Chapter 1

Financial Management
 Reference Text:

• Financial Management - Brigham

• 2. Financial Management - Khan & Jain
• 3. Financial Management - Prasanna Chandra
• 4. Financial Management – Maheshwari
• 5. Financial Management – S.C.Pandey
• 6. Van Horne & Wachowiz: Fundamentals of
Financial Management (Prentice Hall India)
 Reference Text:

• 7. Sharan: Fundamentals of Financial Management (Pearson)

• 8. Financial Management – Rajiv Srivastava & Anil Misra – Oxford
Publications
• 9. Financial Management – Chandra Hariharan Iyer – International Book
House Ltd
• 10.Fundamentals of Financial Management – Sheeba Kapil – Pearson
Publications
• 11. Strategic Financial Management – Prasanna Chandra
 After studying Chapter 1, you
should be able to:
1. Describe "financial management" in terms of the three major decision
areas that confront the financial manager.
2. Identify the goals of the firm and understand why shareholders' wealth
maximization is preferred over other goals.
3. Understand the potential problems arising when management of the
corporation and ownership are separated (i.e., agency problems).
 The Role of
Financial Management

• What is Financial Management?

• The Goal of the Firm
• Corporate Governance
• Organization of the Financial Management
Function
 What is Financial
Management?

Concerns the acquisition,

financing, and management of
assets with some overall goals
in mind.
Finance-decision making

Investment Decisions
Capital budgeting Decisions

Financing decisions
Capital structure

Liquidity Decision
Working capital management

Dividend decision
Working capital management
Distribution decision

DR.VN.BRIMS. 7
 Financing Decisions

Determine how the assets (RHS of

balance sheet) will be financed (LHS
of balance sheet).
• What is the best type of financing?
• What is the best financing mix?
• What is the best dividend policy (e.g.,
dividend-payout ratio)?
• How will the funds be physically acquired?
 Investment Decisions
Most important of the three
decisions.
• What is the optimal firm size?
• What specific assets should be acquired?
• What assets (if any) should be reduced or
eliminated?
 Capital Budgeting
Evaluation Process
Many companies follow a carefully prescribed
process in capital budgeting. At least once a
year:
1) Proposals for projects are requested from each
department.
2) The proposals are screened by a capital budgeting
committee, which submits its finding to officers of
the company.
3) Officers select projects and submit list of projects
to the board of directors.
10
 Capital Budgeting
Evaluation Process
The capital budgeting decision depends
depends on a variety of considerations:
1) The availability of funds.
2) Relationships among proposed
projects.
3) The company’s basic decision-making
approach.
4) The risk associated with a particular
project.
11
 Cash Payback Formula
Study Objective 2

The cash payback technique identifies the time period

required to recover the cost of the capital investment from
the annual cash inflow produced by the investment.
The formula for computing the cash payback period is:

12
 Net Present Value Method

• The present value method technique is

generally recognized as the best conceptual
approach to making capital budgeting decisions.
• This technique considers both the estimated
total cash inflows and the time value of money.
• Two methods are used with the discounted
cash flow technique:
1) net present value and
2) internal rate of return
13
 Net Present Value Method
• Under the net present value method, cash inflows
are discounted to their present value and then
compared with the capital outlay required by the
investment.
• The interest rate used in discounting the future cash
inflows is the required minimum rate of return.
• A proposal is acceptable when NPV is zero or
positive.
• The higher the positive NPV, the more attractive the
investment.
14
Net Present Value
Decision Criteria

15
 Internal Rate of Return
Method

• The internal rate of return method finds the interest yield of the
potential investment.
• This is the interest rate that will cause the present value of the
proposed capital expenditure to equal the present value of the
expected annual cash inflows.
• Determining the true interest rate involves two steps:
STEP 1.Compute the internal rate of return factor using this
formula:

16
 Internal Rate of Return
Decision Criteria

The decision rule is: Accept the project when the internal rate of return
is equal to or greater than the required rate of return. Reject the
project when the internal rate of return is less than the required rate.
17
 Comparison of Discounted
Cash Flow Methods
• In practice, the internal rate of return and cash payback
methods are most widely used.
• A comparative summary of the two discounted cash flow
methods-net present value and internal rate of return- is
presented below:
Item Net Present Value Internal Rate of Return
1. Objective Compute net Compute internal rate of
present value. return.
2. Decision rule If net present If internal rate of return
value is zero or is equal to or greater
positive, accept than the minimum
the proposal; if required rate of return,
net present value accept the proposal; if
is negative, reject internal rate of return is
the proposal. less than the minimum 18
rate, reject the proposal.
 Annual Rate of Return Formula
• The annual rate of return technique is based on
accounting data. It indicates the profitability of a capital
expenditure. The formula is:

The annual rate of return is compared with its required

minimum rate of return for investments of similar risk.
This minimum return is based on the company’s cost of capital,
which is the rate of return that management expects to pay on
all borrowed and equity funds. 19
 Formula for Computing
Average Investment
Expected annual net income (Rs13,000) is obtained from
the projected income statement. Average investment is
derived from the following formula:

For Reno, average investment is Rs65,000: [(Rs130,000 + Rs0)/ 2]

20
 Asset Management
Decisions(wc)
• How do we manage existing assets efficiently?
• Financial Manager has varying degrees of
operating responsibility over assets.
• Greater emphasis on current asset
management than fixed asset management.
 Table 2: Capital budgeting in SA, USA, UK and the
Asia-Pacific region

Method Australia Singapore Indonesia

South Africa USA UK Hong Malaysia Philippine
Kong s

IRR 79% 77% 89% 96% 86% 88% 94% 89% 94%

NPV 82% 85% 99% 96% 88% 86% 94% 91% 81%

ARR 14% 15% 60% 73% 80% 80% 56% 69% 78%

Payback 54% 53% 96% 93% 100% 98% 81% 94% 100%

DR.VN.BRIMS. 22
 What is the Goal of the
Firm?Financial objectives
Profit Maximization
Maximizing a firm’s earnings after taxes.
Problems
• Could increase current profits while harming firm
• Ignores changes in the risk level of the firm.
 What is the Goal of
the Firm?
Maximization of
Shareholder Wealth! Value
creation occurs when we maximize
the share price for current
shareholders or Maximise value of an
enterprise (with stakeholders ).
 Shortcomings of Alternative
Perspectives
Earnings per Share Maximization
Maximizing earnings after taxes divided
by shares outstanding.
Problems
• Does not specify timing or duration of expected
returns.
• Ignores changes in the risk level of the firm.
• Calls for a zero payout dividend policy.
 Strengths of Shareholder
Wealth Maximization
• Takes account of: current and future profits and
EPS; the timing, duration, and risk of profits and
EPS; dividend policy; and all other relevant
factors.
• Thus, share price serves as a barometer for
business performance.
 Financial Objectives
• EVA= NOPAT--WACC *ROCE
• MVA= MPS* No. of Shares
• EPS=PAT/No. of shares
• PAT=EBIT-Int-Tax
 EVA
• Registred trademark of Stern stewart ad co.
• Measure of corporate performane
• NOPAT-excluding non operating items like div,non operating
expenses,CAPITAL EMPLOYED –shareholders fund loan funds
• Calculate EVA :--
• Example: Rs Cr
• Avg Debt Rs 30 Cr
• Av Equity Rs 270 Cr
• PAT Rs 145 Cr
• Interest after taxes 0.5
• Cost of Debt (post tax) 7.50%
• Cost of equity 15%
 Return on investment" (ROI)
• Return on investment" (ROI) metric is to measure, per period, rates
• of return on money invested in an economic entity in order to decide whether or
not to undertake an investment.

• indicator to compare different project investments within a project portfolio. The

project with best ROI is prioritized.
ROI and related metrics provide a snapshot of profitability, adjusted for the size of the
investment assets tied up in the enterprise.
ROI is often compared to expected (or required) rates of return on money invested.
• Marketing decisions have obvious potential connection to the numerator of ROI
(profits), but these same decisions often influence assets usage and capital
requirements (for example, receivables and inventories).
• In a survey of nearly 200 senior marketing managers, 77 percent responded that
they found the "return on investment" metric very useful.
 ROI: Return on investment

• ROI: Divide the return (net profit) by the resources that were
committed (investment)
• Return on investment = Net income / Investment
where: Net income = gross profit − expenses

or
• return on investment = (gain from investment – cost of investment) /
cost of investment or
• return on investment = (revenue − cost of goods sold) / cost of goods
sold
 Return on investment

Return on investment is frequently derived

as the “return” (incremental gain) from an
action divided by the cost of that action. That
is the "simple" version of this cash flow
metric, used for evaluating investments,
business case results, and other actions. For
example:
What is the ROI for a marketing program
expected to cost Rs500,000 and deliver an
additional Rs700,000 in profits over the next
five years?
 How to improve ROI
• 1)Increase sales
• 2)Reduce cost(Managing leverage)
• Consumer goods essential items-high volume /low profit
• Mercedes /rolex watches—low volume high margin
• 3)Reduce assets
• TCS—2008-09 Cost of overseas travel reduced due to increased video
conferencing
• Ahmadnagar-Construction material hire of donkeys 2009
• Tata Motars – Larrgest loss of 500 cr in a yr 2001
• “cost mgt erosion—cross functional teams to monitor cost erosion
initiatives/e procurement rather than traditional
purchasing/rationalising vendor profile /vendor policies/ os change ----
turnaround took 5 years
HUL - MANAGING COST - PROFIT - VOLUME -
MIX
• ―Buoyed by a mix of product price increases and volumes, fast-
moving consumer goods (FMCG) major Hindustan Unilever (HUL)
posted an 18% growth in net profit at Rs. 754 crore for the third
quarter ended December, 31, 2013, compared to Rs. 638 crore in the
corresponding period last year, Net sales rose 16% to Rs. 5,853 crore
from Rs. 5,027 crore during the period.‖
• This is a good example of sales increase (16%) through better
management of price increases, product mix, volumes along with
dynamic cost management through ―aggressive savings programs
coupled with judicious pricing‖. Personal products, oral care,
beverages and packaged foods grew in the range of 11 to 14%.
However, the performance of Knorr soups was muted.
• SOURCE:The Times of India (Mumbai) 7 th February, 2014.
HUL - MANAGING COST - PROFIT - VOLUME -
MIX
• ―Buoyed by a mix of product price increases and volumes, fast-
moving consumer goods (FMCG) major Hindustan Unilever (HUL)
posted an 18% growth in net profit at Rs. 754 crore for the third
quarter ended December, 31, 2011, compared to Rs. 638 crore in the
corresponding period last year, Net sales rose 16% to Rs. 5,853 crore
from Rs. 5,027 crore during the period.‖
• This is a good example of sales increase (16%) through better
management of price increases, product mix, volumes along with
dynamic cost management through ―aggressive savings programs
coupled with judicious pricing‖. Personal products, oral care,
beverages and packaged foods grew in the range of 11 to 14%.
However, the performance of Knorr soups was muted.
• SOURCE:The Times of India (Mumbai) 7 th February, 2012.
 Publication: The Economic Times Mumbai; Date: Jan 28, 2014;
Section: Economy;

• The impressive earnings show so far in the December quarter, led largely by an upbeat information
technology sector, appears to be waning as a rising number of companies from other sectors have
started reporting lack lustre performances.
• Net sales at the aggregate level for a sample of 141 companies, excluding companies from banking &
financial services industry (BFSI) and the oil & gas sector, rose by 12% during the quarter to December
2013 compared with the year ago period. This was slower than the 14.5% increase in the previous
quarter.
• Operating profit and net profit, on the other hand, grew at a five-quarter high rate of 22% and 21%,
respectively. This shows that non-IT firms continued to cut costs to retain profit margins at a time when
revenue growth is hard to come by due to slack in overall demand.
• Last week, a sample of 44 non-BFSI companies had reported a strong growth of 23% in revenue and
36% in net profit from the year ago dominated by better growth from software services companies
which had accounted for 82% of aggregate sales of the sample and as much as 90% of net profit. Results
of manufacturing companies have started portraying a picture of a more growth. The efficient
management of operating costs has been a key feature of the earnings season so far. For instance,
aggregate net sales of 10 capital goods companies that declared results for the quarter to December fell
by 5% but operating profit and net profit rose by 16% and 14%, respectively.
 Capital Asset
Pricing Model (CAPM)
CAPM is a model that describes the relationship
between risk and expected (required) return; in
this model, a security’s expected (required) return
is the risk-free rate plus a premium based on the
systematic risk of the security.
 What is Beta?

An index of systematic risk.

It measures the sensitivity of a stock’s returns to
changes in returns on the market portfolio.
The beta for a portfolio is simply a weighted
average of the individual stock betas in the
portfolio.
 Security Market Line

Rj = Rf + bj(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
bj is the beta of stock j (measures systematic risk
of stock j),
RM is the expected return for the market portfolio.
 Determination of the
Required Rate of Return
Lisa Miller at Basket Wonders is attempting to
determine the rate of return required by their
stock investors. Lisa is using a 6% Rf and a long-
term market expected rate of return of 10%. A
stock analyst following the firm has calculated
that the firm beta is 1.2. What is the required rate
of return on the stock of Basket Wonders?
 BWs Required Rate
of Return

RBW = Rf + bj(RM - Rf)

RBW = 6% + 1.2(10% - 6%)
RBW = 10.8%
The required rate of return exceeds the market
rate of return as BW’s beta exceeds the market
beta (1.0).
 Determination of the
Required Rate of Return
Small-firm Effect
Price / Earnings Effect
January Effect

These anomalies have presented serious

challenges to the CAPM theory.
 What companies say about
their corporate goal*
• Cadbury Schweppes: “governing objective is growth in
shareowner value”
• Credit Suisse Group: “achieve high customer
satisfaction, maximize shareholder value and be an
employer of choice”
• Dow Chemical Company: “maximize long-term
shareholder value”
• ExxonMobil: “long-term, sustainable shareholder value”
*Refer to text for additional details
 The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION between owners

and managers.
 Role of Management

Management acts as an agent

for the owners (shareholders)
of the firm.
• An agent is an individual authorized by
another person, called the principal, to
act in the latter’s behalf.
 Agency Theory

Jensen and Meckling developed

a theory of the firm based on
agency theory.
• Agency Theory is a branch of economics
relating to the behavior of principals and
their agents.
 Agency Theory

Principals must provide incentives

so that management acts in the
principals’ best interests and then
monitor results.
• Incentives include, stock options, perquisites,
and bonuses.
 Social Responsibility

• Wealth maximization does not preclude the

firm from being socially responsible.
• Assume we view the firm as producing both
private and social goods.
• Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.
 Corporate Governance

• Corporate governance: represents the system

by which corporations are managed and
controlled.
– Includes shareholders, board of directors,
and senior management.
• Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.
 Sarbanes-Oxley Act of 2002
• Sarbanes-Oxley Act of 2002 (SOX): addresses corporate
governance, auditing and accounting, executive compensation,
and enhanced and timely disclosure of corporate information
– Imposes new penalties for violations of securities laws
– Established the Public Company Accounting Oversight
Board (PCAOB) to adopt auditing, quality control, ethics,
disclosure standards for public companies and their
auditors, and policing authority
– Generally increasing the standards for corporate
governance
 Organization of the Financial
Management Function

Board of Directors

President
(Chief Executive Officer)

Vice President VP of Vice President

Operations Finance Marketing
 Organization of the Financial
Management Function

VP of Finance
Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mngmt Preparing Fin Stmts
Tax Analysis/Planning Preparing Budgets
Preparing Forecasts
DR.VN.BRIMS.