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8/6/2019 Module1 FM
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S.Niroop, GAT 0
Introduction to
Financial Management
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S.Niroop, GAT 1
Business
Business is an economic/financial entity &
involves economic/financial activities..
Trading activity
Manufacturing activity
Servicing activities
Buying Selling
Buying Processing Selling
Servicing
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Business Organization/entities - Forms
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Business Organization/entities - Forms
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S.Niroop, GAT 4
Business Organization/entities - Forms
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Business Organization/entities - Forms
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Purpose of an economic entity -
Wealth creation
Wealthmanagement, and
Wealthdistribution
Objective To create the best possible values andshare them in the equitable manner among all the
stakeholders.
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Stakeholders in the Business
Investors- Equity holders- Debt holders including banks and financial
institutionsSuppliersDistributors and retailers
EmployeesCustomersCommunity
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Financial Management for a Startup firm
Lets Suppose think you are planning to start your
own business.
No matter what nature of business
What are the questions you think you need toanswer ???
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May be all these..
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Business Finance
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Nature of Financial Management
Financialmanagement ismainly concerned
with the propermanagement of
funds.
It refers to theapplication of
financialmanagementtools and
techniques tocoordinate all the
financialfunctions in the
business
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Financial ManagementDEF
INITIONSAccording to Solomon Financial Management
is concerned with the efficient use of an important
economic resource, namely capital funds
Phillippatus Financial management isconcerned with the managerial decision that result
in the acquisition and financing of short term &
long term credits for the firm.
S.C Kuchhal Financial management deals with
procurement of funds and their effective utilization
in the business.
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Financial Management
Financial management is that managerial activity
which is concerned with the planning and
controlling of the firm's financial resources.
Planning, directing, monitoring, organizing andcontrolling of the monetary resources of an
organization.
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Financial Management
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Scope of Financial Management
1. Traditional Approach
It is concerned with raising of funds andadministration of funds
Raising funds from financial institutions
Maintaining proper records and legal activities
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Modern approach
To decide how much amount is required from
where and maintain records.
What type of assets are required In what ways the funds are utilized i.e optimum
utilization
Taking dividend decision
Scope of Financial Management
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Objectives of Financial management
Profit Maximization
Wealth Maximization
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Objectives of Financial management
1.Profit maximizationDecision making in order
to maximize profit.
Profit
Owner oriented conceptamount and share ofnational income paid to the owners of business
Operational conceptvalue created by the use of
resources is more than the total of the input
resources (Profitability)
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Profit maximization
It is Vague
It Ignores the Timing of Returns
It Ignores Quality aspect of benefits
Assumes Perfect Competition
Direct relationship between risk and profit
Timing of benefits cash flow pattern
Narrow concept ignores socialconsideration
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Wealth Maximization
Wealth maximizationMaximizing the value\wealth
of the shareholders, i.e. the market price of the
companys common stock.
ExactnessWealth is based on cash flows and not
on accounting profit.
Quality of benefits-rate ofEPS & capitalizations
rate Time value of moneytiming of benefits
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Wealth Maximization
Maximizes the net present value
Fundamental objective maximize the market
value of the firms shares
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OTHER OBJECTIVES
Anticipatingfinancialneeds
Acquiringfinancial
resources
Allocatingfunds inbusiness
Administratingthe allocation
of funds
Analyzing theperformance
of finance
Accountingand reporting
to themanagement
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S.Niroop, GAT 24
FINANCE MANAGER
Initially Financemanager was
handling the rolesof accountant.
His role wasto raise fundsfrom different
sources
Modernchanging
economy haschanged the
role ofFinance
manager.
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S.Niroop, GAT 25
CHANGING ROLES OF A FINANCE MANAGER
1.Estimating the requirements of funds
2.Decision regarding capital structure
3.Investment decisions
4.Dividend decision
5.Cash management supply of funds to all parts of the organization
6.Evaluating the financial performance
7.Financial negotiations
8.Keeping touch with stock exchanges
9.Mergers , acquisitions & restructuring
10.Tax planning.
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CHANGING ROLES OF A FINANCE MANAGER
11. Performance Management
12. Risk Management
13.Investor Relations
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ORGANIZATION OF FINANCE FUNCTION
Financial Management in many ways is an integral part of thejobs of managers involved in Planning, resources allocation
and control.
The responsibilities for financial management are dispersed
throughout the organization.
e.g. A Purchase manager influences the level of Investment in
inventories.
A marketing Analyst provides inputs in the process of
forecasting & planning.A sales manager has a say in the determination of the
receivables policy.
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ORGINISATION OF FINANCE FUNCTION
To know, that there are many tasks of financial managementand allied areas( like accounting) which are specialized in
nature and which are attended by specialists.
These tasks are typically distributed between to key financial
officers of the firms, the Treasurer & the Controller.
A Treasurer is mainly responsible forFinancing & Investmentactivities
A Controller is concerned primarily with accounting and
control.
The ChiefFinance Officer, who may be designated asDirector(Finance) or VP(Finance) supervises the work of the
treasurer or controller.
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ORGINISATION OF FINANCE FUNCTION
Treasurer Controller
Obtaining Finance Financial Accounting
Banking Relationship Internal Auditing
Cash Management Taxation
Credit Administration Management Accounting
Capital Budgeting and control
Even though a firm may not have separate financial officers designated as
treasurer and controller, it is helpful to distinguish the functions of treasure &
controller
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ORGANIZATION OF FINANCE FUNCTION
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ORGANIZATION OF FINANCE FUNCTION
Reason for placing the finance functions in thehands of top management
Financial decisions are crucial for the survival of
the firm.
The financial actions determine solvency of the
firm
Centralization of the finance functions can result ina number of economies to the firm.
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CHANGING SCENARIO OFFINANCIAL MANAGEMENT IN
INDIA
Interest
rates havebeen freed
fromregulations
Rupee had
become fullyconvertibleon currentaccount
Optimumdebt-equity
mix ispossible
Free pricingof issues
Liberalizedscenario of
capitalmarkets
Ensuring
managementcontrol with
foreignparticipation
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S.Niroop, GAT 33
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Financial Management Decisions
Capital budgeting
What long-term investments or projects should thebusiness take on?
Capital structure How should we pay for our assets?
Should we use debt or equity?
Working capital management
How do we manage the day-to-day finances of thefirm?
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Finance Functions
1.Investment decision
Selection of particular projects for investments(based on ROI)
This is also known as Capital budgeting, and itrefers to the decision to invest in long termassets.
The assets are expected to be used over a long
period of time e.g. when a firm acquires plantand equipment or replaces an old equipment orwhen you invest in research and development.
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Importance of Capital Budgeting
It determines the asset mix and hence the
business risk.
It involves heavy initial outlays of the business
resources.
Benefits accrue in future which future is
associated with risk and uncertainty
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Working Capital Decision
This is the decision concerned with the short term
assets/resources an organization uses to meet its
day to day obligations.
Such assets include:
Cash reserves of the organization
Funds collected from debtors of the organization.
Inventories
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Financing decision
Objective is to minimize cost of capital This is the decision concerned with the sourcing
of funds that are utilized under the investment
decision.
Much management time and effort is devoted totrying to ensure the adequacy of the company's
profit flow.
However, it is just as important that a company
has an adequate flow of funds if it is to remain in
business and very much less management time
and effort is devoted to this need.
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Dividend Decision
The Financial Manager has to decide on what to do
with the earnings once they have been realised.
There are three options,
To declare and pay all dividends to shareholders
To retain all the earnings and hence declare and
pay no dividends
To decide on what proportion to be paid and whatto be retained.
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Capital BudgetingDecisions
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Risk Return Trade Off
Financial Decisions involve evaluation of
alternative course of action
To every course of action there is a diffrisk
return implications attached
Financial decision = calculated amt of risk nFinancial decision = calculated amt of risk n
return involved = creating the value for thereturn involved = creating the value for the
firmfirm
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Investment Evaluation Criteria
Three steps are involved in the evaluation of an
investment:
Estimation of cash flows
Estimation of the required rate of return (the opportunitycost of capital)
Application of a decision rule for making the choice
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Determining Cash Flows for
Investment Analysis
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Cash Flows Versus Profit
Cash flow is not the same thing as profit, at least,
for two reasons:
First, profit, as measured by an accountant, is based on
accrual concept. Second, for computing profit, expenditures are arbitrarily
divided into revenue and capital expenditures.
CF (REV EXP DEP) DEP CAPEX
CF Profit DEP CAPEX
!
!
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The Cost of Capital
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Introduction
The projects cost of capital is the minimum
required rate of return on funds committed to the
project, which depends on the riskiness of its
cash flows.
The firms cost of capital will be the overall, or
average, required rate of return on the aggregate
of investment projects.
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Significance of the Cost of Capital
Evaluating investment decisions,
Designing a firms debt policy, and
Appraising the financial performance of topmanagement.
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The Concept of the Opportunity Cost of
Capital The opportunity cost is the rate of return foregone
on the next best alternative investment
opportunity ofcomparable risk.OCC
. Equity shares
Risk
. Preference shares. Corporate bonds.
Government bonds
. Risk-free security
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General Formula for the Opportunity Cost of
Capital Opportunity cost of capital is given by the following
formula:
where Io is the capital supplied by investors in period 0(it
represents a net cash inflow to the firm), Ctare returns
expected by investors (they represent cash outflows to
the firm) andk
is the required rate of return or the costof capital.
1 20 2
(1 ) (1 ) (1 )
n
n
CC CI
k k k
!
L
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The opportunity cost of retained earnings is the
rate of return, which the ordinary shareholders
would have earned on these funds if they had
been distributed as dividends to them.
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Weighted Average Cost of Capital Vs. Specific
Costs of Capital The cost of capital of each source of capital is known as
component, orspecific,cost of capital.
The overall cost is also called the weighted averagecost of capital (WACC).
Relevant cost in the investment decisions is the futurecost or the marginal cost.
Marginal cost is the new or the incremental cost that thefirm incurs if it were to raise capital now, or in the nearfuture.
The historical cost that was incurred in the past inraising capital is not relevant in financial decision-making.
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Evaluation Criteria
1. Discounted Cash Flow (DCF) Criteria
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
2. Non-discounted Cash Flow Criteria
Payback Period (PB)
Discounted Payback Period (DPB)
Accounting Rate of Return (ARR)
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Net Present Value Method
Net present value should be found out by subtracting
present value of cash outflows from present value of
cash inflows. The formula for the net present value can
be written as follows:
31 2
02 3
0
1
NPV(1 ) (1 ) (1 ) (1 )
NPV (1 )
n
n
n
t
t
t
k k k k
k!
!
!
L
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Calculating Net Present Value
Assume that Project Xcosts Rs2,500 now and is expected to generate year-
end cash inflows of Rs900, Rs800, Rs700, Rs600 and Rs500 in years 1
through 5. The opportunity cost of the capital may be assumed to be 10 per
cent.
2 3 4 5
1, 0.10 2, 0.10 3, 0.10
4, 0.10 5, 0.
Rs 900 Rs 800 Rs 700 Rs 600 Rs500NPV Rs 2,500
(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)
NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )
+ Rs 600(PVF ) + Rs500(PVF
!
!
10 )] Rs 2,500
NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683
+ Rs500 0.620] Rs 2,500
NPV Rs 2,725 Rs 2,500 = + Rs 225
! v v v v
v
!
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Acceptance Rule
Accept the project when NPV is positive
NPV > 0
Reject the project when NPV is negative
NPV < 0
May accept the project when NPV is zero
NPV = 0
The NPV method can be used to select betweenmutually exclusive projects; the one with the
higher NPV should be selected.
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Calculation of IRR
Uneven Cash Flows: Calculating IRR by Trial
and Error
The approach is to select any discount rate to compute the
present value of cash inflows. If the calculated presentvalue of the expected cash inflow is lower than the present
value of cash outflows, a lower rate should be tried. On the
other hand, a higher value should be tried if the present
value of inflows is higher than the present value of outflows.
This process will be repeated unless the net present valuebecomes zero.
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Calculation of IRR
Even Cash Flows
Let us assume that an investment would cost Rs 20,000 and
provide annual cash inflow of Rs 5,430 for 6 years.
The IRR of the investment can be found out as follows:
6,
6,
6,
PV Rs 20,000 Rs5,430(PVAF ) 0
Rs 20,000 R s5,430(PVAF )
Rs 20,000PVAF 3.683
Rs5,430
r
r
r
!
!
! !
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Acceptance Rule
Accept the project when r> k.
Reject the project when r< k.
May accept the project when r= k.
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Profitability Index
Profitability index is the ratio of the present value
of cash inflows, at the required rate of return, to
the initial cash outflow of the investment.
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Profitability Index
The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow
of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year1 through 4. Assume
a 10 per cent rate of discount. The PV of cash inflows at 10 per cent discount rate
is:
.1235.1
1,00,000Rs
1,12,350RsPI
12,350Rs=100,000Rs112,350RsNPV
0.6820,000Rs+0.75150,000Rs+0.82630,000Rs+0.90940,000Rs=
)20,000(PVFRs+)50,000(PVFRs+)30,000(PVFRs+)40,000(PVFRsPV 0.104,0.103,0.102,0.101,
!!
!
vvvv
!
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Acceptance Rule
The following are the PI acceptance rules:
Accept the project when PI is greater than one. PI > 1
Reject the project when PI is less than one. PI < 1
May accept the project when PI is equal to one. PI = 1
The project with positive NPV will have PI greater
than one. PI less than 1 means that the projects
NPV is negative.
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Payback Method
Payback is the number of years required to recover the
original cash outlay invested in a project.
If the project generates constant annual cash inflows, the
payback period can be computed by dividing cash outlayby the annual cash inflow. That is:
0InitialI n v e s t m e n tP a y b a c k = =A n n u a lC a s h Infl ow
CC
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S.Niroop, GAT 63
Assume that a project requires an outlay of Rs 50,000 and
yields annual cash inflow of Rs 12,500 for 7 years. The
payback period for the project is:
R s 5 0 , 0 0 0P B = = 4 y e a r s
R s 1 2 , 0 0 0
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Payback Method
Unequal cash flows In case of unequal cashinflows, the payback period can be found out byadding up the cash inflows until the total is equal
to the initial cash outlay. Suppose that a project requires a cash outlay of
Rs20,000, and generates cash inflows of Rs8,000;Rs7,000; Rs4,000; and Rs3,000 during the next 4years. What is the projects payback?
3 years + 12 (1,000/3,000) months
3 years + 4 months
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Acceptance Rule
The project would be accepted if its payback period is less
than the maximum or standard payback period set by
management.
As a ranking method, it gives highest ranking to the project,
which has the shortest payback period and lowest ranking to
the project with highest payback period.
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Discounted Payback Period
The discounted payback period is the number
of periods taken in recovering the investment
outlay on the present value basis.
The discounted payback period still fails toconsider the cash flows occurring after the
payback period
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3 DISCOUNTED PAYBACK ILLUSTRATED
Cash Flows
(Rs)C0 C1 C2 C3 C4
SimplePB
DiscountedPB
NPV at10%
P -4,000 3,000 1,000 1,000 1,000 2 yrs
PVof cash flows -4,000 2,727 826 751 683 2.6 yrs 987
Q -4,000 0 4,000 1,000 2,000 2 yrs
PVof cash flows -4,000 0 3,304 751 1,366 2.9 yrs 1,421
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Accounting Rate of Return Method
The accounting rate of return is the ratio of the average
after-tax profit divided by the average investment. The
average investment would be equal to half of the original
investment if it were depreciated constantly.Averageincome
ARR=Averageinvestment
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Acceptance Rule
This method will accept all those projects whose
ARR is higher than the minimum rate established
by the management and reject those projects
which have ARR less than the minimum rate. This method would rank a project as number one
if it has highest ARR and lowest rank would be
assigned to the project with lowest ARR.
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Capital Structure
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Capital Structure Defined
The term capital structure is used to representthe proportionate relationship between debt andequity.
The various means of financing represent thefinancial structure of an enterprise. The left-handside of the balance sheet (liabilities plus equity)represents the financial structure of a company.Traditionally, short-term borrowings are excludedfrom the list of methods of financing the firmscapital expenditure.
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S.Niroop, GAT 72
Meaning of Financial Leverage
The use of the fixed-charges sources of funds, such as
debt and preference capital along with the owners equity
in the capital structure, is described as financial
leverage orgearing ortrading on equity.
The financial leverage employed by a company is
intended to earn more return on the fixed-charge funds
than their costs. The surplus (or deficit) will increase (or
decrease) the return on the owners equity. The rate of
return on the owners equity is levered above or belowthe rate of return on total assets.
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Financial Leverage and the Shareholders
Return The primary motive of a company in using financial leverage
is to magnify the shareholders return under favourable
economic conditions. The role of financial leverage in
magnifying the return of the shareholders is based on the
assumptions that the fixed-charges funds (such as the loanfrom financial institutions and banks or debentures) can be
obtained at a cost lower than the firms rate of return on net
assets (RONA or ROI).
EPS, ROE and ROI are the important figures for analysing the
impact of financial leverage.
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S.Niroop, GAT 74
EPS and ROE Calculations
N
)T1)(INTIT(
N
PAT=PS
sharesofNumberaftertaxProfit=shareperEarnings
!
S
)TINT)(1(EBIT=ROE
equityofValue
aftertaxProfit=equityonReturn
For calculating ROE either the book value or the market value equity may beused.
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Effect of Leverage on ROE and EPS
Favourable I > i
nfavourable I < i
eutral I = i
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Plan I: No debtEBIT 25 00 50 00 75 00 120 00 160 00 300 00
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S.Niroop, GAT 77
EBIT 25.00 50.00 75.00 120.00 160.00 300.00Less: Interest 0.00 0.00 0.00 0.00 0.00 0.00
BT 25.00 50.00 75.00 120.00 160.00 300.00
Less: tax, 50% 12.50* 25.00 37.50 60.00 80.00 150.00
AT 12.50 25.00 37.50 60.00 80.00 150.00
o. of shares (000) 50.00 50.00 50.00 50.00 50.00 50.00
EPS (Rs) 0.25 0.50 0.75 1.20 1.60 3.0
ROE (%) 2.50 5.00 7.50 12.00 16.00 30.00
Plan II: 25% debtEBIT 25.00 50.00 75.00 120.00 160.00 300.00Less: Interest 18.75 18.75 18.75 18.75 18.75 18.75
BT 43.75 31.25 56.25 101.25 141.25 281.25
Less: tax, 50% 21.88* 15.63 28.13 50.63 70.63 140.63
AT 21.87 15.62 28.12 50.62 70.62 140.62
o. of share (000) 37.50 37.50 37.50 37.50 37.50 37.50
EPS (Rs) 0.58 0.42 0.75 1.35 1.88 3.7ROE (%) 5.80 4.20 7.50 13.50 18.80 37.50
Plan III: 50% debtEBIT 25.00 50.00 75.00 120.00 160.00 300.00
Less: Interest 37.50 37.50 37.50 37.50 37.50 37.50
BT 62.50 12.50 37.50 82.50 122.50 262.50
Less: tax, 50% 31.25* 6.25 18.75 41.25 61.25 131.25
AT 31.25 6.25 18.75 41.25 61.25 131.25
o. of shares (000) 25.00 25.00 25.00 25.00 25.00 25.00
EPS (Rs) 1.25 0.25 0.75 1.65 2.45 5.2
ROE (%) 12.50 2.50 7.50 16.50 24.50 52.50
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Operating Leverage
Operating leverage
affects a firms operating
profit (EBIT).
The degree of operatingleverage (DOL) is defined
as the percentage change
in the earnings before
interest and taxes relative
to a given percentagechange in sales.
%ChangeinEBITDOL%Changein ales
EBIT/EBITDOL
ales/Sales
!
(!
(
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Combining Financial and Operating Leverages
Operating leverage affects a firms operating
profit (EBIT), while financial leverage affects
profit after tax or the earnings per share.
The degrees of operating and financialleverages is combined to see the effect of
total leverage on EPS associated with a given
change in sales.
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S.Niroop, GAT 80
Combining Financial and Operating Leverages
The degree of combined leverage (DCL) is given by
the following equation:
another way of expressing the degree of combined
leverage is as follows:
%ChangeinEBIT %ChangeinEPS %ChangeinEPS
%ChangeinSales %ChangeinEBIT %ChangeinSales! v !
( ) ( ) ( )CL( ) ( ) INT ( ) INTQ s v Q s v F Q s v
Q s v F Q s v F Q s v F
! v !
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Financial Leverage and the Shareholders Risk
The variability ofEBIT and EPS distinguish between two
types of riskoperating risk and financial risk.
Operating risk can be defined as the variability ofEBIT
(or return on total assets). The environmentinternaland externalin which a firm operates determines the
variability ofEBIT The variability ofEBIT has two components:
variability of sales
variability of expenses
The variability ofEPS caused by the use of financial
leverage is called financial risk.
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S.Niroop, GAT 82
Dividend Decisions
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S.Niroop, GAT 83
Dividend Theory
Issues in Dividend Policy
Earnings to be Distributed High Vs. Low
Payout.
Objective Maximize Shareholders Return.
Effects Taxes, Investment and Financing
Decision.
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S.Niroop, GAT 84
Relevance Vs. Irrelevance
Walter's Model
Gordon's Model
Modigliani and Miller Hypothesis
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Walters Model
Assumptions
Valuation
Optimum Payout Ratio
Criticism
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S.Niroop, GAT 86
Assumptions
Internal Financing (only Retained Earnings)
Constant Return and Cost of Capital
100% Payout or Retention
Constant EPS and DIV
Infinite Time
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Valuation
Market price per share is the sum of the present
value of the infinite stream of constant dividends
and present value of the infinite stream of capital
gains.
( / )( IV / ) (EPS DIV)
r kP k
k!
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Example
0.15, 0.10, 0.08
0.10
EPS R s 10
DPS 40%
(0.15 / 0.1)(4 / 0.1) (10 4) Rs 130
0.1
(0.10 / 0.1)(4 / 0.1) (10 4) Rs 100
0.1
(0.08 / 0.1)(4 / 0.1) (10 4) Rs 88
0.1
r
k
P
P
P
!
!
!
!
! !
! !
! !
( / )(DIV / ) (EPS DIV)r kkk
!
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Growth Firm r>k
Payout Ratio 0%
Div = Rs0
P=[0+(0.15/0.10)(10-0)/0.10
=Rs.1
50
Payout Ratio 100%
Div = Rs10
P=[10+(0.15/0.10)(10-10)/0.10
=Rs.100
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Normal Firm ,r = k
Payout Ratio 0%
Div = Rs0
P=[0+(0.10/0.10)(10-0)/0.10
=Rs.100
Payout Ratio 100%
Div = Rs10
P=[10+(0.10/0.10)(10-10)/0.10
=Rs.100
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S.Niroop, GAT 91
Declining Firm , r < k
Payout Ratio 0%
Div = Rs0
P=[0+(0.08/0.10)(10-0)/0.10
=Rs.80
Payout Ratio 100%
Div = Rs10
P=[10+(0.08/0.10)(10-10)/0.10
=Rs.100
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S.Niroop, GAT 92
Optimum Payout Ratio
Growth Firms Retain all earnings
Declining Firms Distribute all earnings
Normal Firms No effect
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S.Niroop, GAT 93
Criticism
No external Financing
Constant Rate of Return
Constant opportunity cost of capital
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S.Niroop, GAT 94
Gordon's Model
Assumptions
Valuation
Optimum Payout Ratio
Criticism
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S.Niroop, GAT 95
Assumptions
All Equity Firm
No External Financing
Constant Return and Cost of Capital
Perpetual Earnings
No Taxes
Constant Retention
Cost of Capital greater than Growth Rate
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Valuation
Market value of a share is
equal to the present value
of an infinite stream of
dividends to be received
by shareholders
E P S (1 ) / ( )P b k b r!
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Example
0.15, 0.10, 0.08
0.10
EPS Rs 10
60%
(1 0.6)/ 0.10 (0.15 * 0.6) = Rs400
10(1 6)/ 0.10 (0.10 * 0.6) = Rs 100
10(1 0.6)/ 0.10 (0.08 * 0.6) = Rs 77
r
k
b
P
P
P
!
!
!
!
!
!
!
EPS(1 ) /( )P b k br!
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S.Niroop, GAT 98
Optimum Payout Ratio
Growth Firms Retain all earnings
Declining Firms Distribute all earnings
Normal Firms No effect
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Modigliani and Miller
According to M-M, under a perfect market
situation, the dividend policy of a firm is irrelevant
as it does not affect the value of the firm. They
argue that the value of the firm depends on firmearnings which results from its investment policy.
Thus when investment decision of the firm is
given, dividend decision is of no significance.
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S.Niroop, GAT 100
Working Capital Management
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S.Niroop, GAT 101
Principles of Working Capital
Management
Concepts of Working Capital
Gross working capital (GWC)
GWC refers to the firms total investment in current
assets.
Current assets are the assets which can be
converted into cash within an accounting year (or
operating cycle) and include cash, short-term
securities, debtors, (accounts receivable or bookdebts) bills receivable and stock (inventory).
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Net working capital (NWC).
NWC refers to the difference between current assets and
current liabilities.
Current liabilities (CL) are those claims of outsiderswhich are expected to mature for payment within an
accounting year and include creditors (accounts
payable), bills payable, and outstanding expenses.
NWC can be positive or negative. Positive NWC = CA > CL
Negative NWC = CA < CL
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Operating Cycle
Operating cycle is the time duration required to
convert sales, after the conversion of resources
into inventories, into cash. The operating cycle of
a manufacturing company involves three phases: Acquisition of resources such as raw material, labour, power and fuel
etc.
Manufacture of the productwhich includes conversion of raw material
into work-in-progress into finished goods.
Sale of the producteither for cash or on credit. Credit sales createaccount receivable for collection.
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The length of the operating cycle of a
manufacturing firm is the sum of:
inventory conversion period (ICP).
Debtors (receivable) conversion period (DCP).
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Inventory conversion period is the total time
needed for producing and selling the product.
Typically, it includes:
raw material conversion period (RMCP)
work-in-process conversion period (WIPCP)
finished goods conversion period (FGCP
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The debtors conversion period is the time
required to collect the outstanding amount from
the customers.
Creditors orpayables deferral period (CDP) isthe length of time the firm is able to defer
payments on various resource purchases.
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Permanent orfixed working capital
A minimum level of current assets, which iscontinuously required by a firm to carry on its
business operations, is referred to as permanentor fixed working capital.
Fluctuating orvariable working capital
The extra working capital needed to support the
changing production and sales activities of thefirm is referred to as fluctuating or variableworking capital.
D i f W ki C i l
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S.Niroop, GAT 108
Determinants of Working Capital
Nature of business
Market and demand
Technology and manufacturing policy
Credit policy
Supplies credit
Operating efficiency
Inflation
E i i W ki i l
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Estimating Working capital
Current assets holding period
To estimate working capital requirements on the basis of averageholding period of current assets and relating them to costs based onthe companys experience in the previous years. This method isessentially based on the operating cycle concept.
Ratio of sales To estimate working capital requirements as a ratio of sales on the
assumption that current assets change with sales.
Ratio of fixed investment
To estimate working capital requirements as a percentage of fixedinvestment.
I M
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Inventory Management
Nature of Inventory
Stocks of manufactured products and the
material that make up the product.
Components: raw materials
work-in-process
finished goods
stores and spares (supplies)
N d f I i
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Need for Inventories
Transaction motive
Precautionary motive
Speculative motive
Obj i f I M
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Objectives of Inventory Management
Ensure a continuous supply of raw materials to facilitate
uninterrupted production
Maintain sufficient stock of raw materials in periods of
short supply and anticipate price changes
Maintain sufficient finished goods inventory for smooth
sales operations and efficient customer service
Minimise the inventory costs
Control inventory investment by maintaining optimum
inventory
I M T h i
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Inventory Management Techniques
Economic order quantity (EOQ) ordering costs: requisitioning, order placing, transportation, receiving,
inspecting and storing, administration
carrying costs: warehousing, handling, clerical and staff, insurance,
depreciation and obsolescence
2EOQ =
AO
c
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Reorder point under certainty
lead time
average usage
Reorder point = Lead time x average usage Reorder point under uncertainty
safety stock
Reorder point = (Lead time x average usage) + safety
stock
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Cash Management
F F t f C h M t
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Four Facets of Cash Management
Cash planning
Managing the cash flows
Optimum cash level
Investing surplus cash
M ti f r H ldi C h
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Motives for Holding Cash
The transactions motive
The precautionary motive
The speculative motive
Investing Surplus Cash in Marketable
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Investing Surplus Cash in MarketableSecurities
Selecting Investment Opportunities:
safety,
Maturity, and
Marketability.
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