Financial Management

MSL708
Introduction MSL708
• Classes: M and Th (11 to 12:15p)

• Material
• Solved Problems + PPTs
• Book: Financial Management by Khan and Jain (8e)

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Introduction MSL708
• Marking Scheme

Quizzes X 3 (Best of 2) - 20 marks

Minor test 1 – 15 marks
Minor test 2 – 15 marks
Major test – 30 marks
Attendance and Class Participation– 10 marks
Group Assignment (PPT) – 10 marks

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Introduction MSL708
• Topics:
• Chapter 1 – Introduction/Theory
• Chapter 2 - Capital Budgeting Decisions
• Chapter 3 – Risk Analysis in Capital Budgeting Decisions
• Chapter 4 – Working Capital Management
• Chapter 5 – Cost of Capital
• Chapter 6 – Operating, Financial and Combined Leverage
• Chapter 7 – Theories of Capital Structure
• Chapter 8 – Capital Structure Decision
• Chapter 9 – Dividend Policy Decision
• Case Studies
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Financial Management
An Overview
Chapter 1
 Finance may be defined as the art and science of managing money. The
major areas of finance are:

1. Financial Services

Financial services is concerned with the design and delivery of advice and
financial products to individuals, business and governments.

2. Financial Management

Financial Management is concerned with the duties of the financial

managers in the business firm.

Financial managers actively manage the financial affairs of any type of

business, namely, financial and non-financial, private and public, large and
small, profit-seeking and not-for-profit.
Financial Management
What is it?

Analytical,
Conceptual and
Normative Framework

for taking Financial Decisions

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Scope of Financial Management
The scope of financial management can be broken down into three
major decisions as functions of finance:

1 Investment Decisions
2 Financing Decisions
3 Dividend Policy Decisions

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(1) Investment Decision
The investment decision relates to the selection of assets in which funds will
be invested by a firm. The assets which can be acquired fall into two broad
groups: (1) long-term assets (Capital Budgeting) (2) short-term or current
assets (Working Capital Management).
(1) Capital Budgeting Capital budgeting is probably the most crucial financial
decision of a firm. It relates to the selection of an asset or investment
proposal or course of action whose benefits are likely to be available in
future over the lifetime of the project.
(2) Working Capital Management Working capital management is concerned
with the management of current assets. It is an important and integral part
of financial management as short-term survival is a prerequisite for long-
term success.

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(2) Financing Decision
The second major decision involved in financial management is the financing
decision. The investment decision is broadly concerned with the asset-mix or the
composition of the assets of a firm. The concern of the financing decision is with
the financing-mix or capital structure or leverage. There are two aspects of the
financing decision.
First, the theory of capital structure which shows the theoretical relationship
between the employment of debt and the return to the shareholders.
The second aspect of the financing decision is the determination of an appropriate
capital structure, given the facts of a particular case.

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(3) Dividend Policy Decision
The dividend decision should be analysed in relation to the financing
decision of a firm. Two alternatives are available in dealing with the
profits of a firm:
(i) they can be distributed to the shareholders in the form of dividends
or
(ii) they can be retained in the business itself. The decision as to which
course should be followed depends largely on a significant element in
the dividend decision, the dividend-pay out ratio, that is, what
proportion of net profits should be paid out to the shareholders.

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 Financial Decision Areas
Primary Disciplines
• Accounting
1. Investment analysis • Macroeconomics
Support
2. Working capital management • Microeconomics
3. Sources and cost of funds
4. Determination of capital structure
5. Dividend policy Support Other Related Disciplines
6. Analysis of risks and returns • Marketing

Resulting in • Production
• Quantitative methods

Shareholder wealth maximisation

Figure 1: Impact of Other Disciplines on Financial Management

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Objectives Of Firm
• The goal of the financial manager is to maximise the shareholders
wealth as reflected in share prices rather than profit/EPS
maximisation because the latter ignores the timing of returns, does
not directly consider cash flows and ignores risk.
• As key determinants of share price, both return and risk must be
assessed by the financial manager when evaluating decision
alternatives.

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Timing of Benefits
A more important technical objection to profit maximisation, as a guide to financial decision making, is that it ignores the
differences in the time pattern of the benefits received over the working life of the asset, irrespective of when they were received.

Table 1: Time-Pattern of Benefits (Profits)

Time Alternative A (Rs in lakh) Alternative B (Rs in lakh)
Period I 150 50
Period II 100 100
Period III 50 150
Total 300 300

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Quality of Benefits
Probably the most important technical limitation of profit maximisation as an operational objective, is that it ignores the quality
aspect of benefits associated with a financial course of action. The term quality here refers to the degree of certainty with which
benefits can be expected.

Uncertainty About Expected Benefits (Profits)

State of Economy Profit (Rs crore)
Alternative A Alternative B
Recession (Period I) 9 0
Normal (Period II) 10 10
Boom (Period III) 11 20
Total 30 30

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Wealth maximization
• Concept of cash flows generated by the decision (rather than profit)

• Considers time value of money

• Considers inherent risk

• Thus, net present value method.

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Two issues related with value maximization
• Other stakeholders

• EVA [next class]

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Other stakeholders
• Wealth maximization should be conformity with interests of other major stakeholders
• Lenders, suppliers, employees etc.

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 PRIMARY OBJECTIVE OF CORPORATE MANAGEMENT
The major objective of corporate finance by Indian corporates are summarised as follows:
❖ The two most important objectives of management decision making in corporate finance in India are: (i) maximisation
of earnings before interest and tax (EBIT) and earnings per share (EPS) (85 per cent) and (ii) maximisation of the
spread between return on assets (ROA) and weighted average cost of capital (WACC), that is, economic value added
(EVA) (76 per cent).
❖ Large firms (on the basis of sales, assets and market capitalisation), high growth firms and firms with high exports
significantly focus on maximising EVA than small, low growth and low exports firms respectively.
❖ There is no significant difference in the EVA as a corporate finance objective followed by the firms in public and
private sectors.
❖ The spread between cash flow return on investment (CFROI) and the WACC, that is, cash value added (CVA) is the
third most important objective (54 per cent) of corporate finance management for large firms based on market
capitalisation.
❖ Yet another important objective is the maximisation of market capitalisation. The MVA (market value added) objective
is more likely to be followed by public sector units than by private sector firms.
❖ The overwhelming majority of corporates (70 per cent) consider maximising per cent return on investment in assets as
the most important.
❖ Another perferred goal is desired growth rate in EPS/maximise aggregate earnings.
❖ Wealth maximisation/maximisation of share prices is the least preferred goal of the sample corporates.

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Exhibit 1: Ranbaxy’s Missions and Values
MISSION
To become a research-based International Pharmaceutical Company.
VALUES
❖Achieving customer satisfaction is fundamental to our business.
❖Provide products and services of the highest quality.
❖Practice dignity and equity in relationships and provide opportunities for our people to
realise their full potential.
❖Ensure profitable growth and enhance wealth of the shareholders.
❖Foster mutually beneficial relations with all our business operations.
❖Manage our operations with high concern for safety and environment.
❖Be a responsible corporate citizen.
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Exhibit 2: HLL’s Corporate Purpose
❖Our purpose in Unilever is to meet the everyday needs of people everywhere—to anticipate the
aspirations of our consumers and customers and to respond creatively and competitively with branded
products and services which raise the quality of life.
❖Our deep roots in local cultures and markets around the world are our unparalleled inheritance and
the foundation for our future growth. We will bring our wealth of knowledge and international
expertise to the service of local customer—a truly multi-local multinational.
❖Our long-term success requires a total commitment to exceptional standards of performance and
productivity, to working together effectively and to a willingness to embrace new ideas and learn
continuously.
❖We believe that to succeed requires the highest standards of corporate behaviour towards our
employees, consumers and the societies and world in which we live.
❖This is Unilever’s road to sustainable, profitable growth for our business and long-term value creation
for our shareholders and employees.

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Exhibit 3: Vision of Future of Reliance Industries Ltd.
Reliance is an enterprise that contributes, in a modest way, to critical economic and social needs of India
and attaining global leadership in all of its major initiatives.
Pursuing this vision, over the next few years, Reliance will pursue a strategy of:
❖Reinforcing competitive advantage of existing businesses through new capacities and synergistic
acquisitions
❖Scaling sizeable opportunities in petroleum exploration and production
❖Forward integrating into retailing transportation fuels and creating new customer experiences
❖Building the BSES acquisition, now Reliance Energy, to a major electricity utility
❖Addressing the significant information and communications market opportunity in India and in the world
❖Leveraging its strong balance sheet, cash flows and managerial capacity to create value by adding new
capacities, acquisitions and turnaround of under performing assets
❖Developing strategic alliances in technology and product-market domains with global majors
❖Fostering new higher education institutions for knowledge creation and sharing
❖Leveraging its formidable strengths beyond Indian borders.

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In this endeavour, Reliance will undergo an upgradation:
❖In addition to manufacturing products to developing manufacturing systems
❖From having a manufacturing orientation to providing technical solutions
❖From being an intermediate goods producer to being a final goods and services provider
❖From being a margin energy player to being a global energy major
❖In addition to vertical integration in hydrocarbon energy markets to horizontal integration over diverse
energy markets
❖From licensing technology to developing technology
❖From being an intellectual property user to an intellectual property creator
❖In addition to operating in India to being a global company
❖From building financial equity to fostering social equity

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This change will entail creating new organisational competencies such as:
❖Creating a customer-centric organisation
❖Developing new products and technologies
❖Exploring and producing oil and gas in demanding geological conditions
❖Fostering and sustaining globally-oriented management talent
❖Managing customer-oriented supply chains
❖Developing and protecting intellectual capital
❖Managing strategic technology and product-market relationships
Managing diversity in businesses, technologies, export markets and people is the primary challenge for
Reliance, as it marches ahead in realising its vision.

This vision is the legacy of Shri Dhirubhai Ambani to all of us.

We are committed to pursue it with commitment and conviction.
Reliance is driven by his vision and continues to pursue a trajectory of growth, productivity and global
leadership.
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Session 2
Revision
• Financial Manager role

• The course objectives

• Accounting Profit difficulties – ambiguity, timing, quality

• Wealth maximization

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Wealth maximization
• Concept of cash flows generated by the decision (rather than profit)

• Considers time value of money

• Considers inherent risk

• Thus, net present value method.

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Wealth Maximization

• Eg: Cash outflows at t=0 = Rs 100

Sum of Cash Inflows at t=0 = Rs 110

=> NPV = 10: Added to owners/ shareholders’ wealth

• If NPV > 0, all costs have been recovered

• k0 is overall CoC and includes cost of debt, equity, RE etc

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Contd.
• If I have 100 shares @ Rs 500 each; Wealth = Rs 50,000
• Rs 500 market value depends on political factors, economic scenario, and sound investment decisions
• First two factors are not in purview of the firm but sound investment decisions should be reflected in
the market price in long term under normative framework (efficient market hypothesis)

• Wealth maximization is a better measure than profit maximization as sound financial decisions includes
Time Value of Money, quality of earnings etc.
• FINANCIAL DECISIONS SHOULD BE CONFORMATIVE WITH WEALTH MAXIMIZATION AND SHOULD BE IN
CONTEXT OF LONG TERM

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EVA (Economic Value Addition)
• Let Earnings after taxes, EAT = Rs 100 cr
• Let Shareholder’s Funds (SHF) = Equity Funds (EF) + Pref Shares = Rs 5000 cr + 0

(1) EAT takes into account only debt costs.

• Let riskfree rate = 8%; risk premium ~ 3-4% => RoR = 12%
• Cost of equity = 12% of Rs 5000 = Rs 600 Cr
(2) This is the opportunity cost! Let us take an example!
• Are you losing or earning profit?

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Contd.
• Cost of equity = Rs 600 cr
• EAT = Rs 100 cr
• => Loss = 500 Cr

• Profit maximization does not take into account cost of equity which is cost of owner’s money
• EVA = EAT – Cost of shareholders’ funds

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Example 1
• EAT = Rs 500 cr
• Shareholders’ funds (SHF)
• Equity funds CoC Cost
• Equity Capital = Rs 3000 cr 11% Rs 330 cr
• Retained Earnings = Rs 1000 cr 10% Rs 100 cr
• Preference Shares = Rs 500 cr 9% Rs 45 cr
• Total cost of SHF = Rs 475 cr
• => EVA = Rs 25 cr
• To consider true profitability, we should consider cost of all funds: Debt (in EAT);
Equity funds, Preference shares

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Example 2
EBIT = Rs 500 L
- Interest (10% Debt on 2000L) = Rs 200 L
EBT = Rs 300L
-Tax @ 30% = Rs 90L
EAT =Rs 210L
CoC Cost
• Equity funds (Eq capital +RE) = Rs 2500 L 12% Rs 300
• Preference Shares = Rs 500 L 11% Rs 55 L
• Total cost of SHF = Rs 355 L
• EVA = Rs (145 L)

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Question?
• If there is positive EVA in a year, will the NPV be also positive in that year?

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Has EVA evolved to outperform
conventional earnings measures in
determining firm’s value? A case of
Indian consumer firms
What does research say?
https://doi.org/10.1080/16081625.2019.1584760

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The sector
• The focus is on the consumer goods industry primarily because a
review of annual reports of the NIFTY500 index firms (financial year
2016) shows that the only five EVA disclosing firms belong to
consumer goods industry.
• They are Hero MotoCorp, Hindustan Unilever (HUL), Marico, Pidilite
Industries, and Rallis India.
• Two more firms, Godrej Industries and Godrej Consumer Products,
which just state that they follow an EVA aligned executive
performance management, are also from this sector

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Comparing ROCE (EPS) and EVA
• ROCE (return on capital employed) comes closest to EVA as it reflects
the accounting profitability of the firm on the total capital employed a

• EPS (earnings per share) is the most prevalent measure used to

evaluate the performance of a firm by market analysts and investors
alike

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Results
• EVA as a performance measure has evolved to rank at par if not
outperform the lead conventional earnings measure (ROCE) and is
observed to be superior to ROE and EPS, at least for Indian consumer
goods industry.
• Moreover, the Indian consumer goods sector seems to have
successfully withstood the impact of the financial crisis by
maintaining its accounting profitability measured through ROCE while
delivering significant growth in standardised EVA
• Literature puts the complex and non-standard method of EVA
computation as one of the reasons for its restricted use by corporates

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Agency Cost
Agency Problem
• Divorce of management (Board, CEO) and owners (equity
shareholders)
• An agency problem results when managers as agents of owners place
personal goals ahead of corporate goals
• Conflict arises

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Prevent/ minimise agency problems
Agency problem cannot be eliminated but can be reduced.

• Market forces
• Bulk holders (like mutual funds, insurance organizations, financial
institutions etc) that hold large block of shares, they have in recent times
actively exercised their voting rights to replace more competent
management in place of under-performing management.

• Threat of hostile takeover: Acquisition of the target firm by another firm

(acquirer) that is not supported by management

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Agency Costs
• To prevent/respond to market forces and to maximize owners’ wealth, the
owners (firm) have to incur agency costs:
• Monitoring
• Bonding expenditures (fidelity bonds)
• Structuring expenditures: Structuring managerial compensation to correspond with share
price maximization
• Incentive-based (stock options)
• Performance-based compensation plans

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Examples
• Enron, a U.S. energy giant operated for decades trading large and
highly demanded commodities. However, 2001 saw the fall of the
giant as a result of poor management, and a deeply rooted principal-
agent problem.
• Higher management decided to take on high debt and risky activities, leaving
these transactions 'off the books' and essentially meaning Enron was
falsifying information. Enron had reached the point where it was overstating
profits by $1.2 billion and eventually lead to its collapse.
• This lead Enron's CEO Jeffrey Skilling being sentenced to serve 24 years in
prison, as a result of various counts of conspiracy, fraud and insider trading.

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Thanks!

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