Paper 3B - Financial Management.pdf - FINANCIAL MANAGEMENT Revised Edition For CA \u2013 IPCC CA Raj K Agrawal All India CA Rank Holder \u00a9 All rights

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Unformatted text preview: FINANCIAL MANAGEMENT Revised Edition For CA – IPCC CA Raj K Agrawal All India CA Rank Holder © All rights reserved Revised Edition Price: ` 455/- Every effort has been made to present this publication in the most authentic form without any errors and omissions. In spite of this errors might have inadvertently crept in, or there may be a difference of opinion on certain points. Any mistake, error or discrepancy noted may be kindly brought to the notice of the Author, which shall be dealt with suitably. It is notified that the Author does not guarantee the accuracy or completeness of any information published herein, and will not be responsible for any damage or loss, of any kind, in any manner, arising out of use of this information. No Part of this publication may be reproduced or copied in any form or translated in any other language without prior written permission of the Author. About the Author Raj K Agrawal, a Chartered Accountant devoted to the cause of CA students. He Qualified Chartered Accountancy with all India 27th rank in CA Final and all India 29th rank in CA PE-I. He has been consistent school and college topper. He is endowed with the passion of winning as evinced through demonstrated excellence in Academics and Teaching Career. His distinguished teaching style to face the challenges of tough professional exams has made him famous and favourite amongst the students. He is Educator of a renowned commerce coaching class in the name of “Elite Concepts” at Varanasi. He has authored several books for professional courses. His primary focus is on enhancing student’s knowledge theoretically and practically as well as focused preparations to ensure success in the examinations and to achieve professional expertise. © CA. Raj K Agrawal E-mail: [email protected] [email protected] Website: About the Book I am pleased to commend to readers the revised edition of Financial Management, which has been revised and enlarged as per latest syllabus of professional courses. It is a comprehensive presentation of the subject matter in a lucid form understandable to the students. The book also contains solved problems from key professional and academic examinations. These will help students to maintain a meaningful focus on examination requirements. The book is intended to serve as a standard text for students pursuing their CA- IPCC, CS- Final, BBA, B.Com, B.Com (Hons) and many more Professional Courses. The following are the main features of the book: • • • • Simple Language Self-explanatory notes Illustrations Solved and Unsolved practical problems. I hope this edition will endear itself to students and peers. I welcome comments and suggestions for improving the utility of this book. CA. Raj K Agrawal Syllabus GROUP I OF IPCC/ ACCOUNTING TECHNICIAN COURSE (ATC) Paper 3: Cost Accounting and Financial Management (One paper - three hours – 100 marks) Level of Knowledge: Working knowledge Part II: Financial Management (50 marks) Objectives: (a) To develop ability to analyse and interpret various tools of financial analysis and planning; (b) To gain knowledge of management and financing of working capital; (c) To understand concepts relating to financing and investment decisions; and (d) To be able to solve simple cases. Contents: 1. Scope and Objectives of Financial Management (a) Meaning, importance and objectives (b) Conflicts in profit versus value maximisation principle (c) Role of Chief Financial Officer. 2. Time Value of Money Compounding and discounting techniques – concepts of annuity and perpetuity. 3. Financial Analysis and Planning (a) Ratio analysis for performance evaluation and financial health (b) Application of ratio analysis in decision making (c) Analysis of cash flow statement. 4. Financing Decisions (a) Cost of Capital – weighted average cost of capital and marginal cost of capital (b) Capital Structure decisions – capital structure patterns, designing optimum capital structure, constraints, various capital structure theories (c) Business risk and financial risk – operating and financial leverage, trading on equity. 5. Types of Financing (a) Different sources of finance (b) Project financing – intermediate and long term financing (c) Negotiating term loans with banks and financial institutions and appraisal thereof (d) Introduction to lease financing (e) Venture capital finance. 6. Investment Decisions (a) Purpose, objective, process (b) Understanding different types of projects (c) Techniques of decision making: non-discounted and discounted cash flow approaches payback period method, accounting rate of return, net present value, internal rate of return, modified internal rate of return, discounted payback period and profitability index. (d) Ranking of competing projects, ranking of projects with unequal lives. 7. Management of working capital (a) Working capital policies (b) Funds flow analysis (c) Inventory management (d) Receivables management (e) Payables management (f) Management of cash and marketable securities (g) Financing of working capital. Index S. No. Topics Page No. 1 Time Value of Money 1.1 – 1.9 2 Cost of Capital 2.1 – 2.24 3 Capital Structure 3.1 – 3.12 4 Leverage 4.1 – 4.15 5 Working Capital Management 5.1 – 5.17 6 Receivable Management 6.1 – 6.12 7 Cash Management 7.1 – 7.34 8 Capital Budgeting 8.1 – 8.31 9 Ratio Analysis 9.1 – 9.32 10 Fund Flow 10.1 – 10.29 11 Cash Flow 11.1 – 11.30 12 Types of Financing 12.1 – 12.15 13 Theory 13.1 – 13.16 14 Table 14.1 – 14.2 1 Time Value of Money Time Value of Money The value of money received today is different from the value of money received after some time in the future. An important financial principle is that the value of money is time dependent. This principle is based on the following four reasons: 1. Inflation – Under inflationary conditions the value of money, expressed in term of its purchasing power over goods and services, declines. 2. Risk – ` 1 now is certain, whereas ` 1 receivable tomorrow is less certain. 3. Present Consumption Preference – Many individuals have a strong preference for immediate rather than delayed consumption. 4. Investment opportunities – Money like any other desirable commodity, has a price, given the choice of ` 100 now or the same amount in one year’s time, it is always preferable to take ` 100 now because it could be invested over the next year at (say) 18% interest rate to produce ` 118 at the end of one year. Simple Interest Simple interest is the interest calculated on the original principal only for the time during which the money lent is being used. Simple interest is paid or earned on the principal amount lent or borrowed. Simple interest is ascertained with the help of the following formula: Interest = Pnr Amount = P (1 + nr) Where, P = Principal r = Rate of Interest per annum (r being in decimal) n = Number of years Illustration 1: What is the simple interest and amount of ` 8,000 for 4 years at 12% p.a. Solution: Interest Amount Interest CA- IPCC = Pnr = 8,000 X 4 X 0.12 = ` 3,840 = P (1 + nr) = 8,000 [1 + (4 X 0.12)] = 8,000 (1 + 0.48) = 8,000 X 1.48 = ` 11,840 = Amount – Principal = 11,840 – 8,000 = ` 3,840 1.1 CA. RAJ K AGRAWAL FINANCIAL MANAGEMENT TIME VALUE OF MONEY Illustration 2: At what rate percent will ` 26,435 amount to ` 31,722 in 4 years? Solution: A 31,722 31,722 1,057.40 r r Rate of interest = P(1 + nr) = 26,435 (1 + 4 r/100) = 26,435 + 1,05,740 r/100 = 31,722 – 26,435 = 5,287 / 1,057.40 = 5 = 5% Illustration 3: A sum deposited at a bank fetches ` 13,440 after 5 years at 12% simple rate of interest. Find the principal amount. Solution: A 13,440 13,440 1.6 P P Principal amount = P (1 + nr) = P (1 + 5 X 0.12) = P + P 0.6 = 13,440 = 13,440 / 1.6 = 8,400 = ` 8,400 Compound Interest If interest for one period is added to the principal to get the principal for the next period, it is called ‘compounded interest’. The time period for compounding the interest may be annual, semiannual or any other regular period of time. The period after which interest becomes due is called ‘interest period’ or ‘conversion period’. If conversion period is not mentioned, interest is to be compounded annually. The formula used for compounding of interest income over ‘n’ number of years. A = P (1 + i)n Where, A = Amount at the end of ‘n’ period P = Principal amount at the beginning of the ‘n’ period i = Rate of interest per payment period (in decimal) n = Number of payment periods When interest is payable half-yearly A = P ( 1 + i/2)2n When interest is payable quarterly A = P (1 + i/4)4n When interest is payable monthly A = P (1 + i/12)12n When interest is payable daily A = P (1 + i/365)365n or Pert CA- IPCC 1.2 CA. RAJ K AGRAWAL FINANCIAL MANAGEMENT TIME VALUE OF MONEY Illustration 4: Find out compounded interest on ` 6,000 for 3 years at 9% compounded annually. Solution: A CI = P (1 + i)n = 6,000 ( 1 + 0.09)3 = 6,000 (1.09)3 = 6,000 X 1.29503 =A–P = 7,770 – 6,000 = ` 7,770 = ` 1,770 Illustration 5: What sum will amount to ` 5,000 in 6 years’ time at 81/2% per annum. Solution: A 5,000 5,000 5,000 P = P (1 + i) n = P (1 + 0.085)6 = P (1.085)6 = P X 1.63147 = 3,065 Illustration 6: Find the compound interest on ` 2,500 for 15 months at 8% compounded quarterly. Solution: A A Compound Interest = P (1 + i/4)4n = 2,500 (1 + 0.08/4)4 X 1.25 = 2,500 (1 + 0.02)5 = 2,500 (1.02)5 = 2,500 X 1.104 = 2,760 – 2,500 = ` 2,760 = ` 260 Illustration 7: Assume that a deposit is to be made at year zero into an account that will earn 8% compounded annually. It is desired to withdraw ` 5,000 three years from now and ` 7,000 six years from now. What is the size of the year zero deposit that will produce these future payments? Solution: Let the initial deposit be sum of the present value of the two later withdrawals by using the present value table. PV = FV X PVF(r,n) PV = ` 5,000 PVF (8%, 3) + ` 7,000 X PVF (8%, 6) PV = ` 5,000 (.794) + ` 7,000 (.630) PV = ` 3,970 + ` 4,410 = ` 8,380. An amount of ` 8,380 deposited today will result in the desired withdrawals. CA- IPCC 1.3 CA. RAJ K AGRAWAL FINANCIAL MANAGEMENT TIME VALUE OF MONEY Illustration 8: Assume that a ` 20,00,000 plant expansion is be financed as follows: The firm makes a 15% down payment and borrows the remainder at 9% interest rate. The loan is to be repaid in 8 equal annual instalments beginning 4 years from now. What is the size of the required annual loan payments? Solution: The firm borrows ` 17,00,000 (85%). Compound interest occurs over the entire 11 years of the life of the loan. To compute the size of the annual payment, first compute the amount owed at the end of year 3 (one year before the first payment). By compounding ` 17,00,000 for three years at 9%, FV = PV (1 + r) n FV = ` 17,00,000 (1 + .09)3 FV = ` 22,01,550 Now the FV becomes the present value of the 8-payment annuity discounted at 9%. PV = Annuity Amount X PVAF PV = Annuity Amount X PVAF (9%, 8) ` 22,01,500 = Annuity Amount X (5.535) Annuity Amount = ` 3,97,750. The plant expansion financing plan can be summarized as follows: - Down payment at year zero of ` 3,00,000; the balance borrowed at 9% interest. Eight yearly loan repayments of ` 3,97,750 are to be made beginning at the end of year 4. Illustration 9: A potential investor is considering the purchase of a bond that has the following characteristics: the bond pays 8% per year on its ` 1,000 principal, or face value. The bond will mature in 20 years. At maturity, the bondholder will receive interest for year 20 plus ` 1,000 face value. What is the maximum purchase price that should be paid for this bond if the investor requires a 10% rate of return? Solution: Assume that if the bond is purchased now, the first interest payment will be received in one year and that the bond will mature 20 years from now. The yearly interest payment will be ` 80 (8% of ` 1,000). In year 20 a payment of ` 1,080 will be received (` 1,000 + ` 80). The maximum purchase price for this bond is the sum of the present value of the future inflows discounted at the 10% required rate of return. The interest payments are treated as an annuity; the ` 1,000 principal is discounted as a single payment. The present value of the interest payments is found by discounting for 20 payments and 10% interest. PV = Annuity Amount X PVAF (10%, 20Y) PV = ` 80 X PVAF PV = 80 (8.514) = ` 681.12 Now, the present value of ` 1,000 receivable at the end of year 20 can be found by discounting for 20 years at 10% interest. PV = FV X PVF(r,n) CA- IPCC 1.4 CA. RAJ K AGRAWAL FINANCIAL MANAGEMENT TIME VALUE OF MONEY PV = FV X PVF(10%,20) PV = 1,000 (.149) = ` 149 The maximum purchase price is thus ` 681.12 + ` 149.00 = ` 830.12 Illustration 10: A 10-year savings annuity of ` 2,000 per year is beginning at the end of current year. The payment of retirement annuity is to begin 16 years from now (the first payment is to be received at the end of year 16) and will continue to provide a 20-year payment annuity. If this plan is arranged through a savings bank that pays interest @ 7% per year on the deposited funds, what is the size of the yearly retirement annuity that will result? Solution: Obtain the compounded amount of the 10-payment savings annuity of ` 2,000 corresponding to 10 payments and 7%. FV = Annuity Amount X FVAF(r,n) FV = ` 2,000 X FVAF (7%, 9Y+1) FV = 2,000 (13.816) = ` 27,632 The amount of ` 27,632 is available immediately after the last payment. Now, compound the amount of ` 27,632 for 5 years as a single payment at 7%. This will give the total cumulative value in the beginning of year 16. FV = PV X FVF(r,n) FV = PV X FVF (7%, 5) FV = 27,632(1.403) = ` 38,768. Finally, obtain the size of the equal retirement annuity payment by using the amount of ` 38,768 as the present value of the retirement annuity. Substitute the values corresponding to 20-payments and 7% as follows: PV = Annuity Amount X PVAF(r,n) PV = Annuity Amount X PVAF (7%,20) ` 38,768 = Annuity Amount (10.594) Annuity Amount = ` 3,659. Thus, the savings annuity of ` 2,000 for 10 years will produce a 20 years retirement annuity of ` 3,659 per year starting at the end of 16 years from now. Illustration 11: A company is offered a contract which has the following terms: An immediate cash outlay of ` 15,000 followed by a cash inflow of ` 17,900 after 3 years. What is the company’s rate of return on this contract? Solution: The amount of ` 15,000 cash outflow may be treated as a principal which the company deposits into an account that pays an unknown rate of interest but returns a compounded amount of ` 17,900 after 3 years. FV = PV (1 + r)n ` 17,900 = ` 15,000 (1 + r)3 CA- IPCC 1.5 CA. RAJ K AGRAWAL FINANCIAL MANAGEMENT ` 17,900/` 15,000 1.193 (1.193)1/3 1.0605 r = = = = = TIME VALUE OF MONEY 3 (1 +r) (1 + r)3 1+r 1+r 6.05% Illustration 12: An investor deposits a sum of ` 1,00,000 in a bank account on which interest is credited @ 10% p.a. How much amount can be withdrawn annually for a period of 15 years? Solution: In this case, the deposit of ` 1,00,000 can be viewed as the present value of the future annuity of 15 years @ 10%. ` 1,00,000 = Annuity Amount X PVAF(10% 15y) = Annuity Amount X 7.606 Annuity Amount = 1,00,000 ÷ 7.606 = ` 13,148 So the investor can withdraw an annuity of ` 13,148 for 15 years. Illustration 13: What is the minimum amount which a person should be ready to accept today from a debtor who otherwise has to pay a sum of ` 5,000 today and ` 6,000, ` 8,000, 9,000 and ` 10,000 at the end of year 1,2,3,4 respectively from today? The rate of interest may be taken at 14%. Solution: The minimum amount in this case is the PV of the series of amount due discounted at 14%, as follows: Year Amount due PVF(14%,n) PV (` `) 0 ` 5,000 1 5,000 1 6,000 .877 5,262 2 8,000 .769 6,152 3 9,000 .675 6,072 4 10,000 .592 5,920 ` 28,409 The minimum acceptable amount is ` 28,409. Unsolved Exercises Q1. A sum of money amounts to ` 6,000 in 2 years. If the interest on the sum for that time is ` 1,000. Find the rate of simple interest. Q2. The interest on a certain deposit at 4.5% p.a. is ` 202.50 in one year. How much will the additional interest in one year be on the same deposit at 5% p.a.? CA- IPCC 1.6 CA. RAJ K AGRAWAL FINANCIAL MANAGEMENT TIME VALUE OF MONEY Q3. Shobhit deposited a sum of ` 1,00,000 in a bank. After 2 years he withdrew ` 40,000. At the end of 5 years he received an amount of ` 75,200 from the bank. Find the rate of simple interest. Q4. [Study Material] ` 2,000 is invested at annual rate of interest of 10%. What is the amount after 2 years if the compounding is done: (i) Annually (ii) Semi annually (iii) Monthly (iv) Daily Q5. What is the effective rate of annual compounding interest equivalent to a nominal rate of 6% compounded quarterly? Q6. Which is better from the stand point of the investor (i) 9.1% compounded semi annually, or (ii) 9% compounded monthly. Q7. Children growth policy of LIC is an ideal plan or policy for all class of people under different income group. A small amount can be invested for a period of 1 to 10 years. The certificates are issued at ` 25, ` 100, ` 1,000, ` 1,00,000. The rate of interest is 12% p.a. compounded quarterly. Calculate the issue price of a certificate of ` 1,00,000 to be received after 10 years. Q8. A loan of ` 2 lacs at a rate 14% p.a. is taken with an agreement to pay it in 5 equal annual installments. Calculate the annual installments. Q9. How much deposit should be made in Saving Bank A/c for infinite and uncertain period @ 5% interest, if we need ` 3,000 p.a. as return or interest from such deposit. Q10. Find the amount of an annuity if payment of ` 500 is made annually for 7 years at interest rate of 14% compounded annually. (i) If payment made at the end of each year (ii) If payment made at the beginning of each year Q11. [Study Material] ` 200 is invested at the end of each month in an account paying interest 6% per year compounded monthly. What is the amount of this annuity after 10th payment? Given that (1.005)10 = 1.0511 Q12. [Study Material] How much amount is required to be invested at the end of every year so as to accumulate ` 3,00,000 at the end of 10 years if the interest is compounded annually at 10%? Q13. In how many years will a sum deposited would get doubled, if the rate of interest is 12% p.a. compounded annually. CA- IPCC 1.7 CA. RAJ K AGRAWAL FINANCIAL MANAGEMENT TIME VALUE OF MONEY Q14. [Study Material] Z plans to receive an annuity of ` 5,000 semi-annually for 10 years after he retires in 18 years. Money is worth 9% compounded semi-annually. (i) How much amount is required after 18 years to finance the annuity? (ii) What amount of single deposit made now would provide the funds for the annuity? (iii) How much will Mr. Z receive from the annuity? Q15. [May 2007] A person is required to pay four equal annual payments of ` 4,000 each in his deposit account that pays 10% interest per year. Find out the future value of annuity at the end of 4th year. Q16. [Nov 2008] A company offers a fixed deposit scheme whereby ` 10,000 matures to ` 12,625 after 2 years, on a half-yearly compounding basis. If the company wishes to amend the scheme by compounding interest every quarter, what will be the revised maturity value? Q17. [Study Material] A person opened an account on April, 2005 with a deposit of ` 800. The account paid 6% interest compounded quarterly. On October 1, 2005, he closed the account and added enough additional money to invest in a 6-month Time Deposit for ` 1,000 earning 6% compounded monthly. (i) How much additional amount did the person invest on October 1? (ii) What was the maturity value of his Time Deposit on April 1, 2006? (iii) How much total interest was earned? Q18. [Study Material] Ramesh wants to retire and receive ` 3,000 a month. He wants to pass this monthly payment to future generations after his retirement. He can earn an interest of 8% compounded annually. How much will he need to set aside to achieve his perpetuity ...
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