SET-I SOL-1 Meaning of Financial Management Financial Management means planning, organizing, directing and controlling the financial

activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise. The importance of financial management can be summarized as follows: 1. It brings economic growth and development through investments , financing, dividend and risk management decision which help companies to undertake better projects. 2. When there is good growth and development of the economy it will ultimately improve the standard of living of all people. 3. Improved standard of living will lead to good health and financial stress will reduce considerably. 4. It enables the individual to take better financial decision which will reduce poverty, reduce debts and increase savings and investments. 5. Better financial ability will lead to profitability which will create new jobs and in turn lead to more development , expansion and will promote efficiency. In personal life, financial management helps us to create a comfortable life with an assurance of a secured future and freedom to spend money to make us happy. The importance of financial planning and management is reflected in all the areas of personal and business life , it must not be avoided. All individuals no matter what their financial capacity is, must learn and study financial management and adapt it to improve their life. SOL-2 Meaning of Capital Budgeting Capital expenditure budget or capital budgeting is a process of making decisions regarding investments in fixed assets which are not meant for sale such as land, building, machinery or furniture. The word investment refers to the expenditure which is required to be made in connection with the acquisition and the development of long-term facilities including fixed assets. It refers to process by which management selects those investment proposals which are worthwhile for investing

available funds. For this purpose, management is to decide whether or not to acquire, or add to or replace fixed assets in the light of overall objectives of the firm. What is capital expenditure, is a very difficult question to answer. The terms capital expenditure are associated with accounting. Normally capital expenditure is one which is intended to benefit future period i.e., in more than one year as opposed to revenue expenditure, the benefit of which is supposed to be exhausted within the year concerned Significance of capital budgeting The key function of the financial management is the selection of the most profitable assortment of capital investment and it is the most important area of decision-making of the financial manger because any action taken by the manger in this area affects the working and the profitability of the firm for many years to come. The need of capital budgeting can be emphasised taking into consideration the very nature of the capital expenditure such as heavy investment in capital projects, long-term implications for the firm, irreversible decisions and complicates of the decision making. Its importance can be illustrated well on the following other grounds:(1) Indirect Forecast of Sales. The investment in fixed assets is related to future sales of the firm during the life time of the assets purchased. It shows the possibility of expanding the production facilities to cover additional sales shown in the sales budget. Any failure to make the sales forecast accurately would result in over investment or under investment in fixed assets and any erroneous forecast of asset needs may lead the firm to serious economic results. (2) Comparative Study of Alternative Projects Capital budgeting makes a comparative study of the alternative projects for the replacement of assets which are wearing out or are in danger of becoming obsolete so as to make the best possible investment in the replacement of assets. For this purpose, the profitability of each projects is estimated. (3) Timing of Assets-Acquisition. Proper capital budgeting leads to proper timing of assetsacquisition and improvement in quality of assets purchased. It is due to ht nature of demand and supply of capital goods. The demand of capital goods does not arise until sales impinge on productive capacity and such situation occur only intermittently. On the other hand, supply of capital goods with their availability is one of the functions of capital budgeting. (4) Cash Forecast. Capital investment requires substantial funds which can only be arranged by making determined efforts to ensure their availability at the right time. Thus it facilitates cash forecast. (5) Worth-Maximization of Shareholders. The impact of long-term capital investment decisions is far reaching. It protects the interests of the shareholders and of the enterprise because it avoids over-investment and under-investment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximization of equity share-holders.

(6) Other Factors. The following other factors can also be considered for its significance:SOL:-3 Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital, that is commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. SOL:-4 Leverage: In finance, leverage (sometimes referred to as gearing in the United Kingdom, or solvency in Australia) is a general term for any technique to multiply gains and losses.[1] Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives.Important examples are:

A public corporation may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.[3] A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income.[4][5] Hedge funds often leverage their assets by using derivatives. A fund might get any gains or losses on $20 million worth of crude oil by posting $1 million of cash as margin.[6]

Investopedia explains 'Operating Leverage' The higher the degree of operating leverage, the greater the potential danger from forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be magnified into large errors in cash flow projections. The opposite is true for businesses that are less leveraged. A business that sells millions of products a year, with each contributing slightly to paying for fixed costs, is not as dependent on each individual sale. For example, convenience stores are significantly less leveraged than high-end car dealerships. SOL-5

Factors affecting Financial Plan Nature of the industry The very first factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capital intensive or labour intensive industry. This will have a major impact on the total assets that a firm owns. Size of the company The size of the company greatly influences the availability of funds from different sources. A small company normally finds 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 Status of the company in the industry A well established company enjoys a good market share, for its products normally commands investors confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment Sources of finance available Sources of finance could be grouped 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 finance is closely linked to the firms capability to manage the risk exposure. The capital structure of a company The capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain control overj 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. Matching the sources with utilisation The prudent policy of any good financial plan is to match the term of the source with the term of the investment. To finance fluctuating working capital needs, the firm resorts to short term finance. All fixed asset investments are to be financed by long term sources, which is a cardinal principle of financial planning. Flexibility

The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure whenever need arises. If the capital structure of a company is flexible, there will not be any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalisation of capital market. 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 corporates today. Management of public issues of shares demands the compliances with many statues in India. They are to be complied with a time constraint.

SET-II Operating Cycle The time between the purchase of an asset and its sale, or the sale of a product made from the asset. Most companies desire short operating cycles because it creates cash flow to cover the company's liabilities. A long operating cycle often necessitates borrowing and thereby reduces profitability. The average length of time between when a company purchases items for inventory and when it receives payment for sale of the items. A long operating cycle tends to harm profitability by increasing borrowing requirements and interest expense.

Operating cycle of a firm involves the following elements. Acquisition of resources from suppliers Making payments to suppliers Conversion of raw materials into finished products Sale of finished products to customers Collection of cash from customers for the goods sold The five phases of the operating cycle occur on a continuous basis. There is no synchronisation between the activities in the operating cycle. Cash outflows occur before the occurrences of cash inflows in operating cycle. Cash outflows are certain. However, cash inflows are uncertain because of uncertainties associated with effecting sales as per the sales forecast and ultimate timely collection of amount due from the customers to whom the firm has sold its goods.

Since cash inflows do not match with cash out flows, firm has to invest in various current assets to ensure smooth conduct of day to day business operations. Therefore, the firm has to assess the operating cycle time of its operation for providing adequately for its working capital requirements. SOL-2 Meaning of Capital Rationing Firms may have to make a choice from among profitable investment opportunities, because of the limited financial resources. Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a situation may be due to external factors or due to the need to impose internal constraints, keeping in view of the need to exercise better financial control. Capital rationing may be needed due to: External factors Internal constraints imposed by management External capital rationing External capital rationing is due to the imperfections of capital market. Imperfections are caused mainly due to: Deficiencies in market information Rigidities that hamper the force flow of capital between firms When capital markets are not favourable to the company, the firm cannot tap the capital market for executing new projects even though the projects have positive net present values. The following reasons attribute to the external capital rationing: The inability of the firm to procure required funds from capital market because the firm does not command the required investors confidence National and international economic factors may make the market highly volatile and unstable Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the market for funds High cost of issue of securities i.e. high floatation costs. Smaller firms may have to incur high costs of issue of securities. This discourages small firms from tapping the capital market for funds Internal capital rationing

Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing. This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects. Another internal restriction for capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the managements expectation on the rate of return will be cleared. Generally internal capital rationing is used by a firm as a means of financial control. SOL-3 a) Cost of Capital The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested in a different vehicle with similar risk. b) Stock Split Before going into the concept of stock split, let us start with its definition. A stock split is a method to increase the number of outstanding shares by proportionately reducing the face value of a share. A stock split affects only the par value and does not have any effect on the total outstanding amount in share capital. The reasons for splitting shares are: To make shares attractive The prime reason for effecting a stock split is to reduce the market price of a share to make it more attractive to investors. Shares of some companies enter into higher trading zone making it out of reach to small investors. Splitting the shares will place them in more popular trading range thus providing marketability and motivating small investors to buy them. Indication of higher future profits Share split is generally considered a method of management communication to investors that the company is expecting high profits in future. Higher dividend to shareholders

When shares are split, the company does not resort to reducing the cash dividends. If the company follows a system of stable dividend per share, the investors would surely get higher dividends with stock split. SOL-4 Inventory Control Techniques There are many techniques of management of inventory. Some of them are as shown in the figure 13.5

Figure 13.5: Inventory management techniques Economic order quantity (EOQ) Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage. EOQ model answers the following key quantum of inventory management. What should be the quantity ordered for each replenishment of stock? How many orders are to be placed in a year to ensure effective inventory management? EOQ is defined as the order quantity that minimises the total cost associated with inventory management. EOQ is based on the following assumptions, as shown in figure 13.6:

Figure 13.6: Assumptions Constant or uniform demand: The demand or usage is even through-out the period Known demand or usage: Demand or usage for a given period is known i.e. deterministic Constant unit price: Per unit price of material does not change and is constant irrespective of the order size Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of inventory Constant ordering cost: Cost per order is constant whatever be the size of the order Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Constantly there is no shortage of inventory. Economic order quantity is represented using the following formula:

Where D = Annual usage or demand Qx = Economic order quantity K = ordering cost per order kc = pc = price per unit x percent carrying cost = carrying cost of inventory per unit per annum. ABC system The inventory of an industrial firm generally comprises of thousands of items with diverse prices, large lead time and procurement problems. It is not possible to exercise the same degree of control over all these items. Items of high value require maximum attention while items of low value do not require same degree of control. The firm has to be selective in its approach to control its investment in various items of inventory. Such an approach is known as selective inventory control. ABC system belongs to selective inventory control. ABC analysis classifies all the inventory items in an organisation into three categories. Items are of high value but small in number. All items require strict control Items of moderate value and size which require reasonable attention of the management Items represent relatively small value items and require simple control Since this method concentrates attention on the basis of the relative importance of various items of inventory, it is also known as control by importance and exception. As the items are classified in order of their relative importance in terms of value, it is also known as proportional value analysis. Advantages of ABC analysis ABC analysis ensures closer controls on costly elements in which firms greater part of resources are invested By maintaining stocks at optimum level it reduces the clerical costs of inventory control Facilitates inventory control over usage of materials, leading to effective cost control Limitations A never ending problem in inventory management is adequately handling thousands of low value of C items. ABC analysis fails to answer this problem If ABC analysis is not periodically reviewed and updated, it defeats the basic purpose of ABC approach

SOL-5 Decision tree analysis Many project decisions are complex investment decisions. Such complex investment decisions involve a sequence of decisions over time. Decisions tree can handle the sequential decisions of complex investment proposals. The decision of taking up an investment project is broken into different stages. At each stage the proposal is examined to decide whether to go ahead or not. The multi stages approach can be handled effectively with the help of decision trees. A decision tree presents graphically the relationship between Present decision and future events Future decisions and the consequences of such decisions