FINANCE FUNCTIONS
Financing decisions
Investment decisions
Liquidity decisions
Dividend decisions
FINANCING DECISIONS: Financing decisions relate to the composition of relative
proportion of various sources of finance. The sources could be:
(a) Shareholders Fund: Equity Share Capital, Preference Share Capital,
Accumulated Profits.
(b) Borrowing from outside agencies: Debentures, Loans from Financial Institutions.
Financing decisions relate to the acquisition of such funds at the least cost. In order
to calculate the specific cost of each type of capital, recognition should be given to
two dimensions of cost:
Explicit Cost
Implicit Cost
An investor in a companys shares has two objectives for investing:
Income from capital appreciation (capital gains on sale of shares at market
price)
Income from dividends
INVESTMENT DECISIONS
To survive and grow, all organizations have to be innovative. Innovation demands
managerial proactive actions. Proactive organizations continuously search for
innovative ways of performing the activities of the organization. Innovation is wider
in nature. It could be:
Expanding by entering into new markets.
Adding new products to its product mix.
Performing value added activities to enhance customer satisfaction.
Adopting new technology that would drastically reduce the cost of production.
Rendering services or mass production at low cost or restructuring the
organization to improve productivity.
There are two critical issues to be considered in these decisions. They are:
Evaluation of expected profitability of the new investments.
Rate of return required on the project.
The Rate of Return required by an investor is normally known as the hurdle rate or
the cut off rate or the opportunity cost of capital.
DIVIDEND DECISIONS
Dividends are payouts to shareholders. Dividends are paid to keep the
shareholders happy. Dividend decision is a major decision made by the finance
manager.
Dividend is that portion of profits of a company which is distributed among its
shareholders according to the resolution passed in the meeting of the Board of
Directors. This may be paid as a fixed percentage on the share capital contributed
by them or at a fixed amount per share. The dividend decision is always a problem
before the top management or the Board of Directors as they have to decide how
much profits should be transferred to reserve funds to meet any unforeseen
contingencies and how much should be distributed to the shareholders.
The following issues need adequate consideration in deciding on dividend policy:
Preferences of shareholders Do they want cash dividend or capital gains?
Current financial requirements of the company.
Legal constraints on paying dividends.
Striking an optimum balance between desire of shareholders and the companys
funds requirements.\
The main reasons why a stable dividend is preferred are:
(a) A regular and stable dividend payment may serve to resolve uncertainty in the
minds of shareholders, and it creates confidence among shareholders.
(b) Many investors are income conscious and favor a stable dividend.
(c) Other things being in balance, the market price invariably vary with the rate of
dividend declared by the company on its equity shares. The value of shares of a
company that has a stable dividend policy does not fluctuate as much, even if the
earnings of the company fluctuate now and then.
(d) A stable dividend policy encourages investments from institutional investors.
In this way, stability and regularity of dividends not only affects the market price of
shares but also increases the general credit of the company that pays the company
in the long run. Dividend decisions are thus highly significant.
LIQUIDITY DECISIONS
The liquidity decision is concerned with the management of the current assets,
which is a pre-requisite to long-term success of any business firm. This is also
called as working capital decision. The main objective of the current assets
management is the trade-off between profitability and liquidity, and there is a conflict
between these two concepts. If a firm does not have adequate working capital, it
may become illiquid and consequently fail to meet its current obligations thus
inviting the risk of bankruptcy.
The important elements of liquidity decisions are:
Formulation of inventory policy
Policies on receivable management
Formulation of cash management strategies
Policies on utilization of spontaneous finance effectively
BENEFITS OF FINANCIAL PLANNING
A financial plan is at the core of value creation process. A successful value
creation process can effectively meet the benchmarks of investors expectations.
Financial planning ensures effective utilization of the funds. To manage shortage
of funds, planning helps the firms to obtain funds at the right time, in the right
quantity, and at the least cost as per the requirements of finance emerging
opportunities. Surplus is deployed through well-planned treasury management.
Ultimately, the productivity of assets is enhanced.
Effective financial planning provides firms the flexibility to change the
composition of funds that constitute its capital structure in accordance with the
changing conditions of the capital market.
Financial planning helps in formulation of policies and instituting procedures for
elimination of wastages in the process of execution of strategic plans.
Financial planning helps in reducing the operating capital of a firm. Operating
capital refers to the ratio of capital employed to the sales generated. Maintaining
the operating capability of the firm through the evolution of scientific replacement
schemes for plant and machinery and other fixed assets will help the firm in
reducing its operating capital. Along with fixed assets such as plant and equipment,
working capital is considered a part of operating capital.
GUIDELINES FOR FINANCIAL PLANNING
Never ignore the cardinal principle that fixed asset requirements must be met
from the long-term sources.
Make maximum use of spontaneous source of finance to achieve highest
productivity of resources.
Maintain the operating capital intact by providing adequately out of the current
periods earnings. Give due attention to the physical capital maintenance or
operating capability.
Never ignore the need for financial capital maintenance in units of constant
purchasing power.
Employ current cost principle wherever required.
Give due weightage to cost and risk in using debt and equity.
Keeping the need of finance for expansion of business, formulate plough back
policy of earnings.
Exercise thorough control over overheads.
Seasonal peak requirements to be met from short-term borrowings from banks.
A strategic financial plan of a firm spells out its corporate purpose,
scope, objectives, and strategies. As a financial manager, one must:
Sensitize the strategic planning group to the financial implications of various
choices
Ensure that the chosen strategic plan is financially feasible
Translate the plan that is finally adopted into a long-range financial plan
Coordinate the development of the budget
STEPS IN FINANCIAL PLANNING
Establish corporate objectives
o Qualitative and quantitative objectives
o Short-term, medium-term, and long-term objectives
Formulate strategies
Assign responsibilities
Forecast financial variables
Develop plans
Create flexible economic environment
IMPORTANTANCE OF FORECASTING OF FINANCIAL STATEMENTS
Following are some basic points that would help you to understand the importance
of financial forecasting before we study the methods of forecasting and income
statement/balance sheet.
Financial forecasting is the process of estimating future business performance
(sales, costs, earnings).
Corporations and companies employ forecasting to do financial planning which
includes an assessment of their future financial needs.
Forecasting is also important for production planning, human resource planning,
etc.
Forecasting is also used by outsiders to value companies and their securities.
METHODS OF FORECASTING INCOME STATEMENT
Percent of sales method or constant ratio method
Expense method
Combination of the above two
PERCENT OF SALES METHOD
This is the most basic method of forecasting a financial statement. It assumes that
certain expenses, assets, and liabilities maintain a constant relationship to the level
of sales.
Basically, this method assumes that future relationship between various elements of
cost to sales will be similar to their historical relationships. These cost ratios are
generally based on the average of previous two or three years. For example, cost of
goods sold may be expressed as a percentage of sales.
BUDGETED EXPENSE METHOD
Expenses for the planning period are budgeted on the basis of anticipated behavior
of various items of cost and revenue. The value of each item is estimated on the
basis of expected developments in the future period for which the pro forma P&L
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account is being prepared. It calls for greater effort on the part of management
since they have to define the likely happenings. This also demands effective
database for
reasonable budgeting expenses.
COST THEORY
Under this theory, the total amount of capitalization for a new company is the sum
of:
Cost of fixed assets
Cost of establishing the business
Amount of working capital required
MERITS OF COST APPROACH
It helps promoters to estimate the amount of capital required for incorporation of
company, conducting market surveys, preparing detailed project report, procuring
funds, procuring assets both fixed and current, running a trial production, and
successfully producing, positioning, and marketing its products or rendering of
services.
If done systematically, it will lay the foundation for successful initiation of the
working of the firm.
DEMERITS OF COST APPROACH
If the firm establishes its production facilities at inflated prices, the productivity of
the firm will become less than that of the industry.
Net worth of a company is decided by the investors and the earnings of a
company. Earning capacity based on net worth helps a firm to arrive at the total
capital in terms of industry-specified yardstick (operating capital based on
benchmarks in that industry). Cost theory fails in this respect.
FACTORS AFFECTING FINANCIAL PLANNING
Nature of the industry
Size of the company
Status of the company in the industry
Sources of finance available
The capital structure of a company
Matching the sources with utilization Government policy
Flexibility
Government policy
1. Nature of the industry:- Here, we must consider whether it is a capital
intensive of labor intensive industry. This will have a major impact on the total
assets that the firm owns.
2. Size of the company: - The size of the company greatly influences the
availability of funds from different sources. A small company normally finals it
difficult to raise funds from long term sources at competitive terms. On the
other hand, large companies like Reliance enjoy the privilege of obtaining
funds both short term and long term at attractive rates.
3. Status of the company in the industry:- A well established company enjoying a
good market share, for its products normally commands investors confidence.
Such a company can tap the capital market for raising funds in competitive
term for implementation new projects to exploit the new opportunity emerging
from changing business environment.
4. Sources of finance available:- Sources of finance could be group into debt and
equity. Debt is cheap but risky whereas equity is costly. A firm should aim at
optimum capital structure that would achieve the least cost capital structure. A
large firm with a diversified product mix may manage higher quantum of debt
because the firm may manage higher financial risk with a lower business risk.
Selection of sources of finances us closely linked to the firms capacity to
manage the risk exposure.
5. The capital structure of a company:- Capital structure of a company is
influenced by the desire of the existing management of the company to remain
control over the affairs of the company. The promoters who do not like to lose
their grip over the affairs of the company normally obtain extra funds for growth
by issuing preference shares and debentures to outsiders.
6. Matching the sources with utilization:- The product policy of any good financial
plan is to match the term of the source with the term of investment. To finance
fluctuating working capital needs, the firm resorts to short term finance. All
fixed assets-investment are to be finance by long term sources. It is a cardinal
principal of financial planning.
7. Flexibility:- The financial plan of company should possess flexibility so as to
effect changes in the composition of capital structure when ever need arises. If
the capital structure of a company is flexible, it will not face any difficulty in
changing the sources of funds. This factor has become a significant one today
because of the globalization of capital market.
8. Government Policy:- SEBI guidelines, finance ministry circulars, various
clauses of Standard Listing Agreement and regulatory mechanism imposed by
FEMA and Department of Corporate Affairs (Govt of India) influence the
financial plans of corporate today. Management of public issues of shares
demands the companies with many status in India. They are to be compiled
with a time constraint.
What are the 4 finance decisions taken by a finance manager.
Modern approach of financial management provides a conceptual and analytical
framework for financial decision making. According to this approach there are 4
major decision areas that confront the Finance Manager these are:-
1. Investment Decisions
2. Financing Decisions
3. Dividend Decisions
4. Financial Analysis, Planning and Control Decisions
a) Investment Decisions;
Investment decisions are made by investors and investment managers.
Investors commonly perform investment analysis by making use of fundamental
analysis, technical analysis, screeners and gut feel.
Investment decisions are often supported by decision tools. The portfolio theory is
often applied to help the investor achieve a satisfactory return compared to the risk
taken.
b) Financing Decisions;
What are the three types of financial management decisions? For each type of
decision, give an example of a business transaction that would be relevant.
There are three types of financial management decisions: Capital budgeting,
Capital structure, and Working capital management.
Capital budgeting is the process of planning and managing a firm's long-term
investments. The key to capital budgeting is size, timing, and risk of future cash
flows is the essence of capital budgeting. For example, yesterday I received a call
from our manager over our Sand & Gravel Operations. He is looking into buying a
new crusher (to crush stone into gravel and sand). I helped him today evaluate the
return on investment for this opportunity. It quite a lot of work, but we determined
that buying the new crusher would bring in 60,000 more tons of production/sales
within the 1st year of owning the machine.
Capital Structure refers to the
c) Dividend Decisions
The Dividend Decision is a decision made by the directors of a company. It relates
to the amount and timing of any cash payments made to the company's
stockholders. The decision is an important one for the firm as it may influence its
capital structure and stock price. In addition, the decision may determine the
amount of taxation that stockholders pay.
There are three main factors that may influence a firm's dividend decision:
Free-cash flow
Dividend clienteles
Information signaling
Under this theory, the dividend decision is very simple. The firm simply pays out, as
dividends, any cash that is surplus after it invests in all available positive net
present value projects.
Why wealth maximization is superior to profit maximization in todays
context? Justify you answer?
Superiority of Wealth Maximization over Profit Maximization:
1. It is based on cash flow, not based on accounting profit.
2. Through the process of discounting it takes care of the quality of cash flows.
Distant uncertain cash flows into comparable values at base period facilitates
better comparison of projects. There are various ways of dealing with risk
associate with cash flows. These risk are adequately considered when present
values of cash of any project.
3. In todays competitive business scenario corporate play a key role. In company
from of organization, shareholders own the company but the management of
the company rests with the board of directors. Directors are elected by
shareholders and hence agents of the shareholders. Company management
procures funds for expansion and diversification from Capital Markets. In the
liberalized set up-, the society expects corporate to tap the capital market
effectively for their capital requirements. Therefore to keep the investors happy
through the performance of value of shares in the market, management of the
company must meet the wealth maximization criterion.
4. When a firm follows wealth maximization goal, it achieve maximization of
market value of share. When a firm pact wealth maximization goal, it is
possible only when procedures quality goods at low cost. On this account
society gains became of the society welfare.
5. Maximization of wealth demands on the part of corporate to develop new
products or render new services in the most effective and efficient manner.
This helps the consumers all it will bring to the market the products and
services that consumers need.
6. Another notable features of the firms committed to the maximization of wealth
is that to achieve this goal they are forced to render efficient service to their
customers with courtesy. This enhance consumer and hence the benefit to the
society.
7. From the point of evaluation of performance of listed firms, the most
remarkable measure is that of performance of the company in the share
market. Every corporate action finds its reflection on the market value of
shares of the company. Therefore, shareholders wealth maximization could be
considered a superior goal compared to profit maximization.
8. Since listing ensures liquidity to the shares help by the investors shareholders
can reap the benefits arising from the performance of company only when they
sell their shares. Therefore, it is clear that maximization of the net wealth of
shareholders.
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Q1. A. What is the cost of retained earnings?
Cost of Retained Earnings
Cost of retained earnings (ks) is the return stockholders require on the companys
common stock.
There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach
a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first estimate
the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day
Treasury-bill rate as well as the expected rate of return on the market (rm).
The next step is to estimate the companys beta (bi), which is an estimate of the
stocks risk. Inputting these assumptions into the CAPM equation, you can then
calculate the cost of retained earnings
1. Capital outlays are estimated by engineering department after examining all
b) Bond-Yield-Plus-Premium Approach
This is a simple, ad hoc approach to estimating the cost of retained earnings.
Simply take the interest rate of the firms long-term debt and add a risk premium
(typically three to five percentage points):
ks = long-term bond yield + risk premium
ks = D1 + g;
P0
where:
D1 = next years dividend
g = firms constant growth rate
P0 = price
c) Discounted Cash Flow ApproachAlso known as the dividend yield plus growth
approach. Using the dividend-growth model, you can rearrange the terms as
follows to determine ks
Explain Miler and Modigliani Approach to capital structure theory?
Miller and Modigliani Approach
Miller and Modigliani criticize that the cost of equity remains unaffected by leverage
up to a reasonable limit and Ko being constant at all degrees of leverage. They
state that the relationship between leverage and cost of capital is elucidated as in
NOI approach. The assumptions for their analysis are:
Perfect capital markets: Securities can be freely traded, that is, investors are
free to buy and sell securities( both shares and debt instruments), there are no
hindrances on the borrowings, no presence of transaction costs, securities
infinitely divisible, availability of all required information at all times.
Investors behave rationally, that is, they choose that combination of risk and
return that is most advantageous to them.
Homogeneity of investors risk perception that is all investors have the same
perception of business risk and returns.
Taxes: There is no corporate or personal income tax.
Dividend pay-out is 100%, that is, the firms do not retain earnings for future
activities.
Basic propositions: The following three propositions can be derived based on the
above assumptions:
Proposition I: The market value of the firm is equal to the total market value of
equity and total market value of debt and is independent of the degree of leverage.
The basic argument for proposition I is that equilibrium is restored in the market by
the arbitrage mechanism. Arbitrage is the process of buying security at lower price
in one market and selling it in another market at higher price bringing about
equilibrium. This is a balancing act. Miller and Modigliani perceive that the investors
of firm whose value is higher will sell their share and in return buy shares of the firm
whose value is lower. They will earn the same return at lower outlay and lower the
share prices risk.. Such behaviors are expected to increase the share price of
whose shares are being purchased and lowering the shares price of those share
which are being sold. This switching operation will continue till the market price of
identical firms becomes identical.
Proposition II: The expected yield on equity is equal to discount rate (capitalization
rate) applicable plus a premium.
Ke = Ko + [ ( Ko Kd ) D/S ]
Proposition III: The average cost of capital is not affected by the financing decisions
as investment and financing decision are independent.
How to estimate cash flows? What are the components of incremental cash
flows?
Estimation of cash flows
Estimating the cash flows associated with the project under consideration is the
most difficult and crucial step in the evaluation of an investment proposal. It is the
result of the team work of many professionals in an organization.
aspects of production process.
2. Marketing department on the basis of market survey forecasts the expected
sales revenue during the period of accrual of benefits from project executions.
3. Operating cost is estimated by cost accountants and production engineers.
4. Incremental cash flows and out flows statement is prepared by the cost
accountant on the basis of details generated in the above steps. The ability of
the firm to forecast the cash flows with reasonable accuracy lies at the root of
the implementation of any capital expenditure decision.
Investment (Capital budgeting) decision required the estimation of incremental cash
flow stream the life of the investment. Incremental cash flow are estimated on after
tax basis.
1. Initial Cash outlay (Initial investment): Initial cash outlay to be incurred is
determined after considering any post tax cash inflows if any. In replacement
decision existing old machinery is disposed of and new machinery incorporating
the latest technology is installed in its place. On disposed of existing old
machinery the firm has a cash inflow. This cash inflow has to be computed on
post tax basis. The net cash out flow (total cash required for investment in
capital assets minus post tax cash inflow on disposal on the old machinery being
replaced by a new one) therefore is the incremental cash outflow. Additional net
working capital required on implementation of new project is to be added to initial
investment.
2. Operating Cash inflows: Operating cash inflows are estimated for the entire
economic life of investment. Operating cash inflows constitute a stream of
inflows and outflows over the life of the project. Here also incremental inflows
and outflows attributable to operating activities are considered. Any saving in
cost on installation of new machinery in the place of the old machinery will have
to be accounted to on post tax basis. In this connection incremental cash flows
refer to the change in cash flows on implementation of a new project over the
existing position.
3. Terminal Cash inflows: At the end of the economic life of the project, the
operating assets installed now will be disposed off. It is normally known as
salvage value of equipment. These terminal cash inflows are computed on post
tax basis.
What are the steps involved in capital rationing?
Steps involved in Capital Rationing are:
1. Ranking of different investment proposals
2. Selection of the most profitable investment proposals
Ranking of different investment proposal
The various investment proposals should be ranked on the basis of their
profitability. Ranking is done on the basis of NPV. Profitability index or IRR in the
descending order.
Profitability index as the basis of Capital Rationing
The following details are