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Financial Management Objectives

R O I
(Return on Investment)

DEFINATION The term finance can be defined as the management of the flows of money through an organisation, whether it will be a corporation, school, Bank or Government agency. Finance is the life blood of various managerial function, viz., production, marketing, Human Resource (personnel) and Research & Development (R&D).
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Business runs on MONEY (Finance)

Three important activities of a Business Firm

Finance

Production

Marketing

Functions Of Finance
Three major decisions that the firm must make: 1) Investment Decision: Capital Budgeting. 2) Financing Decision: Issue of Shares, Debentures, etc 3) Dividend Decision: Dividend and Retained Earnings. Financial Management is that managerial activity which is concerned with the planning and controlling of the firms financial resources.
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Objectives/ Goal of Financial Management (Short term)


Proper utilisation of funds Maximisation of Return on Investment (ROI) so that the company need not depend on external borrowings and give shareholders better returns in the form of dividend and bonus. Survival due to competition, change in consumer behaviour or technology, labour problem. Cash flow to ensure availability of adequate cash flow to meet the working capital requirements. Break Even Point no profit no loss Total Revenue= Total Cost

Objectives/ Goal of Financial Management (Short term)

Minimum profits to earn minimum profits in short term so as to cover up the cost of capital. No Profit, No Business. Ensure Co-ordination proper co-ordination in the activities of finance department with those of the other departments in the organisation. Good Image for the Organisation good name, reputation, image and goodwill.

Objectives/ Goal of Financial Management ( Long Term)


1) Profit Maximisation Approach 2) Wealth Maximisation Approach

Profit Maximisation Approach


It implies that investment, financing and dividend policy decisions of the firm should be oriented towards maximisation of profits Profit is the test of economic efficiency. It leads to efficient allocation of resources. Ensures maximum social welfare to ensure efficient use of scarce resources.

Profit Maximisation Approach


Limitations Profit in absolute term is not a proper guide to decision making It has no precise connotations (loose term) Profit can be long term or short term, before tax or after tax It leaves considerations of timing and duration undefined, i.e. No guide for comparing profit now with the future. It depends on the risk factor higher risk higher returns. Exclusive attention on profit maximisation misdirects the managers.
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Wealth Maximisation Approach


Value Maximisation or Net Present worth Maximisation. It implies the maximisation of the market price of the shares. It satisfies all the requirements of a suitable operational objective of financial course of action, namely exactness, quality of benefits and time value of money.
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Wealth Maximisation Approach Advantages to Shareholders


Long term strategy emphasising on raising the present value of owners investment in the company. Implementation of projects that will increase the market value of shares. Recognises the risk or uncertainty. Recognises the timing of returns by taking into account trade- off between various return and the associated level of risk. Considers shareholders returns as takes into account payment of dividend to shareholders.

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Definition
Ezra Solomon has defined wealth maximisation objectives in the following manner:the gross present worth of a course of action is equal to the capitalised value of the flow of future expected benefits, discounted at a rate which reflects the certainty or uncertainty. net present value is the difference between gross present worth and the amount of capital investment required to

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Profit and Profitability


Profit refers to the net earnings i.e. RevenueExpenditure. Reflects actual earning of the business including any non-operational income or loss. It could be profit before tax or profit after tax. Profit is an absolute figure. Profitability reflects the final result of business operations. Refers to the operating net profit i.e. Profit before considering non-operating income or expenses. it helps to establish future earning capability of the business. Profitability is in relation to the sales or capital employed. eg: loss due to fire would reduce the profit of a business but not the profitability of the business as it not an operating loss.

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Du Pont Chart
Net Profit Margin
Net Profit

Return on Total Assets Total Asset Turnover

X Net sales

Net Sales

Average total Assets

Net Sales+/Non Operating Surplus /Deficit

Total Cost

Avg Current Assets


Avg Cash, Bank & Marketable Securities

Avg Fixed Assets

Cost of Goods Sold

Operating Expenses

Average Debtors

Interest

Tax Average Inventory

Average of others
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ROI & Du Pont Approach


The true test whether the profits are too great or to small is the rate of return on the money invested in the business and not the percent of profit on cost. The earning power or the ROI ratio is a central measure of the overall profitability and operational efficiency of the firm. The Du Pont chart shows the interaction of profitability and activity ratio. It implies that the performance of a firm can be enhanced either by generating more sales volume per rupee of investment or by increasing the profit margin per rupee of sales.

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Net PAT Total Assets Return on Equity = Net Profit After Tax (NAT) (ROE) Shareholders Equity

ROI =

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Ways of Improving Return on Investment (ROI)


1) 2) 3)

4)

5)

By increasing net profit for same amount of sales By increasing sales volume for the same amount of investment Reducing the cost- e.g. In case of a replacement proposal where the asset has worn out or become outdated, the firm has to decide in terms of lower operational cost and outlay cost that would be needed to replace the old machine. Increasing Profits-by expansion of present operation or development of new product line. By diversification, productivity, improvement, expansion, product improvement. 17

ROI not the end of Financial Objectives (only a tool for analysis)

It is only a ratio. It is calculated from financial statements which are affected by financial policies adopted eg. Depreciation, valuation of stock. Financial statements do not represent a complete picture of business , dont refer to other factors which effect performance. Overuse of ROI is dangerous. Management may simply concentrate on improving the ratio than on dealing with

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Financial management objectives


Maximising Sales/Revenue/Earnings Maximising Profit Maximising Return on Sales/on Investment Maximising Corporate Wealth Maximising Shareholders Value Social Acceptability and Recognition Maximising Social Wealth

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Illustration 1
The comparative Bal/Sheet & Income statement for ABC ltd for the years 2004-2008

Comparative Financial Statement Part A : Bal Sheet (Rs in Crores) 2004 Share Capital Reserves & Surplus 2005 2006 2007 2008 11.20 6.90 10.00 10.00 15.00 15.00 15.00 6.50 10.50 2.25 7.60 2.60 8.50 9.10 10.60 2.40 7.60 2.50

Secured Loans
Unsecured Loans Current Liabilities & Provisions Fixed Assets (Net)

12.75 13.50 13.25 13.10 14.30


8.10 10.50

25.20 28.30 30.40 32.20 33.00

Investments
Current Assets, Loans & Advances Debtors Inventories

1.00
6.10 6.00

1.00
6.90 8.20

1.00
7.35 8.00

1.00

1.00

12.10 15.10 15.35 15.60 23.40 7.90 12.80 7.70 10.60

Misc Exp & Losses


Total

0.80

0.70

0.60

0.50

0.50

39.10 45.10 47.35 49.30 57.90


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Part B : Income Statement (Rs in Crores) 2004 2005 2006 2007 2008

Net Sales
Cost Of Goods Sold Gross Profit Operating Expenses

47.50 54.20 60.50 62.30 70.10


35.20 38.00 44.40 47.50 55.20 12.30 16.20 16.10 14.80 14.90 3.50 0.40 2.00 3.00 4.20 2.00 4.10 0.70 2.10 4.40 6.30 2.30 4.40 4.90 5.60

Operating Profits
Non Operating Surplus/ Deficit P/EBIT Interest

8.80 12.10

11.70
0.90 2.50 4.20 5.90 2.30

9.90

9.30
8.90 2.10

0.60 (0.40) 2.20

9.20 12.80 12.60 10.50

PBT
TAX PAT Dividends

7.20 10.70 10.10

8.30
4.10 4.20 2.70

6.80
3.50 3.30 2.70

Retained Earnings

2.20

4.00

3.60

1.50

0.60

Prepare the DU Pont Chart for the year 2008

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Illustration 2
The comparative Bal/Sheet & Income statement for XYZ Ltd for the years 2004-2008 Comparative Balance Sheet s(Rs in Crores)

2004 Liabilities & Equity:


Share Capital Reserves & Surplus Long Term Debt Short Term Bank borrowings Current Liabilities Total Assets: 4.30 4.70 3.60 6.50 2.50 21.30

2005

2006

2007

2008

4.30 6.70 3.10 5.20 3.20 22.50

6.50 5.70 2.30 5.60 7.50 27.60

6.50 7.40 5.20 8.30 6.60 34.00

6.50 9.30 3.80 11.70 6.70 38.00

Net Fixed Assets Current Assets (a) Cash and Bank


(b) Receivables (c) Inventories Other assets Total

10.80 1.20
3.10 5.10 1.10 21.30

11.90 2.60
1.80 4.60 1.60 22.50

14.80 0.70
2.80 6.20 3.10 27.60

19.60 0.60
2.90 8.20 2.70 34.00

23.20 1.10
2.00 9.30 2.40 38.00
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Comparative Income Statement (Rs in Crores)


2004 Net Sales Cost Of Goods Sold 2005 2006 2007 2008 29.80 34.90 34.60 39.00 57.40 24.50 26.20 26.00 30.50 45.80

Gross Profit
Operating Expenses Operating Profits Non Operating Surplus/ Deficit

5.30
3.70 1.60 0.20

8.70
4.20 4.50 0.10

8.60
4.60 4.00 0.20

8.50
4.90 3.60 0.50

11.60
7.00 4.60 0.40

P/EBIT
Interest PBT TAX

1.80
1.00 0.80 -

4.60
0.90 3.50 0.60

4.20
0.80 3.40 1.20

4.10
1.50 2.60 -

5.00
2.00 3.00 -

PAT
Dividends Retained Earnings

0.80
0.60 0.20

2.90
0.60 2.30

2.20
0.90 1.30

2.60
0.90 1.50

3.00
1.10 1.90

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Case Study
Assume

that there are two firms A and B, having total assets amounting to Rs 5,00,000 and average net profits of 10% that is Rs 50,000 each. Firm A has sales of Rs 5,00,000 whereas the sales of firm B aggregates Rs 50,00,000. Determine the earning power of firms A and B.

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Case Study
SOL:
1 Nets Sales Firm A 5,00,000 Firm B 50,00,000

2 3
4 5 6

Net profit Total Assets


Profit Margins(2/1) Investment Turnover (1/3) ROI Ratio (4x5)

50,000 5,00,000
10% 1 times 10 %

50,000 5,00,000
1% 10 times 10 %

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Capital Expenditure Project


Refers to acquiring inputs with long term returns Is long term planning for making & financing proposed capital outlay

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Financial analysis, planning and control


Balance sheet Long term financing Fixed assets Short term financing Current assets Mgt of firms financial firms assets Structure mgt of structure
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Ty p e s o f i n v e s t m e n t p r o j e c t s that a firm undertakes


Purchase

of new machinery Expansion of product lines Replacement of worn out or less productive existing assets Mergers/acquisition

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Capital Budgeting Techniques


Capital budgeting techniques Non Discounted techniques Pay back period Avg /Accounting rate of return (ARR)

Discounted techniques
Net present value Discounted payback period

Profitability index/ benefit cost ratio


Internal rate of return (IRR)

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Assumptions of C. E. Projects

All the alternative investment proposals are riskless or carry equal amount of risks Cash inflows are net of corporate tax Investment outlays are made at the beginning of the year, and cash inflows are received at the end of the year. Sunk cost : are part of cash outflow which have already been incurred and therefore have no effect on cash flows relevant to current decision.
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Pro forma of calculation of cash inflows


Particulars Sales Less: all expenses excluding depreciation EBDT Less: Deprn EBT Less: Tax @--- % EAT Add: Deprn Cash Inflows NOTES: (Important) 1. For ARR method use profit/ earnings after tax 2. For all other methods in Capital Budgeting except ARR use cash inflows.
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Pay Back Method


Two situations 1. Cash flows are of uniform amounts Payback Period = Initial investment Annual Cash Inflows
2.

Cash flows are of uneven amounts Payback Period = xxx years + ( Required Amt
* 12 Months) Annual net inflows
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Payback Profitability = Annual cash inflows * (estimated life


payback period)

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ARR Method
ARR = Average Net Profit after Tax * 100 Original Investment 2. ARR = Average Net Profit after Tax * 100 Average Investment Where, Net Profit can be NPBT before Depn. NPAT before Deprn. NPAT after Deprn. Average Annual Profits = Total Profits of all years No. Of years
1.
Average = Initial cost of machinery - salvage value + Additional Net + Salvage value Investment 2 Working capital
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3. ARR = Incremental Earnings or Profits * 100 Incremental Investment Consideration of old and new machines NPAT Machine B NPAT Machine A * 100
Purchase Price of new mach sale proceeds of old mach

Consideration of 2 projects ( mach) to be purchased NPAT Machine B NPAT Machine A * 100


Investment Mach B Investment Mach A
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Illustration 1
Payback period
PQR co ltd. has invested in a machine at a cost of Rs 9,00,000. following details are estimated:
retrenchment in staff 4 staff @ salary of Rs 20000 Additional staff required 1 staff @ salary of Rs 40000 saving in wastage Rs 40000 savings in maintenance Rs 10000 Additional electricity bill Rs 15000 Calculate : payback period, ignore taxation & depreciation
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Illustration 2

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Illustration 3

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Illustration 4
Better Co Ltd. is considering the purchase of New Machine for the immediate expansion programme. There are three types of machines in the market for this purpose. Their details are as follows:
Particulars Mach A Mach B Mach C
17500 400 2750 100 750 10 12500 750 6000 400 550 800 6 Cost of Mach Estimated savings in Scrap per year Est. Savings in direct wages per year Add cost of indirect mat. per year Expected saving in indirect mat. p.a. Add cost of maint. p.a. Add cost of supervision Est. Life of mach(Yrs) 9000 250 2250 250 500 5
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Taxation @ 40% of profit

You are required to advise the mgt to which type of mach should be purchased on the basis of payback period

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Illustration 5

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Illustration 6

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Illustration 9

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Illustration 10

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Present Value Method (PV)


PV > C ------ Accept the proposal PV < C ------Reject the proposal PV = C ------Indifferent

(C is the Outlay)

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Net Present Value Method (NPV)


NPV = Present value of cash inflows Less: Original Investment If NPV = positive ---- Accept If NPV = negative---- Reject If NPV = zero---------- Indifferent

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Profitability Index (PI) / Benefit- Cost Ratio (B/C Ratio)


PI = PV of cash Inflows PV of cash Outflows = Benefits Cost PI > 1 accept (NPV +ve) PI< 1 reject (NPV ve) PI = 1 indifferent (NPV zero)

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Benefit Cost Ratio ( B/C)


B/C = Discounted Inflows Discounted Outflows B/C >1 accept B/C < 1 reject

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Internal Rate of Return (IRR) method


IRR is the Rate at which CFAT =C i.e. When NPV = Zero, r = ? (r = IRR) Under IRR, NPV = Zero Conditions: IF NPV > Zero, Interest rate higher than the rate selected would be tried. NPV < Zero, Interest rate lower than the rate selected would be tried.

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IRR =D1 + PVD1 PVC *(D2 D1) PVD1 PVD2 Where, D1= Lower rate of discount D2 = Higher rate of discount PVc = Present value of Outflows PVD1= Present value of cash inflows at D1 PVD2= Present value of cash inflows at D2

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Interpolation Technique
IRR =D1 + PVD1 PVC *(D2 D1) PVD1 PVD2 Fake payback period (F) F= Cash Outlay Average annual cash inflows Fake Average Payback = Initial Outlay OR Original Investment Fake Annuity Average Annual CFAT Fake Annuity = CFAT(including salvage) No. Of years

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Locate the factor closest to the Fake payback in the Annuity factor table along the economic life of the Machine. Actual cash flows in the earlier years is more than average cash flows take higher Interest Rate. Actual cash flows in the earlier years is less than average cash flows take lower interest Rate.
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