Fundamentals of Financial management

Chapter 1 INTRODUCTION OF FINANCIAL MANAGEMENT:

Financial management:

Financial management is used to refer to the management of funds in the context of a business firm. Financial management is decision making process of investment, financing and assets management decision.

Responsibilities of financial manager:

1.     Planning and controlling:

Planning of cash flow, future expenditure, cost and expenses and revenue on the basis of forecasted sales by analyzing demand and supply, fixed, semi-variable and variable cost to calculate estimated cost

2.     Investment financing and dividend decision:

3.     Dealing with financial markets:

4.     Risk management:

The goal of the firm:

1.     Profit Maximization:

·        Maximization of net income

·        Sound profit

Arguments:               

·        Understandable

·        Decision criteria

·        Incentive to work

·        Maximize social welfare

Criticisms:

·        Vague and ambiguous:  rate of return, time, tax

·        Ignores time value of money

·        Ignores risk element

·        Incomplete

2.     Stockholders’ wealth maximization:

·        Maximize the net present value (NPV)

·        NPV = TPV of future benefit-TPV of cost

·        Profit maximization + capital gain due to appreciation of market value of common stock

There are two types of market i.e. Bull market and Bear market:

a.     Bull market:

 

In this market the value of share is increasing

b.     Bear market:

 

In this market the value of share is decreasing 

Superiority of stockholders’ wealth maximization:

1.   The meaning of stock price maximization is clear:

The meaning of stock price and objectives is clear, increment value of assets by profit maximization and stockholders’ wealth maximization.

2.   Consider time value of money:

It evaluates and compares time value of money by using net present value methods

3.   Consider risk element:

After the consideration time value of money, it calculates risk by using discount factor or interest rate.

Interest= risk free rate of return + other risk

4.   Appropriate for all types of firms

5.   Emphasis on the cash flow

6.   Consider social responsibility

Financial management and related disciplines:

1.     Accounting and finance

2.     Economics and finance

3.     Marketing, production, quantitative method and HRM (indirectly related):

MARKETING DOES POLICY MAKING, promotion decision

PRODUCTION DOES increase in financial position and working capital, sales, it decide inventory management, quantitative research

HRM searches local, high skill manpower for the job

The Agency Problem:

1.     Stockholders and manager:

Mechanism used to motivate managers:

1) Management compensation:

2) Direct intervention by shareholders:

3) The threat of firing:

4) Take over:

2.     Stockholders versus Creditors:

While going to invest in risky are conflict arises because creditors gets fix amount while shareholder gets unfix amount

Resolve the conflict:

1) Compensate creditor for increased risk:

Higher risk premium

2) Protective terms and conditions for creditors:

          ·          Restriction of repurchase of shares

          ·          Restructure of capital structure

          ·          Dividend policy decisions

Review:

       I.            Finance as a discipline is categorized into three domains: public finance, financial management and personal finance.

     II.            Finance is growing discipline.

  III.            High cash flow projects generally contribute to higher share price of the firm.

  IV.            The board of directors is free to pay or not to pay dividend.

    V.            A high earning per share is translated into a high stock price.

  VI.            The likelihood that managers may place personal goals ahead of corporate goals is called agency problem.

VII.            Stock price maximization is considered superior goal to profit maximization.

VIII.            The primary emphasis of financial manager is in efficient utilization of resources, deciding sources of financing and making dividend decision.

  IX.            Investment decision involves decision making related to fixed assets.

     X.            The primary goal of financial manager is maximizing wealth.

  XI.            Return and risk are the key determinants in share price. Increased return results in a higher share price, other things remaining same.

XII.            In agency relation, shareholders are principals.

Chapter 2 Financial statements and cash flows:

Net cash flow (NCF)

·          It is calculated for to distribute dividend and for tax payment.

Net cash flow (NCF) =Cash inflow-Cash outflow

NCF=Net income –Non cash revenue + Non cash expenses

Operating working capital (OWC) = all current assets used in regular operation

Net Operating Working Capital (NOWC) = operating working capital- noninterest bearing current liabilities

Total Operating Capital (TOC) = NOWC + Net Fixed Assets

Net Operating Profit after Tax (NOPAT) = EBIT (1-T)

Note: interest expenses on debt capital are financing charge, so that it is excluded in calculation of operating cash flow.

Free Cash Flow (FCF) = NOPAT – Net investment in operating capital

Cash flow statement:

Format: (indirect)

Particular	Amount	Amount
Cash flow from operating activities:
Net income
Add:    depreciation
Less:  Increase in all current assets (purchase)
Add: decrease in all current assets (sales)
Add: increase in all current liabilities (Credit purchase)
Less:  decrease in all current liabilities (Credit paid)
A.  Net cash flow from operating activities:
Cash flow from investing activities:
Less/add: Purchase/sold of fixed assets
B.  Net cash flow from investing activities:
Cash flow from financing activities:
Add: issue of common or preference share
Long term debt
Less: dividend paid
Notes payable
C.   Net cash flow from financing activities:
Net cash balance (A+B+C)
Add: Opening cash balance
Closing cash balance

Format direct method

Particular	Amount
Cash collection from customers:
Sales
Increase in receivables
Decrease in receivables
Cash paid to supplier, employees and other expenses:
Cost of goods sold
Cash from operating expenses including interest and tax
Increase in current liabilities
Decrease in current liabilities
Increase in current assets
Decrease in current assets
A.  Net cash flow from operating activities:
Cash flow from investing activities:
Less/add: Purchase/sold of fixed assets
B.  Net cash flow from investing activities:
Cash flow from financing activities:
Add: issue of common or preference share
Long term debt
Less: dividend paid
Notes payable
C.   Net cash flow from financing activities:
Net cash balance (A+B+C)
Add: Opening cash balance
Closing cash balance

Formulas:

ü Total assets= total liabilities + preferred stock + shareholder’s equity

ü Net cash flow (NCF) = net income - noncash revenues + non cash expenses

Where non cash expenses= depreciation, amortization

ü Net operating working capital (NOWC) = OWC – Noninterest bearing current liabilities

ü Total operating capital (TOC) = NOWC + net fixed assets

ü Net operating profit after tax (NOPAT) = EBIT(1-T)

ü Free cash flow (FCF) = NOPAT- net investment in operating capital

ü Market value added (MVA) = Market value of stock-equity capital supplied by shareholders

ü Economic value added (EVA) = EBIT(1-T)- [(TOC) (after tax cost of capital]

Chapter 3 Financial analysis

Financial analysis is the process of analyzing various items of financial statements of a firm to examine its comparative strength and weaknesses.

Financial ratios are the important tools of financial analysis. They provide information relating to strengths and weaknesses on various aspects of the firm’s performance and status.

Liquidity Ratio:

Liquidity ratios measure a firm’s ability to pay its short term obligation out of current or liquid assets.

·        It examine the ability to pay short-term loan

                    i.        Current ratio:

A current ratio is the quantitative relationship between current assets and current liabilities.

Current ratio = Current assets/current liabilities

Standard current ratio is 2:1. Current ratio less than 2:1 is typically considered low and indicates financial difficulties. The current ratio of 2:1 means for every rupee of current liabilities there is Rs.2 worth of current assets.  In other words, current assets are 2 times of current liabilities.

                  ii.        Quick ratio (Acid test ratio/Liquid ratio):

Quick ratio = quick assets/current liabilities

Quick assets = current assets – Inventories

Standard quick ratio is 1:1.

Assets Management Ratio:

To measure how efficiency the firm is using the assets to generate income.

                    i.        Inventory Turnover ratio (ITOR):

Measures firms’ average investment in inventory capability of generating sales

Inventory Turnover ratio = Cost of goods sold/Average Inventory

Where, Cost of goods sold = sales revenue-Gross profit

   In the absence of cost of goods sold and average inventory

Inventory Turnover ratio = Sales/Inventories

Decision: Higher ratio is preferable

                  ii.        Receivable Turnover Ratio (RTOR):

Measures the frequency of accounts receivable turnover occur during the year

Receivable Turnover Ratio = Annual credit sales/Average account receivable

If credit sales is unavailable,

Receivable Turnover Ratio = Annual sales/Average account receivable

Decision: Higher ratio is preferable

                iii.        Days Sales Outstanding/Average collection period:

Days Sales Outstanding=Receivables/Average sales per day [Annual: 360 days]

Average sales per day=Annual sales (Credit sales)/360 days

If Receivable Turnover Ratio is given

Days Sales Outstanding=360 days/ Receivable Turnover Ratio

                 iv.        Fixed Assets Turnover Ratio (FATOR):

Effectiveness of firms’ ability to make efficient allocation of fixed assets

Fixed assets turnover ratio=Sales/Net fixed assets

Net fixed assets=Fixed assets-depreciation

Decision: Higher ratio is preferable

                   v.        Total Assets Turnover ratio (TATOR):

Total Assets Turnover ratio=Sales/Total assets

Decision: Higher ratio is preferable

                 vi.        Working Capital Turnover ratio:

Working Capital Turnover ratio=Annual Net sales/Average working capital

Working Capital=current assets-current liabilities

Decision: Higher ratio is preferable

Debt Management Ratio/Leverage/Capital structure:

                    i.        Debt Ratio/Debt Assets Ratio (DA):

Debt Assets Ratio=Total debt/total assets

Decision: Creditors prefer low debt ratio

How much portion of total assets is financed by debt?

                  ii.        Debt-Equity Ratio (DE):

Debt-Equity Ratio=Total debt/Total equity

Total debt=Long term debt + current liabilities

Total Equity=Equity capital + preferred share + undistributed profit

If Debt Assets Ratio is given

Debt-Equity Ratio= Debt Assets Ratio/ (1- Debt Assets Ratio)

                iii.        Interest coverage ratio (Time interest + Earned ratio), (TIE)

Measures the extent to which interest on debt capital is covered by Earning before Interest and Tax (EBIT)

TIE ratio=EBIT/Interest expenses

Decision: Higher ratio is more satisfy to creditors.

                 iv.        Long term debt to total assets ratio (Long term debt ratio)

Long term debt ratio = Long term debt/ total assets

Debt financing =Financial leverage

It measures the financial leverage of the firm and use of long term debt.

Long term debt to total assets ratio=Long term debt/total assets

Decision: higher the ratio, higher the financial leverage and vice-versa.

                   v.        Equity multiplier/Leverage factor/Financial leverage (EM)

Equity multiplier=Total Assets/Total Equity

Debt equity ratio=1-1/ (Equity multiplier)

Equity multiplier=1+ Debt equity ratio

Interpretation: Higher the equity multiplier, higher the financial risk of the firm and vice-versa

Fixed charge coverage ratio=EBIT + Lease payments/Interest + Lease charge payment + sinking fund payments /1-Tax rate

Interpretation: Increasing ratio is preferable which shows that company can pay fixed charges

Profitability ratio:

       I.            Net profit margin on sales = Net profit/Sales

     II.            Gross profit margin = Gross profit/Sales

  III.            Operating profit margin = EBIT/Sales

  IV.            Basic Earning power ratio = EBIT/Total Assets

Return on total Assets

    V.             Return on total Assets = Net profit/Total Assets

·        Measure the return on all the firm’s assets after interest and taxes

·        Increasing ratio is favourable

  VI.            Return on common equity = Net income/Total Assets

Market value ratio:

a)  Price earnings ratio = price per share/earnings per share

Higher ratio is preferable

b) Market to book ratio=MPS/BVPS

Higher Market to book ratio are generally associated with firms that have a high rate of return on common stock.

A ratio bigger than 1:0 indicates that the firm has been successful in creating value of stockholders

c)  Dividend per share=Dividend paid to Equity shareholders/Numbers of Equity shares

d) Earning yield=EPS/Market value per share

	Formula	Example	Meaning
1.     Current ratio	Current assets/current liabilities	1.35:1	There are 1.35 current assets to pay every Rs.1 current liabilities.
2.     Quick ratio	Quick assets/current liabilities	0.49:1	There are 0.49 quick assets to pay every Rs.1 current liabilities.
3.     Debt to equity ratio

Du-pont analysis:

 

ROE=ROA*Equity multiplier

=ROA*Total Assets/Equity

Debt Equity ratio (DE) = total debt ratio/ (1-toatl debt ratio)

DE= DA/ (1-DA)

Equity multiplier (EM) = 1+DE

Debt ratio = 1/ (1-debt ratio)

Debt ratio = 1/ (1-EM)

Uses of du-pont analysis:

1.     To measure profitability of the firms in terms ROA and ROE.

2.     It allows the financial manager to breakdown firms ROE into three components i.e. profitability on sales, productive power of assets and leverage effect on equity return.

3.     To analyze the profit condition and utilization of assets in the firm.

4.     It helps to pinpoint the strength and weakness of the firm

5.     It brings together net profit margin and total assets turnover.

Format of income statement:

Particular	Amount
Sales revenue	xxx
Less: cost of goods sold
Gross profit
Less: selling expenses
Less: general and administrative expenses
Earnings before depreciation, interest and tax (EBDIT)
Less: depreciation
Net Operating income
Add: other income
Earnings before interest and tax (EBIT)
Less: interest
Earnings before tax (EBT)
Less: income tax
Net income

Chapter 4 Risk and return

Investor likes return but does not like risk. Generally, investors are risk avoider. Those who want to invest in high risky area they thought high risk gives high gain.

  At the world of investment cash which is at our pocket is risky assets, not risk free assets because of time value of money, inflation future value of our money.

       The interests that are given at our bond is called coupon rate.

Return= Terminal wealth-Initial wealth

   Where,

Terminal wealth= what an investor received

Initial wealth=what an investor invest

The above formula can be simply written as

Return=Amount received-Amount invested.

 

Return

                          O              Risk

Calculation of rate of return:

Rate of return=Amount received-Amount invested

                               Amount invested

Symbolically,

    R= D_t+ (P_t-P_t-1)

           P_t-1

Where,

D_t =dividend received

P_t = Ending price of stock

P_t-1 =Beginning price of stock

Measurement of Return:

1.   Rupee Return (Dollar / Absolute / Relative return)

·        Total capital gain and cash receipt from investment.

Capital gain = Ending price of stock (selling price)-beginning price of stock

Buying price

Normal gain = dividend = cash receipts

Therefore, rupee return = Capital gain + Normal gain (cash receipt)

2.   Percentage Return:

r_j = [(P_t+1 -P_t) + C_t+1]

               P_t

Where,

r_j = periodic rate of return on assets j

P_t+1 = ending or selling price

P_t =beginning price

C_t+1 = Cash receipts during the period

Co-Variance:

·          Measures the relationship between two variables (returns)

·          Cov_{ab =}

·          If the returns of the two securities move in the same direction consistently the covariance would be positive and vice versa

·          Covariance = 0 means both are independent

Capital assets pricing model (CAPM)

CAPM derives the relationship between the expected return and systematic risk of individual securities and portfolios. It is used in finance to determine as theoretically appropriate price of an asset such as security.

     It is also called Sharpe- Linther- Mossion Capital Assets pricing model.

·        Assets sensitivity to non diversifiable risk.

·        Expected return of the market.

·        Expected return of a theoretical risk free asset.

CAPM specifies the relationship between risk and required rate of return on assets when they are held in well diversified portfolio.

Chapter 5 Time value of money

Time value of money is a concept to understand the value of cash flow occurred at different point of time. Every sum of money received earlier has reinvestment opportunity. The money that we receive at future has less purchasing power than the money that we have at present due to the inflation.

Cash flow time line:

Cash flow time line is a graphical presentation of cash flows occurring at different points of time, and is helpful for analyzing the time value of cash flows.

Factors affecting time value of money:

1.   Inflation: purchasing power

2.   Re-investment opportunity: Earning capacity of money

3.   Involvement of risk: future uncertain

4.   Sacrifice of present consumption: saving

5.   Time preference: earlier time

6.   Liquidity preference:

Importance of time value of money:

1.   Valuation of securities and other assets:

2.   Capital budgeting:

3.   The cost of Capital:

4.   Working capital management:

5.   Lease analysis:

6.   Trade off between risk and return

Types of interest:

1.     Simple interest:

2.     Compound interest:

Future value:

The future value is the sum of beginning amount and interest earned. It is the value at some future time of a present amount of money or series of payments, evaluated at a given interest rates.

FV_n = PV (1+i) ⁿ

Where,

FV_n = future value in n period

PV = present value

I= interest rate

Tabulation:

FV_n = PV (FVIF _{i, n)}

Present value:

Present value is the current value of the future amount of money or a series of payments’ evaluated at a given interest rate or discounting rate.

Calculation of Present value:

For single period

PV = FV/ (1+i)

Where,

PV= present value

FV=future value

 I= interest rate

For multiple period

PV = FV_n / (1+i) ⁿ

Annuity:

An annuity is a cash flow stream in which the cash flows are all equal and occur at regular intervals. There are two types of annuities, i.e. ordinary annuity and annuity due.

a)   Ordinary annuity:

Each equal payment is made at the end of each interval of time throughout the period is called ordinary annuity.

b)   Annuity due:

Each equal payment is made at the beginning of each interval of time throughout the period is called annuity due.

Perpetuity:

Perpetuity is a stream of equal payment made at the end of equal interval of time to indefinite period.

Amortized loans:

Amortized loan refers to the loan that is repaid in equal periodic installments including both principal and interest.

Periodic rate:

The rate of interest charged by lender or paid by borrower at each interest period is known as periodic rate.

Annual percentage rate:

The period rate multiplied by the number of periods in a year.

Effective annual rate:

Effective annual rate is the annual equivalent interest rate of a given periodic rate.

v How much money you have to deposit in the beginning of BBS 2^nd year, to complete the BBS, if you have to pay Rs 4300 in the beginning of each year as an admission fee, Rs 750 monthly fee, Rs 1500 annually as examination fee, Rs 5000 educational tour fee and Rs 300 field report fee in the third year Assume 12% annual interest rate and monthly fee is compounded monthly.

Chapter 6 Bond Valuation

A bond is a long term promissory note, promising to pay interest and principal to the holders of the bond.

Bond = long term securities/ assets

Types of bond:

1.     Treasury bonds:

Treasury bonds are issued by government and have no default risk.

2.     Corporate bonds:

Corporate bonds are issued by corporation or companies to raise debt capital.

3.     Municipal bonds:

Municipal bonds are issued by municipality or local government or state.

4.     Foreign bonds:

Foreign bonds are issued by foreign government or foreign corporations.

Coupon rate:

Interest on bonds

Par value:

Issue price/ book value/ face value

Maturity period:

Original maturity:

On call maturity:

Bond valuation:

a.     Perpectual bond:

Regular payment

Maturity period is infinite

b.     Zero coupon bond:

No any coupon payment, maturity period is given this is issued by service sector

c.      Coupon bond with finite period (maturity)

·        Coupon payment

·        Maturity period

Redeemable bond

Value of bond (V₀) = Iₓ PVIFA _{(YTM%, n)} +Mₓ PVIF _{(YTM%, n)}

Callable bond:

Value of callable bond (V_c) = Iₓ PVIFA _{(YTC%, Nc)} +Mₓ PVIF _{(YTC%, Nc)}

Calculation of YTM

Step: 1 Approximate YTM = [I + (M-V₀)/n] /[M + 2V₀]/3

Step: 2 Trial and error method

Try at lower rate and at higher rate

Step: 3 Interpolation

YTM = LR + (V_LR-V₀)/ V_LR-V_HR (HR-LR)

Return from the bond:

1.     Sinking fund:

It is a special provision in a bond contract that facilitates the orderly retirement of the bond or repayment in installment.

2.     Indenture fund:

Written document or agreement between the bond issue and investor

3.     Trustee:

A trustee is the representative of bondholders, who deals with the issuing company. Usually a commercial bank or finance company is appointed as a trustee.

Difference between YTM and YTC:

Basis of difference	YTM	YTC
1.   Maturity:	Full maturity	redeemable
2.   Par value or maturity value:	Call price is at par	Call at premium so call price is not equal to par value.
3.   Value of bond:
4.   Approximate value:

Chapter 7 Stock valuation

Common stock:

1.     Authorized share:

2.     Issued share:

3.     Outstanding share:

4.     Treasury stock:

Features of Common stock:

1.     Par value:

According to Nepal company act 2063 the par value of shares must be Rs 50 or divisible by 50.

2.     Maturity:

Common stock has no maturity time.

3.     Priority assets and earnings:

4.     Voting rights:

5.     Preemptive rights:

Common stockholders often have the right, called the preemptive right, to purchase any additional shares sold by the firm. A provision in the corporate charter or bylaws that gives common stockholders the right to purchase on a pro rata basis new issues of common stock (or convertible securities).

6.     Limited liability:

7.     Classified common stock:

Common stock value:

1.     Book value:

2.     Liquidation value:

3.     Going concern value:

That values that a company realize if it sold its business as an operating business.

4.     Intrinsic value: is Sock valuation

The present value of expected future cash flows discounted at appropriate required rate of return (discount rate).

5.     Market value:

The price of assets at which the asset is traded in the market

Basis of difference	Bond	Share
1.   Face value	Rs 1000	Rs 100
2.   Interest	Coupon interest (fixed)	Dividend (unfixed)
3.   Total return	Interest + capital gain or loss	Dividend + capital gain or loss
4.   Priority	Gets first priority than shares	Shareholders get their money after the payment of all debt and dues.
5.   Maturity	It has fixed maturity period	It has no maturity period
6.   Ownership	It does not have ownership in the company	Shareholders are the owner of the organization
7.   Voting right	They do not have voting right.	They have voting right where 1 share = 1 vote

Common stock valuation:

Dividend discount model (DDM):

Zero growth:

Expected return remain constant forever

Constant or normal growth: Gordon model

Myron J. Gordon, develop and popularize this theory

Net investment operating capital is a two part analysis that looks at two different types of business activities first net investment represents Capital expenditure minus depreciation later being non cash expenses deducted for this cash analysis method.

Capital spending typically means purchases made for items such as property plan or equipment which are long term assets as defined by accounting principles. Operating capital is another term of working capital which is the daily cash available for running of business. The Net investment in operating capital looks as

The net liquid or non-liquid assets a company has for its operation.

Odd dividend policy:

Certain time period, dividend will be added in terms of rupees (money) after that period dividend will not pay for infinite period there is no provision of growth rate.

7-12 c) same value or equal value of stock so, all the strategy are equally preferable.

Preferred stock:

Preference share

Hybrid stock of bond and common stock

Features of Preferred stock:

a)   Regular return/Fixed dividend:

b)   Cumulative dividends:

c)    Par value:

d)   Participative feature:

e)   Voting rights:

f)     Redemption\retirement\maturity:

g)   Call provision:

h)   Convertibility:

i)     Sinking fund:

Valuation of Preferred stock:

1.     Valuation of perpetual stock:

V_ps= dividend/ required rate of return = D_ps/K_ps

Where,

V_ps= current intrinsic value of preferred stock

D_ps= preferred stock cash dividend

K_ps=required rate of return

2.     Valuation of redeemable stock:

V_ps= D_ps/ (1+ K_ps)^t + M/ (1+ K_ps)ⁿ

Where,

M= maturity value

T = time period

n=number of period

V_ps= D_ps*PVIFA _{kps, n} +M*PVIF _{kps, n}

Process or step of computing value of supernormal growth (Non-constant growth)

1.     Find the DPS for the period of non-constant growth i.e. D₁, D₂, D₃ D_n.

2.     Find the value of stock at the end of non-constant growth period or horizon value (P_n)

3.     Find the PV of dividends during the period of non-constant growth.

4.     Find the PV of the horizon/terminal value of stock (PV of P_n)

5.     Add these two components.

Therefore, PV of stock = PV of dividends + PV of horizon value

Chapter 8 Cost of capital

The firms’ overall cost of capital reflects the combined cost of all long term sources of financing used by the firm. Cost of capital is the rate of return that must be earned on investment in order to satisfy all the investor’s required rate of return. It is the minimum required rate of return from an investment at which price of firm’s common stock remains unchanged. It is the discount rate used to calculate the firm’s capital project i.e. NPV and IRR. It is also known as weighted average cost of capital (WACC).

If firms earn a rate of return lower than the cost of capital value of common stock decreases.

Required rate of return< cost of capital= lower common stock price

Basic assumptions:

1.     Constant business risk:

2.     Constant financial risk:

3.     Constant dividend policy:

4.     Constant tax rate:

Use of cost of capital in financial decisions:

1.     Investment decision:

2.     Capital structure decision:

3.     Dividend policy decision:

Source of long term capital

Components of cost of capital/ determinants:

1.     Cost of debt:

2.     Cost of common equity:

                                i.            Cost of debt:

Cost of perpetual debt:

It is also called irredeemable debt.

Before tax cost of debt (K_d) =I/NP

NP = selling price (Par value + premium or -discount) – flotation cost

After tax cost of debt (K_dT) = K_d (1-T)

Cost of redeemable debt:

Before tax cost of debt (K_d) = [I+ (M-NP)/n] / [M+2NP]/3

After tax cost of debt (K_dT) = K_d (1-T)

Cost of internal or retained equity:

a)   Discounted cash flow approach (DCF):

Ø Dividend growth mode/Gordon model:

Ø K_s = D₁/P₀ + g

b)   Capital assets pricing model (CAPM):

K_s = r_f + (r_m- r_f) ɮ_j                            

c)    Bond-yield plus risk-premium approach:

K_s = Bond yield + risk premium

Cost of external equity:

K_e = D₁/NP + g

3.     Cost of preferred stock:

a)  Cost of perpetual preferred stock:

Cost of preferred stock (K_ps) = preferred stock dividend/Net proceeds = D_ps/NP

Where,

Net proceed = selling price (Par value + premium or -discount) - flotation cost

b) Cost of redeemable preferred stock:

Cost of preferred stock (K_ps) = [Pd+ (M-NP)/n] / [M+NP]/2

Marginal cost of capital (MCC) 15marks or weighted average cost of capital (WACC) 10 marks: important

Volume of finance has positive relationship with Marginal cost of capital (MCC)

Below:

WACC = K_dtW_d + K_psW_ps + K_sW_s

Above: funds to be needed

WACC = K_dtW_d + K_psW_ps + K_eW_e

Break point:

The amount of new capital can be raised before an increase occurs in the firm’s WACC.

Chapter 9 Capital budgeting

The planning and management of expenditure on long term assets is called capital budgeting.

Importance/Nature/feature of capital budgeting:

a.     Irreversible decisions:

Only one time decisions

b.     Growth:

Long term effect tends to growth

c.      Large amount of funds:

d.     Risk:

e.     Complex:

f.       National importance:

Process of capital budgeting decision:

1.     Generation of investment proposals:

2.     Estimation of cash flows for the proposals:

3.     Evaluation of the proposals:

4.     Post completion audits of proposal:

Classification of capital budgets:

1)   Independent projects:

2)   Dependent projects:

3)   Mutually exclusive projects:

4)   Replacement projects:

5)   Expansion of business:

6)   Diversification of projects:

Capital budgeting techniques:

A.    Non-discounted cash flow method:

a)    (Cash) payback period (P B P)

ü When annual cash inflows are equal:

PBP = initial investment/Annual cash flow =I/CFA

ü When the annual cash inflows are unequal:

PBP = Minimum year + (Amount to be recover/Cash flow during the year)

Where,

 Amount to be recover = initial investment – minimum year’s cumulative cash flow

Decision: Lowest PBP is better

Advantages of PBP:

                                i.            Simple and easy to understand

                              ii.            Gives an indication of liquidity

                            iii.            It deals with risk (long time →high risk and vice versa

Disadvantages of P B P:

        i.            Ignores time value of money

      ii.            P B P entirely ignores many of cash inflows which occur after the payback.

    iii.            Difficulties in determining the maximum acceptable payback period

   iv.            P B P is not consistent with the objective of maximizing the market value of the firms’ share.

b)    Net present value (N P V)

The sum of the present values of all cash inflows less sum of present values of all the outflows associated with proposed is N P V.

N P V= sum of all P V of cash flow - sum of all P V of cash outflow

= {C F ₁/ (1+i)¹ + C F₂/ (1+i)² +………. CF_n/ (1+i)ⁿ } – CF₀

=C F _a  ₓ P V I F A _i,n –C F₀

c)     Internal rate of return (IRR)

Advantages of IRR:

        i.            It considers time value of money.

      ii.            It is based on the cash flow.

    iii.            It is consistent with the value maximization decision criterion.

NPV=cost of capital (WACC)

IRR=required rate of return

Cost of capital < IRR →project accepted

   iv.            It is easy to understand and communicate to the management and investors in terms of percentage.

Disadvantages of IRR:

        i.            The problem of multiple rates arises in case of unconventional cash flow.

      ii.            IRR may give conflicting decision in case of mutually exclusive project.

    iii.            IRR does not hold value additive principle.

   iv.            IRR does not consider scale of investment.

NPV or IRR which to use:

	YES or NO	Project ranking
Criterion	Choosing whether or not to undertake a single project	Comparing two mutually exclusive project
NPV	The project should be undertaken. If its NPV > 0	Project A is preferred to project B if NPVA >NPVB
IRR	The project should be undertaken if its IRR > r, where r is appropriate discount rate	Project A is preferred to project B if IRRA >IRRB
Where a conflict exists between NPV and IRR, the project with larger NPV is preferred that is, the NPV criterion is the correct criterion to use for capital budgeting. NPV is preferred over IRR because it indicates the increase in wealth that the project produces.

d)    Modified internal rate of return (MIRR)

MIRR overcomes problems of conflicting decision and multiple returns of IRR method by shifting the assumption of reinvestment rate of cash flows from IRR cost of capital (fund) and converting the cash flows into terminal value.

MIRR is the discount rate at which present value of projects cost is equal to present value of its terminal value.

e)    NPV profiles and cross over rate:

NPV profile is a graph that plots a project’s NPC against the cost of capital rate.

Cross over rate is that discount rate where NPV of two projects is equal.

Calculation of cross over rate:

NPV_a =NPV_b

CF_a1 / (1 + k)¹ + CF_a2 /(1 + k)²+ CF_a3 /(1 + k)³+ CF_an /(1 + k)ⁿ –CF_a0 = CF_b1 / (1 + k)¹ + CF_b2 /(1 + k)²+ CF_b3 /(1 + k)³+ CF_bn /(1 + k)ⁿ –CF_b0

FACTORS TO BE CONSIDERED WHILE WRITING BUSINESS PROPOSAL:

a)    Cash flow statement

b)    Profit and loss account

c)     Balance sheet

d)   Evaluation of:

                    i.        PBP

                  ii.        DPBP

                iii.        Breakeven point

                 iv.        NPV

                   v.        IRR

                 vi.        MIRR

Some startup cost (initial investment), revenue and expenditure (Budget)

Chapter 10 Working capital management

Components of Working capital management:

1.     Operating cycle (OC):

OC = ICP+RCP

2.     Capital conversion cycle (CCC):

CCC= OC –PDP

        = ICP+RCP-PDP

3.     Inventory conversion period (ICP):

ICP= 360/inventory turnover

       = average inventory/cost of goods sold ₓ 360

4.     Receivable conversion period (RCP/DSO):

RCP/DSO= 360/payable turnover

               = average payable/cost of goods sold ₓ 360

5.     Payment deferral period (PDP):

Average length of time mainly related with payment for workers and raw materials.

PDP= 360/payable turnover ratio

=360 ₓ payable/cost of goods sold

Working capital financing

Working capital financing = working capital per day ₓ CCC

                                              = Cost of goods sold/360 ₓ CCC

                                              = daily production ₓ Costₓ CCC

Working capital structure

Working capital structure = Cost of goods sold/working capital financing

                                             = Days in year/CCC

How we can shorten the Cash conversion cycle (CCC)?

Determinants of working capital:

1.     Nature of business:

There are two types of nature of business i.e. industrial and commercial business.

Industry needs less working capital due to long operating cycle and commercial business needs larger working capital due to short operating cycle.

2.     Production cycle:

3.     Business/trade cycle:

4.     Dividend policy:

5.     Credit policy:

For e.g. 2/10 net 30

Where 2 represent cash discount

10 represents discount period

Net 30 represent credit periods

Larger the credit period →larger working capital requirement

6.     Price level changes:

Increase in price level → increase working capital requirement and vice versa.

7.     Operational efficiency of manager:

Management efficient → lower working capital requirement and vice versa

Working capital management policies:

A.    Working capital investment policies:

Conservative policy

·        Holding larger amount of current assets

·        Adopts relatively liberal credit policy

·        Firm always maintains high level of current assets to sales

·        Both profitability and risk decline because of holding relatively larger amount of current assets

Aggressive policy/ restrictive

·        Lower ratio of current assets to sales

·        Assumes high risk

·        Find difficult to pay current bills in time, lost in sales because of restrictive credit policy, interruption in production because of shortage of inventory, and so on.

·        Provides highest expected return on investment as it keeps low level of less productive assets.

Working capital financing policy

Conservative/flexible/relaxed current assets investment/fat cat policy

·        Ratio of current assets to sales is high

·        Finances most part of expected fund requirement with long term funds while short term funds are reserved for use in emergency period

·        Results in relatively lower profits since the firm uses more of the expensive long term financing and may pay interest on unused funds

·        Has less risk because of high level of net working capital

·        A firm reserve short term borrowing power for meeting unexpected demand or fund

Aggressive financing policy

·        Use more short term financing to satisfy the financing needs of current assets

·        A firm finances a part of its permanent current assets by short term funds including trade credit, bank lines of credit or commercial paper to minimize cost of investment in current assets

·        Seeks to increase profit by reducing investment in current assets and by using less expensive short term financing sources

·        Increases risk since the firm operates with minimum net working capital

·        May use short term funds for financing some portion of fixed assets too

·        Use of short term funds is cheaper than long term funds

·        Tries to shorten cash conversion cycle in order to reduces amount of working capital requirement and holding cost of inventories

Moderate policy

·        Also called maturity matching or self liquidating approach because this policy tries to match assets and liabilities maturities

·        This policy finances all fixed assets and permanent current assets with long term funds and seasonal current assets with short term fund

·        Ratio of current assets to sales is neither too high nor too low

·        There is problem in exact maturity matching because the lives of assets are not accurately predictable on the other hand firms must use common equity that has no maturity

Policies	Profitability	Liquidity	Risk
Conservative	Low	High	low
Aggressive	high	low	high
Moderate	Moderate	Moderate	Moderate

Chapter 11 Cash management

Cash:

According to accounting – cash is the currency at hand. In broad sense, high liquid and easily available for payment is called cash management. For e.g. currency, coins, negotiable money, order, cheque, bank balance and near cash assets.

Cash management is the process of efficient collection and disbursement of cash, investing the surplus cash in marketable securities and managing the funds to meet the cash deficit and determination and maintenance of optimal level of cash balance.

Significance/importance of cash management:

1.     Management of cash flows:

2.     Meeting the obligatory cash flows:

3.     Capital expenditure projects:

4.     Favourable external financing:

5.     Discount, special purchase and business opportunities:

6.     Investment of surplus cash:

Function of cash management:

1.     Cash planning:

2.     Managing cash flow:

3.     Determining optimum cash balance:

4.     Financing deficit cash balance and investing surplus cash:

Advantages of holding cash:

1.     Advantage of cash discount

2.     Favourable credit rating

3.     Favourable business opportunities

4.     Work against emergencies

Cash management techniques:

1.     Managing collections

2.     Control of disbursement

3.     Using the float

Why cash management?

To determine disbursement of cash and collection of cash

To know the cash surplus and cash shortage where cash shortage will decrease the goodwill and liquidity of the company.

Chapter 12 Receivable management

Effects of relaxing the credit standard

Items	Credit terms relax		Increase in cash discount		Increase in collection effectiveness and capacity
	Change in direction	Effect on profit	Change in direction	Effect on profit	Change in direction	Effect on profit
Sales	Increase	Positive	Increase		None	None
Investment in receivables	Increase	Negative	Decrease	Positive	Decrease	Positive
Bad debt expenses	Increase	Negative	Decrease	Positive	Decrease	Positive
Discount amount	–	–			–	–
Collection expenses	–	–	–	–	Increase	Positive

Control of monetary receivables

a.     Days sales outstanding or average collection period

b.     Aging schedule

Chapter 13 Inventory management

Inventory refers to the goods and materials used by a firm for the purpose of production and sales.

Types of inventory:

1.     Raw materials:

2.     Work in process:

3.     Finished goods:

Main aim of inventory management:

Maintaining optimum investment in inventory

Excessive investment in inventory → higher cost of fund being tied up, misused, lost, damage, reduces in profitability

Insufficient investment in inventory → stock out problems, interruption in production and selling operations

Significance of inventory management:

Objectives of holding inventory:

1)   To avoid losses of sales:

2)   To gain quantity discounts:

3)   To reduce order costs:

4)   To achieve efficient production run:

Cost

1.     Carrying cost

2.     Ordering cost

3.     Number of order

Chapter 14 Dividend policy

1.     Dividend payout ratio

2.     Retention ratio

Dividend payout procedures

1.     Dividend declaration date

The date on which a firm’s directors issue a statement declaring a dividend

ü Set the amount of dividend to be paid

ü Holder of record date

ü Payment date

ü Announced as a percentage of the par value of stock or absolute value

2.     Date of record/holder of record date

The date when company opens the ownership books to determine who will receive the dividend; the stockholders’ record on this date receive the dividend.

3.     Ex-dividend date

The date several days (normally 2 days) prior to record date share purchased after the ex-dividend date as not entitled to the dividend

4.     Payment date

The date on which the firm actually pay the declared dividend

Dividend payout scheme

Forms of dividend (types)

A.    Cash dividend

B.    Stock dividend

C.     Property dividend

D.    Bond dividend

E.     Script dividend

Further issues in dividend policy

Factors affecting dividend policy

Important  

1.     Definition and significance of inventory management