No Slide Title

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Sandeep Gokhale

Financial Management

Sandeep Gokhale1

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References

Financial Management Authors :Khan & JainPrasanna ChandraMyersVan Horne

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Syllabus

Ratio AnalysisFund & Cash flow analysisCost of CapitalWorking Capital Mgmt.Means of FinancingCapital BudgetingDividend StructuringBonus SharesShare Holder Value Measurement

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Corporate Financial Objective Objective: Create share holder value Methodology: Capturing of value at all Levels.

Business Process restructuring

Enterprise resource management.

Vertically integrated operations.

Customer relationship Management Sustained up scaling of operations

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Financial Management an Overview Business Environment

Planning Policies & Decisions(Management Accounting)RestructuringResource MobilizationTreasury Control & Information( Audit & Taxation)Valuation TechniqueFinancial Markets

Investor Preferences

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BackFiscal deficit / Inflation / Interest ratesFDI Incoming / OutgoingGDP Industrial Growth rateExim Policies CADRole & Intervention of Central BankConvertibility of INRAgricultural growth SubsidiesNon-plan ExpenditureDirect / Indirect tax regimeGovt. Programs & ExpenditureRegulators, Judiciary Role & CanvasAttitude towards consumption & investment

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Back

Exit OptionsUnderlying Asset class SPVsStrategic InvestorFinancial InvestorFDI limits

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Back

Role of RegulatorDepth & width of secondary debt & equity marketFloting stock Listing norms

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Back

Analysis of Historical performance and estimate continuing value.Rate of discount in holding company structure collapsed SPVAsset based valuation replacement costMarket based PE multipleEarnings based EV - DCF

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Government Policy:Industrial policyGovernment programmes and expendituresTax regime Direct & IndirectAllocation of natural resourcesTax regime & jurisdiction GAAR MAT Lending norms of Institutions and banksInfrastructure Development & CPSUsRating of Govt paperGAAP : Consolidation of AccountsConsequential ownership thresholds in holding Co structures.

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Technology:Emergence of new technologies.Access to technical Up gradationLevel of obsolescence.Socio Demographic:

Population trendsAge shifts in populationEducational profile.Attitudes toward consumption and investment

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Competition:Number of players in the industry and their market share.Duty barrier and status of international cost and volume positioning.Degree of homogeneity and differentiation among products.Entry barriers for new capacities.Comparison with substitute products.Unorganised sector operations. Marketing polices and practices.

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ORGANISATIONAL INTERFACE OF FINANCE AreasInterfaceCorp planning:Long term financial goals in terms of assets, sales,profits,dividends etc.Expansion, new projects diversificationstakeovers , mergers,disinvestments.Internal generation, tax planning.

Operations:Integrating functional plans.Working capital management

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AreasInterfaceControl:Budgetary control of all divisionsVariance analysisMarketing:Credit normsCost analysis of decisions like discounts , premium pricing,product promotion etc.

Manufacturing:Budgeting for manufacturing operations.Product mix decisions.

Personnel:Budgeting for personnel & administrative function.

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FINANCIAL FUNCTION

Money Mgmt

Accounting

ControlAdvisory Role

Resource Mobilisation

Financial Accounting

BudgetsProject Financing

Working Capital MgmtCost AccountingVariance AnalysisPricing

Investment MgmtMgmt AccountingProfit CenterDiv. Policy

Valuation of Assets

Cost Center

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Financial Decision AreasInvestment analysisWorking capital managementSources and cost of fundsDetermination of capital structureDividend policyAnalysis of risks & returnsTreasury - interest / exchange rate swapsRestructuring of operations / term debt profileEquity buyback / Bonus / Capitalisation

To result in shareholder wealth maximisation

Sandeep Gokhale16

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PROFIT AND LOSS ACCOUNTFor the Period 1st April to March 31stIncome:Gross sales from Goods & ServicesLess: Excise DutyNet SalesOther IncomeNon operating IncomeTotal Income

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Expenses

Raw materials consumedManufacturing expensesAdministrative expensesSelling expensesWIP +FG adjustmentPBIDT (Gross Profit)Less: InterestLess DepreciationPBT (Operating Profit)Less: TaxPAT (net profit)Gross cash accruals : PAT + DepnNet cash accruals : GCA - Dividend

Sandeep Gokhale18

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THE BALANCE SHEETAs on March 31st ...Liabilities:Equity share capitalReserves & SurplusTerm loanDebenturesFixed depositsOther unsecured loansCommercial bank borrowingsCreditorsOther current liabilities

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Assets:Gross fixed assetsLess: Acc. DepnNet BlockInvestmentsCurrents Assets: RM Stock WIP F.G.Stock Debtors Cash in bankLoans & AdvancesDeferred expenditureOther Current assets

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RATIO ANALYSIS

Principal tool for analysis

Inter firm comparison

Intra firm comparison

Industry analysis

Responsibility accounting

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TYPES OF FINANCIAL RATIOS Liquidity

Leverage

Turnover

Profitability / Valuation

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LIQUIDITY RATIOSCurrent Ratio: Current assetsCurrent liabilities

Acid test ratio:C.A- InventoriesCurrent liabilities

Cash position ratio:Cash in bank + handCurrent liabilities

Inventory to G.W.C:InventoryCurrent assets

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LEVERAGE RATIOS Debt / Equity ratio:Long term debtNet worth

Borrowing / Assets: 1 - Net worth Total Assets

Fixed asset / Networth:Fixed AssetsNet worth Total Debt / EBIDTA : 5 times

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Capital gearing ratio: Capital entitled to fixed return Capital not entitled to fixed return

Debt. Service coverage ratio: PBDIT - Tax Interest + Annual installment

Interest coverage ratio: PBDIT - Tax Interest

F. Asset coverage ratio: Gross fixed asset - Acc. Depn LT Secured liabilities

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ACTIVITY RATIOS

Total asset turnover: Net salesTotal assets

Fixed asset turnover: Net salesFixed assets

Inventory turnover: Net sales Inventory

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Debtors turnover:Credit salesAvg. debtor

Collection period:Avg. debtor * 365CR. Sales

Creditors Turnover:Credit purchaseAvg.. Creditors

Payment period:Avg. Creditor * 365Net Purchases

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PROFITABILITY / VALUATION RATIOS

Gross profit ratio: PBDIT / Sales EBITDA / SalesRONW : PAT / Networth ROSE: PAT - Pref. Div Net worth Return on CAP. Employed: PBIT Total Lia - Creditors ProvisionsReturn on Investment : PBIT / Investments

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Book value per share: Net WorthNO of Equity SharesEV / EBITDA: Enterprise value / Gross profit Earning per share:PAT - Pref DivNo. of Equity shares

Price Earning ratio:Market priceEarnings per share

Pay out ratio:Dividend paidProfit after Tax

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USERS OF FINANCIAL RATIOS

Lenders of funds for appraising credit worthiness for long term / short term lending decisions.

Valuations in investment / disinvestment decisions.

Financial analyst / Mutual Funds / Investment Bankers.

Management for operational short / long term planning.

Credit Rating Agencies

Tax authorities

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LIMITATIONS OF RATIO ANALYSISA ratio in absolute terms has no meaning. It has to be compared. Inter firm comparison.Companies resort to window dressing of Balance sheets.Operating and accounting practices differ from company to company.Consolidation of group / subsidiary companies figures.E.G.Changes in Depreciation methodsInventory ValuationTreatment of contingent liabilities.Valuation of investments.Conversion or transaction of foreign exchange items.

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FUND FLOW ANALYSISIt is a statement indicating the methods by which a company has been financed and the uses to which it has applied its funds over a period of time.

It provide an insight into the movement of funds and helps in understanding the changes in the structure of asset & liabilities.

Provides information as to how funds are raised and utilised.

Determines need for funds and helps in deciding finance mix

Determines financial consequences of business decisions.

Free cash flow generation ability and Utilisation of the same.

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FUND MANAGEMENT

Mobilisation Requirement

Quantum

Source

Cost

Normal Capital expenditureIncrementalWorking capital

New Investments

Equity Buy back

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FUND FLOW OCCASIONSSourcesUsesFunds from operationsLoss from operations

Sale of fixed assetsIncrease in fixed assets

Increase in liabilitiesRedemption of liabilities

Sale of securitiesPurchase of securities

Decrease in W.CIncrease In W.CCash Dividends, Equity buy back

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FUND FLOW

Assets Uses of funds

LiabilitiesUses of funds

AssetsSource of funds

LiabilitiesSource of funds

Comparison of balance sheets of consecutive years.

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TYPES OF FUND FLOW STATEMENTS

OVERALL FUND FLOW

OPERATIONAL FUND FLOW

WORKING CAPITAL BASED FUND FLOW(ONLY STS/STU STATEMENT)

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COST OF CAPITALAggregate of the liabilities raised by a company is the total capital employed in business.

Different sources have different cost and tax implications.

Cost of capitalIt is a single rate (weighted average ) for a finance mix.It is computed on a post - tax basis since cost of different sources have different tax implicationsE.g.. Interest on debt capital enjoys tax shield while dividend paid on equity has no tax shield.COC is used as a discounting rate in DCF analysis.

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RELEVANCE OF COC

Used as a hurdle rate in DCF analysis.Wt. Average cost of capitalMarginal cost of capital

K0 = Ki + Ke

K0 = WT. Average cost of capitalKi = Cost of debt capitalKe = Cost of equity capital

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COST OF CAPITAL

Consists of three components:

Risk less cost of a particular type of finance (rj)

Business risk premium(b)

Finance risk premium(f)

K0 = rj + b + f

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RELATIONSHIP BETWEEN WEIGHTED AVERAGE COST AND MARGINAL COST OF CAPITAL

Degree of leverage

Cost of instruments

Tax Rate / Treatment

WACOC :K0 1 = Ki1 + Ke1

MCOC :K0 2 = Ki2 + Ke1

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METHODS OF COMPUTATION OF COST OF EQUITYROI approach

Ke = PAT - pref. div + non tax shield portion of depnEquity block (E + R +S + acc depn)

Market capitalisation approachKe = D/P + GD = Dividend per shareG = Growth rate P = Market price per share

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Capital Asset Pricing model

Ke = Rf +beta ( Rf Rm)

Rf = risk free rate of returnBeta = stock relationship with a index Rm = Market expectations of return ( Bloomberg base )

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If ROI approach is used to determine Ke then book value to be considered as weights.If market capitalization approach is used then market value to be considered as weights.All cost to be considered on a post tax basis.The market capitalization approach is superior to the ROI approach since the parameters are market determined and futuristic as compared to the ROI approach.The CAPM approach is a further refinement which also includes premium for riskIn loss making companies minimum cash flow approach is used.Cost of equity could be benchmarked with return on guilts,market risk and portfolio risk ( Asset Beta )

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WORKING CAPITAL MANAGEMENT

Objective:Optimise current asset deployment.

Advantages:Lower interest cost.Inventory holding cost reduced.

Disadvantages:Interruption in production.Stock out to customers.

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ASSET STRUCTURE FOR VARIOUS INDUSTRIAL SEGMENTSFACAPower Generation80%20%Chemical process plants50%50%Engineering40%60%Service20%80%Trading10%90%

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WORKING CAPITALCurrent assets comprise of stocks of raw materials, work in progress, finished goods, and receivables.Gross working capital = total current assets.Net working capital = CA - CLObjective is to optimse asset requirement and funding the same at minimal cost.

Working capitalrequirement

Permanent componentVariable component)

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CONSTITUENTS OF CURRENT ASSETS

Raw material stockWork in progressFinished goods stockCash in hand / bankDebtors / Receivables

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OPERATING CYCLE TIMETime required for rolling or rotation of current assets.

Date of receipt RM issued toThroughput timeof RM production Dept

Collection of Despatched to consumers Converted to FGReceivables

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FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTSNature of businessManufacturing processCompetitive forces in raw material & finished goods segment.Infrastructural support.Through put timeSeasonality in demandShelf life of RM / Finished product Customer relationship management

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CREDIT MANAGEMENT

Terms of paymentCash against deliveryConsignee basisProforma invoiceLetter of creditAdvancesSuppliers / Buyers LOCCredit policy variablesCredit standardsCredit periodCash Discounts

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Credit evaluationCharacterCapacityCapitalCollateralMacro conditions

Control of accountsDays sales outstanding receivablesAgeing schedule (in days)Collection matrixAverage collection period

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RECEIVABLES MANAGEMENT

Credit standardsCollection costAverage collection periodBad debtsLevel of incremental saleCredit terms

Collection policies

Factoring

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WORKING CAPITAL FINANCING

Cash accrualsTrade creditCommercial bank borrowingsCash credit limitWCTLBill discountingLetter of creditBank guaranteePublic deposits

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Short term / medium term loans from FIs BanksDebentures for working capitalCommercial Paper.Euro Commercial BorrowingsInter Corporate depositsTrade credit notes ( commodity exchanges )Factoring

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Long Term Financing

Basis of evaluationAvailabilityFlexibilityCost

Availability : should be available at the point / time when requiredFlexibility : certain instruments are user/ application specificCost : to be evaluated on a post tax basis

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SOURCES OF TERM FINANCETerm loans from Financial institutions & BanksState level financial institutionsDebentures:NCDPCDOFCDFixed DepositsEquity share capitalEquity shares with Differential voting rights.Non voting sharesPreference share capital

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Retained earningsExchangeablesVenture CapitalDeferred payment guranteesLeasingExternal commercial borrowingsDepository receiptsFloating interest rate Debt.Securitisation of future receivablesDerivative linked bonds

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FINANCIAL / INVESTMENT INSTITUTIONSThey are major source of long term debt funds for financing:Fixed AssetsMargin money for working capital Indian FIsIDBI / ICICI / IFCI / IIBIForeign InstitutionsSectoral InstitutionsHDFC / IL&FS / HUDCO / IDFCUniversal BanksICICI Bank

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Investment institutionsGIC & SubsidiariesUTILICInvestment Banks23 State level financial institutions (IDCs)23 State level financial institutions (MSFC)

Scheduled Commercial Banks

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Features:Interest rate is based upon the base rate + risk. Basic interest rate linked to inflation rate Linked to G-Sec rate or SBI FD rate Security Hypothecation & mortgageCollateralCovenantsMoratorium periodAmortisation scheduleDoor to Door tenure

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GUIDE LINES FOR KEY RATIOS

DCSR > 1.8 TIMESD/E 1:5:1Promoters contribution : 20 - 25%CR: > 1.33ADDITIONAL FEATURES :Interest rate re-set clause Tapering of interest rate post project risk

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Debentures:

Approval from SEBI mandatory if public issue is proposed

Debentures used to finance margin money not to exceed more than 20% of N.W.C

Convertibility clause terms to be specified at issuance time.

Credit rating mandatory

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Types of Debentures: NCDFCDPCDOCDCoupon rate depends on terms of issue.

Other featuresNo TDS for interest paid upto Rs 2500 per annumRedemption premiumListing on stock exchangesFully securedCall and put options

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Advantages from Issuers point of view:Lower cost due to low risk and tax deductibility of interest payment.No / limited dilution of controlOffer stable return to investors having fixed maturity and subsequently redemption/ conversion to equityNo increase in equity base during non conversion period

Fixed depositsLimit on quantum : 25% of networthCost : 8-10 % depending on maturity period & riskunsecured

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EQUITY SHARE CAPITAL

Authorised , issued, subscribed and paid upPar value, issue price, book value, market valueResidual claims on Income /AssetsNo upper limitCostliest sources of financeEntails permanent servicing by way of dividends without tax shieldVoting rights/ Control in management/ Limited liabilityUnder preview of SEBI and SEB guidelinesBuy Back allowed

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Equity investments in foreign cos allowed to resident indian shareholder in the event foreign co has 10% stake in Indian co.For Listing on exchanges atleast 25% to be offered to the public by way of a prospectusIssuance of Non-Voting & differential rights shares allowedDebentures on conversion becomes equity share capital.Listed / Unlisted sharesSweat Equity / Employee Stock Options

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EVALUATION OF ESCCompanys point of viewAdvantagesRepresents almost permanent capitalDoes not involve any fixed obligation for servicingEnhances credit worthiness of the company to secure additional debt.DisadvantagesHigh cost of capitalDividends paid on profit after tax further subjected to dividend distribution tax of 15%High flotation costDilution of control (Treasury issue)

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Investors point of viewAdvantagesEnjoy voting right in the company with limited liability.Short term capital gains tax reduced to 10%Long term Capital gains tax abolished. ( Exchange traded securities ) Indexation benefit available under 54E.DisadvantagesControlling power could be notionalTurn over tax on sale of the security on an exchangeHave residual claim to income / assetsVide fluctuations in stock priceDividends subjected to distribution tax of 15%

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Retained earnings

Made up of Accumulated depreciation and retained profits.

Represent the internal sources of finance available to the company.

Availability : Level of profitability / payout ratioCost : Identical to ESC.Flexibility : High

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DisadvantagesHigh opportunity costLimitation on amountBonus issue may capitalise reservesAdvantagesReinvestment of profit may be convenient to many shareholders.No dilution of control since Co. Relies on retained earningsNo flotation cost/ Losses on account of underpricing.Proceeds could be used in a subsequent buyback.

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Preference share capital

Fixed minimum dividend rateNo voting rightsPrior claim on income / assetsRedeemable at issuers & investors discretion

Features:No dilution of controlProvision to skip dividend in absence of profits

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CAPTAL BUDGETING

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Capital investment decisionCapital investments involve increase in the fixed assets of a company.(Expansion / diversification / Green field / takeover / merger)Characteristics of investmentsCapital outlay needs to be made up front returns come laterCertain amount of risk is involvedCapital investment tend to be indivisible. (difficult to phase out).Financial techniquesThe purpose of financial techniques is to enable the making of investment acceptance / rejection decisions.

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Non financial factors in project appraisalMarketTechnicalInfrastructureEcologicalEconomicInfluence of non - financial factorsFinancial projectionsGestation periodProfitabilityLife of project / Terminal valueSensitivity analysis

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NON FINANCIAL FACTORS DETERMINING FINANCIAL VIABILITY OF PROJECTS

Market factorsPresent and future size of the marketPresent and future demand and supply situationAchievable market shareSelling & distribution channels

Technical factorsLevel of Technological obsolencePlant locationScales of operationRaw material & utilities consumption norms

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Ecological factorsPollutant levelsTreatment of effluentEnvironmental impact of the project

Economic factorsSocial cost benefit analysisEconomic rate of protectionDomestic resource costProtection enjoyed by industry.

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FINANCIAL TECHNIQUES IN CAPITAL BUDGETINGReturn on investmentAVG ROI =PBIT(over 10 yrs) Total Inv.AdvantagesSimple to calculate and easy to understandMaximisation of shareholders wealth and maximising the market value of investments..DisadvantagesTime value of money not consideredIt is a concept based on profit and not cashNo objective criterion for acceptance / Rejection decision.

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Payback period

It is the time required to get back the original investment companies going through liquidity crisis /for small investments will use the pay back period method.

DisadvantagesCash inflows / Outflows after payback Period are ignored.Time value for money is ignored

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Discounted cash flow (DCF)Cash inflow and outflow for the entire life of the project is considered. It considers time value for money as a result earnings in earlier years have higher value than earned in later years.IRR MethodIRR is that rate of discount at which the net present value of cash flows equals net present value of cash outflows.If IRR > COC Investment is support worthy.NPV methodUsing COC discount the netflowsIf NPV is + VE investment is support worthy..

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Comparison of elements

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Comparison of elements

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CONCEPTS IN CAPITAL BUDGETINGLife of project Physical Market Techno efficientIncremental principle Sunk / Allocated costs to be ignored Only incremental cash flows to be consideredEvaluation of post tax basis since COC is on a post tax basisPrinciple of separation of Finance from Investment decision. Financing cost (interest) to be ignored.Effect of tax shield on the company as a whole to be considered

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PROJECT COST COMPONENTSLandCivil ConstructionPlant & MachineryMisc Fixed AssetsErection and commissioningTechnical Know how feesPreliminary & preoperative expensesContingenciesTotal Capital CostMargin money for working capitalTotal project cost

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PROJECT CASH FLOWSCash outflowsCapital expenditureMargin moneyNormal capital expenditureCash inflowNet cash accrualsSalvage valueRecovery of WC

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NPV vs IRR conflictNPV is technically superior to IRR and is also able to handle selection of mutually exclusive projects.The decision rule for the NPV assumes that cash flows resulting during the life cycle of the project have an opportunity cost equal to the discount rate used.The decision rule for the IRR assumes that such resulting cash flows have an opportunity cost equal to IRR which generated them.NPV approach provides an absolute measure that fully represents the value from the project to a company.IRR by contrast provides a % figure from which the benefits in terms of wealth creation cannot be grasped.

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Capital Budgeting Sensitivity AnalysisMonte Carlo Simulation

Break even analysis

Decision tree analysis

Expected value Criterion

Alternate business plans

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Share holder value creationCash DividendsStock DividendsBonus SharesBonus Debentures-issued from free reservesEquity Buy back / Secondary ListingStock SplitSynergic Investments Synergic AcquisitionsDisinvest out of unrelated businessesShares of holding co. with fungibility

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DIVIDEND STRUCTURING

Appropriation of PAT towards Dividend pay out and Reserves

Payout ratio = Dividend paid / PAT Retention ratio = PAT - Dividend paid / PAT Dividend rate (%) could be high but payout could be low.Dividend rate will be depended upon the PAT, Payout ratio and Equity base.

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Dividend Structuring100% retention scenarioFor some shareholders dividend acts as a regular income source EX: investors for whom it is a regular source of income, mutual funds, investment companies.Declaration of dividend is perceived as an indication that the companies operations are profitable.100% payout scenarioRepeated raising of capital increases floatation costCompanies requirement for expansion / margin money / new investment.Tax inefficient due to 15% distribution tax. Though not csacaded in a holding Co structure.

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Factors influencing dividend policy

If the appetite for funds is high due to increase in level of existing operation or due to major capital investment plan then a high retention policy will be adopted.

A closely held company having major capital investment plans will follow a low pay out policy so that internal accruals could act as a major source of finance in the future thereby reducing dependence on infusion of fresh equity.Tax implications Company has to pay 15% distribution tax. Receipt of dividend tax exempted in the shareholders hands. Grossing up of DDT allowed to prevent cascading effect.

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Restriction in loan agreement / government regulations / FIs on on payment of dividend during the currency of the loan.Legal requirement under Companies act.Liquidity position : Higher PAT does not necessarily mean healthy liquidity. A strained liquidity position would force a policy of low payout.Stability in the rate of dividend : companies usually follow a policy of gradually rising or stable dividend policy and not directly link it with PAT.Generally the Indian corporate sector follows a payout policy of 30% . The retention ratio keeps increasing so as to counter inflation, floatation cost, help in Equity buyback etc.

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BONUS SHARESBonus share are issued to existing share holders as a result of capitalization of reserves.In the wake of a bonus issueThe shareholders proportional ownership remains unchangedThe book value, market price, E.P.S decreases.Fallout of a bonus issueNormally the Ex-bonus price comes down by the proportion of bonus given with a mark up of approximately 30 - 35%More active trading in stock exchanges.The nominal rate of dividend tends to decline this may dispel the impression of profiteering.Shareholders regard a bonus issue as a firm indication that the prospects for the company are good.Capital gains tax exemptions with indexation available for bonus issue

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GUIDELINES FOR ISSUE OF BONUS SHARESIssuer : Security exchange board of IndiaBonus issue should be made from capitalisation of free reserves built out of genuine profits and share premium.Reserves created by revaluation of assets, statutory reserves etc. are not allowed for capitalisationBonus issue greater than 1:1 allowedResidual reserve test: residual reserves after the proposed capitalisation should be at least 40% of the increased capital For computation all contingent liabilities, statutory reserves and revaluation reserves to be excluded.Yield test: 30% of the average P.B.T for the last 3 years should give a return of at least 10% on the enhanced capital.Bonus in lieu of dividend is not permitted

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If R = Reserves before bonus issue S = Share capital before bonus issue B = Bonus Quantum PRT = Average PBT for last 3 years RPT = .4 (S + B) > (R - B) YIELD TEST = .3 (PBT) > (.1) (S+B)

Bonus issue also to be given to debenture holders if there is an impending conversion.

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ElementsPaybackNPVIRR

Net investment.ComparablecomparableComparable

Subsequent investment

Possible to use rough approx.Exact timingExact timing

Recovery of terminal value

Not PossibleSpecific economic impactSpecific economic impact

Accounting profit

Rough approximationNot relevantNot Relevant

Operating cash flowApproximation of patternNot relevantNot relevant

Year by year operating cash flow pattern Cannot accomodateExact economic impactExact Economic impact

Economic LifeNot consideredIntegral to analysisIntegral to analysis

ResultYears to cover the initial investmentNet Balance of equivalent cash inflows and outflowsYield rate of discount equating inflows and outflows.