Transmission, copying or posting on web are violation of intellectual property rights. C HAPTER 1 Introduction to Financial Management After reading this chapter, you will be conversant with: Nature and Objective of Financial Management Role of the Finance Manager Interface between Finance and Other Functions Environment of Corporate Finance Section 1 Nature and Objective Financial Management One participant in a course titled, ‘Finance for Non-Finance Executives’, made a very interesting observation during the discussion. He said, “There are no executive development programs titled, ‘Production Management for Non-Production Executives’ or ‘Marketing Management for Non-Marketing Executives’ and so on. Then why books and Executive Development Programs like ‘Finance for Non-Finance Executives’ are so popular among managers of all functions like marketing, production, personnel, R&D, etc.?” The answer is simple. The common thread running through all the decisions taken by various managers is money and there is hardly any manager working in any organization to whom money does not matter. To illustrate this point, let us consider the following instances. The R&D manager has to justify the money spent on research by coming up with new products and processes which would help to reduce costs and increase revenue. If the R&D department is like a bottomless pit, which only swallows money, but does not yield any positive results in return, then the management would have no choice but to close it. No commercial entity runs an R&D department to conduct unprofitable basic research. Likewise the materials manager should be aware that inventory of different items in stores is nothing but money in the shape of inventory. He should make efforts to reduce inventory so that the funds released could be put to more productive use. At the same time, he should also ensure that inventory of materials does not reach such a low level as to interrupt the production process. He has to achieve the right balance between too much and too little inventory. This is called the ‘liquidity-profitability trade-off’ about which you will read more in the Chapter on Working Capital Management. The same is true with regard to every activity in an organization. The results of all activities in an organization are reflected in the financial statements. The Finance Manager, as his very designation implies, should be involved in all financial matters of the organization since almost all activities in the organization have financial implications. It would therefore not be inaccurate to say that the Finance Manager is involved in most decisions of the organization. Let us try to understand what financial management is by examining what the Finance Manager does and with what objectives. Let us examine the objective sought to be achieved by a Finance Manager. Suppose he manages to make available the required funds at an acceptable cost and that the funds 3 are suitably invested and that everything goes according to the plan because of the effective control measures employed by him. If the firm is a commercial or profit-seeking firm, then the results of good performance are reflected in the profits the firm earns. But how are the profits utilized? They are partly distributed among the owners as dividends and partly recycled into the operations of the firm. As this process continues over a period of time the value of the firm increases for the simple reason that the firm is able to generate attractive surpluses from operations. If the shares of a firm are traded on the stock exchange, the good performance of the firm is reflected in the price at which its shares are traded. When the firm’s shares attract a good price, the owners or shareholders are better off because they would realize much more than what they had invested. Their wealth increases. Profit Maximization vs. Wealth Maximization In the case of public sector companies, till recently the only objective was to increase the wealth to the society and nation at large. This objective was achieved by ensuring availability of essential goods and services to all citizens in all corners of the country, uniform development of all regions in the country, providing employment opportunities, investing in projects with long gestation periods where private investment may not be forthcoming and investing in import-substitution industries, etc. But now the public sector has also begun to realize that they have to perform in order to exist and that its products/services will not be subsidized any longer by the government. The government has identified a number of Public Sector Undertakings (PSUs) for disinvestment / privatization purposes in order to improve / increased their operational efficiencies. Keynote 1.1.1: Objective of Financial Management So, we can see that as a result of good financial management the value of the company to the owners (shareholders) increases, thereby increasing their wealth. Therefore, we can say that the objective of a Finance Manager is to increase or maximize the wealth of the owners by increasing the value of the firm which is reflected in its Earnings Per Share (EPS) and the market price of its shares. 4 Role of a Finance Manager The Finance Manager is engaged in the following activities: Mobilization of Funds The Finance Manager has to plan for and mobilize the required funds from various sources when they are required and at an acceptable cost. This decision is called the Financing Decision. For this purpose he would have to liaison with banks and financial institutions. He also has to deal with merchant banking agencies for procuring funds from the public through issue of shares, debentures and inviting the public to subscribe to its fixed deposits. In deciding how much to procure from various sources, he would weigh many options like the cost of the funds in the form of interest/dividend and the cost of public issue in the case of shares and debentures, the length of time for which funds would be available, etc. Banks and other financial institutions which give short-term and long-term loans generally lay down some conditions. These conditions are aimed at ensuring the safety of the loans given by them and contain provisions restricting the freedom of the borrower to raise loans from other sources. Therefore, the Finance Manager would try to balance the advantages of having funds available with the costs and the loss of flexibility arising from the restrictive provisions of the loan contract. Let us take a look at a real life example XYZ Limited, a well-known company in computer training, software development, information systems, consultancy, etc., is undertaking a modernization cum expansion scheme which envisages addition of new services, product lines and upgradation of existing systems. The cost of this expansion-cummodernization program is estimated at Rs.3,578 lakh, which is going to be mobilized as follows, as per the prospectus of the company: Rs.lakh Public issue of equity shares including premium 1,804 Term loan - ICICI 130 Leasing - ICICI 125 Others 75 Deferred payment guarantee 99 Internal accruals 1,345 3,578 5 Deployment of Funds Control over the use of Funds There would always be many competing needs for the allocation of funds. In consultation with the managers of various departments such as production, marketing, personnel, R&D and the top management, the Finance Manager decides on the manner of deployment of funds in various assets such as land, buildings, machinery, materials, etc. Sometimes the managers of the various departments constitute an ‘Investment Committee’ and appraise an investment proposal along the marketing, technical and financial dimensions. The Finance Manager appraises the proposal along the financial dimensions to determine its worthiness in relation to the investment involved. This decision, called the ‘Investment Decision’, constitutes one of the core activities of the Finance Manager. After deciding on projects and proposals in which the funds are to be invested and after procuring them, the Finance Manager has to continuously monitor their use in order to ensure proper deployment, as per the plan. This task of the Finance Manager is called Financial Control. The Finance Manager sends frequent reports to the Managing Director. These reports contain information in the form of facts and figures regarding the extent to which procurement and deployment of funds is proceeding according to the plan. For example, the reports would inform the management regarding the extent to which credit sanctioned by banks for the day-today use of the firm (working capital) has been utilized and how much more can be borrowed. It would also contain information on how much money is due to the firm from various customers and how much money the firm owes its suppliers, creditors, etc. The report would also contain information on the funds required at different points of time in the future and the availability of funds from various sources including those available out of any surpluses generated internally. He would also be reporting to the top management about the performance of individual departments within the organization. All such reports are called ‘Control Reports’ and the whole process constitutes ‘control’ because it helps management to take timely corrective action to ensure that planned results are achieved. The funds mobilized through various sources by XYZ are proposed to be deployed as follows, as indicated in the prospectus of the company: Rs. lakh Buildings 985 Computers & Accessories 941 Plant & Machinery 116 Infrastructure 213 Normal Capital Expenditure 241 Repayment of Loans 283 Increase in Working Capital 799 6 the company is even exposed to the risk of insolvency. Similarly, the various investment opportunities have a certain amount of risk associated with the return and also the time when the return would materialize. The finance manager has to decide whether the opportunity is worth more than its cost and whether the additional burden of debt can be safely borne. In fact, decision-making in all areas of management including financial management involves the balancing of the trade-off between risk and return. Interface between finance and other functions Source: Risk-Return Trade-Off While making the decisions regarding investment and financing, the Finance Manager seeks to achieve the right balance between risk and return. If the firm borrows heavily to finance its operations, then the surpluses generated out of operations would be utilized to ‘Service the Debt’ in the form of interest and principal payments. You will recall that we started this introductory chapter by describing the pervasive nature of finance. Let us discuss in greater detail the reasons why knowledge of the financial implications of the finance manager’s decisions is important to the non-finance managers. One common factor among all managers is that they use resources and since resources are obtained in exchange for money, they are in effect making the investment decision and in the process of ensuring that the investment is effectively utilized they are also performing the control function. The surplus or profit available to the owners would be reduced because of the heavy ‘Debt-servicing’. If things do not work out as planned and the firm is unable to meet its obligations, 7 Figure 1.1: Responsibilities of Managers inventory. Other key decisions of the Marketing Manager which have financial implications are pricing, product promotion and advertisement, choice of product mix and distribution policy. Production-Finance Interface Marketing-Finance Interface The Marketing Manager takes many decisions which have a significant impact on the profitability of the firm. For example, he should have a clear understanding of the impact of the credit extended to the customers on the profits of the company. Otherwise in his eagerness to meet the sales targets he is likely to extend liberal terms of credit which may put the profit plans out of gear. Similarly, he should weigh the benefits of keeping a large inventory of finished goods in anticipation of sales against the costs of maintaining that In any manufacturing firm, the Production Manager controls a major part of the investment in the form of equipment, materials and men. He should so organize his department that the equipments under his control are used most productively, the inventory of work-in-process or unfinished goods, stores and spares are optimized, and the idle time and work stoppages are minimized. If the production manager can achieve this, he would be holding the cost of the output under control and thereby help in maximizing profits. He has to appreciate the fact that while the price at which the output can be sold is largely determined by the factors external to the firm, such as competition, government regulations, Video 1.1.1: Effective Finance Functions etc., the cost of production is more amenable to his control. Similarly, he would have to make decisions regarding make or buy, buy or lease, etc., for which he has to evaluate the financial implications before arriving at a decision. 8 Top Management-Finance Interface The top management, which is interested in ensuring that the firm’s long-term goals are met, finds it convenient to use the financial statements as a means for keeping itself informed of the overall effectiveness of the organization. We have so far briefly reviewed the interface of finance with the non-finance functional disciplines like production, marketing, etc. Besides these, the finance function also has a strong linkage with the functions of the top management. Strategic planning and management control are two important functions of the top management. Finance function provides the basic inputs needed to undertake these activities. With the recent liberalization of the Indian economy, abolition of the office of the Controller of Capital Issues, who used to fix issue prices beforehand, and with increased globalization of the Indian economy, Finance Managers are presently facing a slew of new challenges. Some of which are as follows: Challenges in Financial Management Treasury Operations: Short-term fund management must be more sophisticated. Finance Managers could make speculative gains by anticipating interest rate movements. Foreign Exchange: Finance Managers will have to weigh the costs and benefits of transacting in foreign exchange, particularly now that the Indian economy is going global and the future value of the rupee has became difficult to predict. Financial Structuring: An optimum mix between debt and equity will be essential. Firms will have to tailor financial instruments to suit their and investors’ needs. Pricing of new issues is also an important task for the Finance Manager’s portfolio now. Video 1.1.2: Stakeholder Theory Maintaining Share Prices: In the premium equity era, firms must ensure that share prices stay healthy. Finance Managers will have to devise appropriate dividend and bonus policies. Ensuring Management Control: Equity issues at premium mean management may lose control if it is unable to take up its share entitlements. Strategies to prevent this and also initiate other steps to prevent dilution of management control are vital. 9 Keynote 1.1.2: Agency Problem Review 1.1 Question 1 of 3 Which of the following is not an objective of financial management? A. Maximization of wealth of shareholders. References: B. Maximization of profits. C. Mobilization of funds at an acceptable cost. Beyond Shareholder Wealth Maximization D. Efficient allocation of funds. The finance function effectiveness Diagnostic Principal–agent problem E. Ensuring discipline in the organization. Agency theory Check Answer 10 Section 2 Environment of Corporate Finance Review 1.2 References: Question 1 of 2 Which of the following is an advantage of partnership firms? Department of Industrial Policy & Promotion Ministry of Corporate Affairs A. The life of the firm is perpetual. Foreign Exchange Management Act B. Personal liabilities of the partners are limited. C. Its ability to raise funds is virtually unlimited. D. It is relatively free from Governmental regulations as compared to joint stock companies. E. None of the above. Check Answer 11 C HAPTER 2 Time Value of Money After reading this chapter, you will be conversant with: The concept of Time Value Process of Compounding Process of Discounting Future Value of a Single Flow Future Value of Multiple Flows Future Value of Annuity Present Value of a Single Flow Present Value of Uneven Multiple Flows Present Value of Annuity Section 1 Introduction to the Concept of Time Value of Money To keep pace with the increasing competition, companies have to go in for new ideas implemented through new projects be it for expansion, diversification, or modernization. A project is an activity that involves investing a sum of money now in anticipation of benefits spread over a period of time in the future. How do we determine whether the project is financially viable or not? Our immediate response to this question will be to sum up the benefits accruing over the future period and compare the total value of the benefits with the initial investment. If the aggregate value of the benefits exceeds the initial investment, the project is considered to be financially viable. While this approach prima facie appears to be satisfactory, we must be aware of an important assumption that underlies. We have assumed that irrespective of the time when money is invested or received, the value of money remains the same. Put differently, we have assumed that: value of one rupee now = value of one rupee at the end of year 1 = value of one rupee at the end of year 2 and so on. We know intuitively that this assumption is incorrect because money has time value. How do we define this time value of money and build it into the cash flows of a project? The answer to this question forms the subject matter of this chapter. We intuitively know that Rs.1,000 in hand now is more valuable than Rs.1,000 receivable after a year. In other words, we will not part with Rs.1,000 now in return for a firm assurance that the same sum will be repaid after a year. But we might part with Rs.1,000 now if we are assured that something more than Rs.1,000 will be paid at the end of the first year. This additional compensation required for parting with Rs.1,000 now is called ‘interest’ or the time value of money. Normally, interest is expressed in terms of percentage per annum, for example, 12 percent p.a., or 18 percent p.a. and so on. Why should money have time value? Here are some important reasons for this phenomenon: Money can be employed productively to generate real returns. For instance, if a sum of Rs.100 invested in raw material and labor results in finished goods worth Rs.105, we can say that the investment of Rs.100 has earned a rate of return of 5 percent. In an inflationary period, a rupee today has a higher purchasing power than a rupee in the future. Since future is characterized by uncertainty, individuals prefer current consumption to future consumption. 13 The manner in which these three determinants combine to determine the rate of interest can be symbolically represented as follows: Keynote 2.1.1: Time Line Nominal or market interest rate = Real rate of interest or return + Expected rate of inflation + Risk premiums to compensate for uncertainty Time line There are two methods by which the time value of money can be taken care of. They are: compounding and discounting. Video 2...
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