MOD I

A Framework for Financial Decision-Making

Here's a condensed framework tailored for financial decision-making within the

financial environment:

Environmental Analysis: Understand the current financial landscape by

assessing economic indicators, market trends, and regulatory changes.

Goal Alignment: Align financial goals with the prevailing financial conditions,
considering factors like interest rates, inflation, and market stability.

Risk Assessment: Identify and evaluate risks inherent in the financial

environment, including market volatility, credit risk, and regulatory compliance.

Instrument Evaluation: Analyze available financial instruments within the

environment, such as stocks, bonds, and commodities, to optimize investment
strategies.

Financial Modeling: Utilize financial models and analysis techniques to forecast

outcomes and assess the potential impact of decisions on financial performance.

Regulatory Compliance: Ensure adherence to relevant financial regulations and

standards to mitigate legal and compliance risks.

Ethical Considerations: Incorporate ethical principles and corporate governance

standards into financial decision-making processes.

Stakeholder Engagement: Engage with key stakeholders, including investors,

regulators, and employees, to gain insights and support for financial decisions.

Monitoring and Evaluation: Continuously monitor financial performance and

evaluate the effectiveness of decisions against established benchmarks.

Adaptation and Learning: Embrace a culture of learning and adaptation to

respond effectively to changes in the financial environment and improve
decision-making capabilities over time.

Introduction to Financial Markets

A financial market is a word that describes a marketplace where bonds, equity,

securities, and currencies are traded. Few financial markets do a security
business of trillions of dollars daily, and some are small-scale with less activity.
These are markets where businesses grow their cash, companies decrease risks,
and investors make more cash.
A Financial Market is referred to space, where selling and buying of financial
assets and securities take place. It allocates limited resources in the nation’s
economy. It serves as an agent between the investors and collector by
mobilising capital between them.

In a financial market, the stock market allows investors to purchase and trade
publicly companies share. The issue of new stocks is first offered in the primary
stock market, and stock securities trading happens in the secondary market.

Functions of Financial Market

 It mobilises savings by trading it in the most productive methods.

 It assists in deciding the securities price by interaction with the investors
and depending on the demand and supply in the market.
 It gives liquidity to bartered assets.
 Less time-consuming and cost-effective as parties don’t have to spend
extra time and money to find potential clients to deal with securities. It also
decreases costs by giving valuable information about the securities traded in the
financial market.

Financial Instruments Changing Role of Finance Managers

1. Introduction to Financial Instruments: Finance managers are adapting to a

landscape of diverse financial instruments beyond traditional stocks and bonds.
These instruments include derivatives, ETFs (Exchange-Traded Funds),
cryptocurrencies, and structured products, each offering unique risk-return
profiles and investment opportunities.

2. Risk Management Expertise: With the proliferation of complex financial

instruments, finance managers must possess advanced risk management skills to
navigate heightened market volatility and uncertainty. They must understand the
intricacies of derivatives and other sophisticated products to hedge against
various risks effectively.

3. Enhanced Analytical Abilities: Finance managers now require enhanced

analytical abilities to evaluate the performance and suitability of a wide range of
financial instruments. They must conduct in-depth analysis, utilizing
quantitative models and data analytics, to assess the potential impact of these
instruments on portfolio returns and risk exposure.

4. Regulatory Compliance and Governance: In response to the proliferation

of new financial instruments, finance managers must stay abreast of evolving
regulatory frameworks and compliance requirements. They play a critical role
in ensuring adherence to regulatory standards and promoting ethical conduct in
the use of financial instruments to protect investor interests and maintain market
integrity.

5. Strategic Asset Allocation: Finance managers are increasingly tasked

with strategic asset allocation decisions, incorporating a diverse mix of
traditional and alternative investments to optimize portfolio performance and
achieve long-term financial objectives. They must consider factors such as
liquidity, diversification, and correlation dynamics when allocating resources
across different asset classes.

6. Technological Proficiency: The changing landscape of financial

instruments necessitates a strong foundation in financial technology (Fintech)
among finance managers. They must leverage technological tools and platforms
for trading, risk management, and portfolio optimization to enhance efficiency
and decision-making processes in an increasingly digitalized financial
ecosystem.

Objectives of the firm

Maximizing Shareholder Wealth: The firm aims to enhance shareholder wealth

by driving profitability through efficient resource allocation and strategic
decision-making, ultimately increasing the value of equity and delivering
attractive returns to shareholders.

Profit Maximization: While not as prominent as shareholder wealth

maximization, profit maximization remains vital for sustaining business
operations and growth, focusing on optimizing net income and profit margins to
ensure financial viability and competitiveness in the market.

Value Creation: The firm endeavors to create value for stakeholders by

generating positive economic returns while fulfilling social and environmental
responsibilities, fostering long-term sustainability and stakeholder trust.

Risk Management: Financial management emphasizes identifying and

mitigating risks associated with business operations and investments,
safeguarding the firm's assets, reputation, and long-term viability through
effective risk assessment and management strategies.

Liquidity and Solvency: Maintaining a healthy balance between short-term

liquidity needs and long-term solvency requirements is critical for ensuring the
firm's financial stability and resilience, enabling it to meet financial obligations
and sustain business continuity.

Optimal Capital Structure: Financial management seeks to establish an optimal

capital structure that minimizes the cost of capital while balancing the use of
debt and equity financing, ensuring financial flexibility and risk tolerance to
maximize shareholder value and support long-term growth initiatives.

Time Value of Money

The time value of money (TVM) is the concept that a sum of money is worth
more now than the same sum will be at a future date due to its earnings
potential in the interim. The time value of money is a core principle of finance.
A sum of money in the hand has greater value than the same sum to be paid in
the future. The time value of money is also referred to as the present discounted
value.

The most fundamental formula for the time value of money takes into account
the following: the future value of money, the present value of money, the
interest rate, the number of compounding periods per year, and the number of
years. Based on these variables, the formula for TVM is:

FV=PV(1+ni)n×t

where:
FV=Future value of money
PV=Present value of money
i=Interest rate
n=Number of compounding periods per year
t=Number of years

How Is the Time Value of Money Used in Finance?

The time value of money is the central concept in discounted cash flow (DCF)
analysis, which is one of the most popular and influential methods for valuing
investment opportunities. It is also an integral part of financial planning and
risk management activities. Pension fund managers, for instance, consider the
time value of money to ensure that their account holders will receive adequate
funds in retirement.

Risk- Return Analysis

Risk and return analysis creates a fundamental framework that guides

investment decisions across a diverse range of assets and markets. Investors
ascertain their acceptable risk threshold to attain their desired level of return.
This necessitates a comprehension of their investment objectives, risk
tolerance, and investment horizon.

Risk and Return Analysis in Financial Management

Risk and return within the realm of financial management encompass the
potential risks linked to a specific investment alongside the corresponding
gains. Typically, investments with heightened risk offer more favourable
financial returns, whereas investments with reduced risk offer comparatively
lower returns. In essence, the risk associated with a particular investment
correlates directly with the returns it generates.

Investment objectives may encompass goals such as preserving capital,

generating income, or achieving long-term growth. Risk tolerance pertains to
the magnitude of risk an investor can comfortably withstand considering their
investment aims and individual situation. Investors must strike a balance
between risk and return that aligns with their goals and risk tolerance. This
relationship is embodied in the risk-return trade-off, where higher potential
returns come with greater risk.

Objectives of Risk and Return Analysis

Objectives of risk and return analysis can be found below:

Risk Assessment and Management: The primary objective of risk and return
analysis is to assess the various risks associated with different investment
opportunities. This enables investors to implement risk management strategies
to mitigate potential losses.
Informed Decision-Making: The analysis helps investors compare different
investment options based on their risk-return profiles. This aids in making
rational and informed decisions about where to invest their money.
Setting Investment Goals: By analyzing the trade-off between risk and return,
investors can set clear and achievable investment goals. They can decide on the
level of risk they are willing to accept to achieve their desired returns.
Performance Evaluation: Investors and financial analysts use risk and return
analysis to evaluate the historical performance of investment options or
portfolios. This assessment helps determine whether the returns achieved
justify the level of risk taken.

MOD II

Leverage Analysis

The term leverage represents influence or power. In financial analysis leverage

represents the influence of one financial variable over some other related
financial
variable. These financial variables may be costs, output, sales revenue, Earnings
Before Interest and Tax (EBIT), Earning per share (EPS) etc. Generally, if we
want to
calculate impact of change in variable X on variable Y, it is termed as Leverage
of Y
with X, and it is calculated as follows:

Operating Leverage means tendency of operating income (EBIT) to change

disproportionately with change in sale volume. This disproportionate change is
caused by operating fixed cost, which does not change with change in sales
volume.
In other words, operating leverage (OL) maybe defined as the employment of
an
asset with a fixed cost so that enough revenue can be generated to cover all the
fixed and variable costs.
The use of assets for which a company pays a fixed cost is called operating
leverage.
Operating leverage is a function of three factors:
(i) Amount of fixed cost,
(ii) Variable contribution margin, and
(iii) Volume of sales.

Financial leverage (FL) maybe defined as ëthe use of funds with a fixed cost in
order to increase earnings per share.í In other words, it is the use of company
funds on which it pays a limited return. Financial leverage involves the use of
funds
obtained at a fixed cost in the hope of increasing the return to common
stockholders.

EBIT = Sales - (Variable cost+ Fixed cost)

EBT = EBIT – Interest

Degree of Financial Leverage (DFL)

Degree of financial leverage is the ratio of the percentage increase in earnings
per
share (EPS) to the percentage increase in earnings before interest and taxes
(EBIT).
Financial Leverage (FL) is also defined as the ability of a firm to use fixed
financial charges to magnify the effect of changes in EBIT on EPS.

Combined leverage may be defined as the potential use of fixed costs, both
operating and financial, which magnifies the effect of sales volume change on
the earnings per share of the firm.

Degree of combined leverage (DCL) is the ratio of percentage change in earning

per share to the percentage change in sales. It indicates the effect the sales
changes will have on EPS.

Computation of Cost of Capital

The cost of capital is an important and central concept in financial management.

It is used for evaluating investment projects and for determining the capital
structure. It is also referred to as cut-off rate, target, hurdle rate, minimum
required rate of return standard return and so on.

The term cost of capital refers to the minimum rate of return a firm must earn on
its investment so that the market value of the company’s equity shares is
maintained. The term cost of capital is the minimum acceptable of return on
new investment made by the firm

Features of Cost Of Capital

1. Cost of capital is really a rate of return. It is the minimum rate of return
expected by investors.2. Cost of capital is calculated on the basis of
actual cost differentcomponents of capital Cost of capital is usually related
to long-termfunds.3. Cost of capital is used as a discount rate to discount future
cash flowsin order to determine their present value.

WEIGHTED AVERAGE COST OF CAPITAL

It is defined as an average representing the expected return on all of a

company’s securities. Each source of capital, such as stocks, bonds, and other
debt, is assigned a required rate of return, and then these required rates of return
are weighted in proportion to the share each source of capital contributes to the
company’s structure. The resulting rate is what the firm would use as a
minimum for evaluating a capital project or investment.

COST OF EQUITY (Ke):

The cost of equity capital for a particular company is the rate of return on
investment that is required by the company's ordinary shareholders. The return
consists both of dividend and capital gains, e.g. increases in the share price.
COST OF RETAINED EARNING (Kr)
The percentage of net earnings not paid out as dividends, but retained by the
company to be reinvested in its core business or to pay debt. It is recorded under
shareholders' equity on the balance sheet.
COST OF PREFERENCE CAPITAL (Kp):
The cost of preference share capital is the rate of return that must be earned on
preference capital financed investments, to keep unchanged the earning
available to the equity share holders.
COST OF DEBT (Kd):-Debt may be in the form of debentures, bonds, term
loans from financial institutions and banks etc. The debt is carried a fixed rate
of interest payable to them, irrespective of the profitability of the company.

Capital Structure Theories

Capital structure is the combination of capitals from different sources of

finance. The
capital of a company consists of equity share holders’ fund, preference share
capital
and long term external debts. The source and quantum of capital is decided on
the
basis of need of the company and the cost of the capital. However, the objective
of
a company is to maximise the value of the company and it is prime objective
while
deciding the optimal capital structure.
Capital Structure decision refers to deciding the forms of financing (which
sources
to be tapped); their actual requirements (amount to be funded) and their relative
proportions (mix) in total capitalisation.
Where:
• Ko: is the weighted average cost of capital (WACC)
• Kd: is the cost of debt
• D is the market value of debt
• S is the market value of equity
• Ke is the cost of equity
THEORIES OF CAPITAL STRUCTURE

(a) Net Income (NI) Approach

(b) Traditional approach
(c) Net Operating Income (NOI) approach
(d) Modigliani-Miller (MM) approach

Net Income (NI) Approach

According to this approach, capital structure decisions is relevant to the value of
the
firm. An increase in financial leverage will lead to a decline in the weighted
average cost
of capital (WACC), while the value of the firm as well as the market price of
ordinary shares
will increase. Conversely, a decrease in the leverage will cause an increase in
the overall
cost of capital and a consequent decline in the value as well as the market price
of equity
shares.

Value of Firm (V) = S + D

V = Value of the firm
S = Market value of equity
D = Market value of debt

NI = Earnings available for equity shareholders

Ke = Equity Capitalisation rate
Under, NI approach, the value of the firm will be maximum at a point where
weighted
average cost of capital (WACC) is minimum. Thus, the theory suggests total or
maximum
possible debt financing for minimising the cost of capital. The overall cost of
capital
under this approach is
Thus according to this approach, the firm can increase its total value by
decreasing
its overall cost of capital through increasing the degree of leverage. The
significant
conclusion of this approach is that it pleads for the firm to employ as much debt
as
possible to maximise its value.

Traditional Approach

This approach favours that as a result of financial leverage up to some point,

cost of
capital comes down and value of firm increases. However, beyond that point,
reverse
trends emerge. The principle implication of this approach is that the cost of
capital
is dependent on the capital structure and there is an optimal capital structure
which
minimises cost of capital.

According to net operating income approach, capital structure decisions are

totally
irrelevant. Modigliani-Miller supports the net operating income approach but
provides
behavioural justification. The traditional approach strikes a balance between
these
extremes.

Main Highlights of Traditional Approach

(a) The firm should strive to reach the optimal capital structure and its total
valuation
through a judicious use of the both debt and equity in capital structure. At the
optimal capital structure, the overall cost of capital will be minimum and the
value
of the firm will be maximum.
(b) Value of the firm increases with financial leverage upto a certain point.
Beyond
this point the increase in financial leverage will increase its overall cost of
capital
and hence the value of the firm will decline. This is because the benefits of use
of
debt may be so large that even after offsetting the effect of an increase in cost of
equity, the overall cost of capital may still go down. However, if financial
leverage
increases beyond an acceptable limit, the risk of debt investor may also
increase,
consequently cost of debt also starts increasing. The increasing cost of equity
owing to increased financial risk and increasing cost of debt makes the overall
cost
of capital to increase.

Net Operating Income Approach (NOI)

NOI means earnings before interest and tax (EBIT). According to this approach,
capital
structure decisions of the firm are irrelevant.
Any change in the leverage will not lead to any change in the total value of the
firm
and the market price of shares, as the overall cost of capital is independent of
the
degree of leverage. As a result, the division between debt and equity is
irrelevant.
As per this approach, an increase in the use of debt which is apparently cheaper
is
offset by an increase in the equity capitalisation rate. This happens because
equity
investors seek higher compensation as they are opposed to greater risk due to
the
existence of fixed return securities in the capital structure.

Ko: (Overall capitalisation rate) and (debt – capitalisation rate) are constant and
Ke: (Cost of equity) increases with leverage

Modigliani-Miller Approach (MM)

The NOI approach is definitional or conceptual and lacks behavioral
significance. It
does not provide operational justification for irrelevance of capital structure.
However,
Modigliani-Miller approach provides behavioral justification for constant
overall cost
of capital and therefore, total value of the firm.

The Trade-off Theory

The trade-off theory of capital structure refers to the idea that a company
chooses
how much debt finance and how much equity finance to use by balancing the
costs
and benefits. Tradeoff theory of capital structure basically entails offsetting the
costs
of debt against the benefits of debt.
Trade-off theory of capital structure primarily deals with the two concepts - cost
of
financial distress and agency costs. An important purpose of the trade-off theory
of
capital structure is to explain the fact that corporations usually are financed
partly with
debt and partly with equity. Trade-off theory of capital structure, considered as
the cost of debt is usually the financial distress costs or bankruptcy costs of
debt. The direct cost of financial distress refers to the cost of insolvency of a
company. Once the proceedings of insolvency start,
the assets of the firm may be needed to be sold at distress price, which is
generally
much lower than the current values of the assets. A huge amount of
administrative and
legal costs is also associated with the insolvency. Even if the company is not
insolvent,
the financial distress of the company may include a number of indirect costs
like - cost
of employees, cost of customers, cost of suppliers, cost of investors, cost of
managers
and cost of shareholders.

Pecking order theory

This theory is based on Asymmetric information, which refers to a situation in

which
different parties have different information. In a firm, managers will have better
information than investors. This theory states that firms prefer to issue debt
when they
are positive about future earnings. Equity is issued when they are doubtful and
internal
finance is insufficient.
The pecking order theory argues that the capital structure decision is affected by
manager’s choice of a source of capital that gives higher priority to sources that
reveal
the least amount of information.

FACTORS DETERMINING CAPITAL STRUCTURE

Choice of source of funds

A firm has the choice to raise funds for financing its investment proposals from
different
sources in different proportions. It can:
(a) Exclusively use debt (in case of existing company), or
(b) Exclusively use equity capital, or
(c) Exclusively use preference share capital (in case of existing company), or
(d) Use a combination of debt and equity in different proportions, or
(e) Use a combination of debt, equity and preference capital in different
proportions, or
(f) Use a combination of debt and preference capital in different proportion
(in case of existing company)

MOD III

Capital Budgeting

Capital Budget is also known as "Investment Decision Making or Capital

Expenditure Decisions" or "Planning Capital Expenditure" etc. Normally such
decisions where investment of money and expected benefits arising therefrom
are spread over more than one year, it includes both raising of long-term funds
as well as their utilization. Charles T. Horngnen has defined capital budgeting
as "Capital Budgeting is long-term planning for making and financing proposed
capital outlays."

Importance of Capital Budgeting

Capital budgeting is important because of the following reasons:
(1) Capital budgeting decisions involve long-term implications for the firm and
influence its risk
complexion.
(2) Capital budgeting involves the commitment of large amounts of funds.

Criteria for Capital Budgeting Decisions Pay back

The basic element of this method is to calculate the recovery time, by year wise
accumulation
of cash inflows (inclusive of depreciation) until the cash inflows equal the
amount of the
original investment. The time taken to recover such original investment is the
“payback
period” for the project. Pay back method is also known as „pay out‟ or „pay off
period „or „recoupment „or replacement period”. “The shorter the payback
period, the more desirable a project”.

Advantages of pay back period

1. It is simple to understand and easy to apply

2 It is very important for cash forecasting, budgeting and cash flow analysis.

3. The method can be used profitably for short term capital project which start
yielding
returns in the initial years.
4. It minimises the possibility of losses through obsolescence.

5. It takes into account liquidity.

6. This method can also be used for projects with high uncertainty.

Disadvantages of pay back period

1. It ignores the time value of money.

2. It completely ignores cash inflows after the payback period.

3. Sometimes a project having higher pay back period may be better than lower
pay back
period owing to higher return after pay back period. This is true in the case of
long term
project.
4. It does not measure profitability of projects. It insists only on recovery of the
cost of the
project
5. It does not measure the rate of return.

ARR

Average Rate of Return Method/Accounting Rate of Return Method

(ARR)
This method measures the increase in profit expected to result from investment.
It is based on
accounting profits and not cash flows. It is also known as accounting rate of
return method or
return on investment method or unadjusted rate of return method.

Advantages of ARR

1. It is simple to understand and easy to apply.

2. It takes into consideration earnings over the entire life of the project.

3. It considers profitability of the investment.

4. Projects of different character can be compared.

5. Rate of return may be readily calculated with the help of accounting data.

Disadvantages of ARR

1. It ignores the time value of money.

2. It does not differentiate between the sizes of the investment required for each
project.

3. It is based upon accounting profit, instead of cash flow.

4. It considers only the rate of return and not the life of the project.

5. It ignores the fact that profit can be reinvested.

Discounted Pay back Period

A major shortcoming of the conventional pay back period method is that it does
not take into
account the time value of money. To overcome this limitation, the discounted
pay back
period method is suggested. In this modified method, cash flows are first
converted into their
present values (by applying suitable discounting factors) and then added to
ascertain the
period of time required to recover the initial outlay on the project.

Net present value method (NPV)

Under this method present value of all cash inflows is compared against the
present value of
all cash outflows.
NPV= Present Value of Cash Inflows – Present Value of Cash Outflows

Advantages of NPV

1. It takes into account the time value of money

2. It considers the cash flow stream over the entire life of the project.

3. It focuses attention on the objective of maximisation of the wealth of the

firm.

4. This method is most suitable when cash inflows are not uniform.

5. This method is generally preferred by economists.

6. It is highly useful in case of mutually exclusive projects.

7 .It is the true measure of profitability

Disadvantages of NPV

1. This method may not provide satisfactory results in case of two projects
having different
useful lives.
2. This method is not suitable in case of projects involving different amounts of
investment.
3. Different discount rates will give different present values. As such, the
relative desirability
of projects will change with a change in the discount rate. It is difficult to select
the discount
rate.
5. It involves complicated calculations.

(Profitability Index method) (PI)

The Profitability Index (PI) signifies present value of inflow per rupee of
outflow. It helps to
compare projects involving different amounts of initial investments
Advantages Profitability Index

1. It is very scientific and logical.

2. It considers the fair rate of return.

3. It is useful in case of capital rationing,

4. It is very useful to compare the projects having different investments.

5. It reflects time value of money.

6. It considers all cash flows during the life of the project.

Disadvantages Profitability Index

1. This method is not in accordance with accounting principles and concepts.

2. It is comparatively difficult to understand and follow.

3. It is difficult to estimate the effective life of a project.

4. It cannot be used for comparing those projects having unequal lives.

5. It is not useful when many small projects have to be aggregated and

compared with a large
project.

Comparison of NPV and Profitability Index

Profitability index method is based on the NPV method. It is an extension of

NPV method.
There are many similarities and differences between NPV and PI.
Similarities

1. Both satisfy the principle of time value of money.

2. Both are discounted cash flow techniques.

3. Both will give the same accept/reject decision.

Differences

1. The NPV is an absolute measure of a project's acceptability, whereas, PI is a

relative
measure.
2. NPV and PI may give different evaluation results when initial costs and the
monetary
Benefits are different.
3. In times of capital rationing (or in case of mutually exclusive projects) PI
would give
superior results.
4. In all cases except in capital rationing (or in case of mutually exclusive
projects) NPV
technique is superior to the PI technique.

Internal Rate of Return method (IRR)

Internal Rate of Return is a percentage discount rate applied in capital

investment decisions
which brings the cost of a project and its expected future cash flows into
equality, i.e., NPV is
zero.

Decision Rule (or Acceptance Criterion): The calculated internal rate of return
is compared
with the desired minimum rate of return (cut-off rate). If IRR is equal to or
greater than the
desired minimum rate of return, then the project is accepted. If it is less than the
desired
minimum rate of return, then the project is rejected.

Advantages of IRR

1. This method considers all the cash flows over the entire life of the project.

2. It takes into account the time value of money.

3. Cost of capital need not be calculated.

4. IRR gives a true picture of the profitability of the project even in the absence
of cost of
capital.
5. Projects having different degrees of risk can easily be compared.

Disadvantages of IRR

1. The IRR method is difficult to understand and use in practice because it

involves tedious
and complicated calculation.
2. Under certain conditions it becomes very difficult to take any decision. For
example, under
conditions of irregular cash flows, IRR may give two or more answers.
3. Sometimes it may yield negative rate or multiple rate which is rather
confusing.

4. It yields results inconsistent with the NPV method if projects differ in their
expected life
span, investment timing of cash flows,
5. It is applicable mainly in large projects.

Comparison between NPV and IRR similarities

1. Both consider time value of money
2. Both lead to the same acceptance or rejection decision rule when there is a
single project
3. Both methods use cash inflows after tax.
4. Both consider cash inflows throughout the life of the project.

DIFFERENCE BETWEEN NPV AND IRR

The NPV method is comparatively better because of the following reasons:

1. NPV provides an absolute amount of net addition to the shareholders' wealth.

2. In NPV method, reinvestment rate for each project is the same. But IRR
provides different
rates for different projects.
3. NPV always ranks mutually exclusive projects correctly, but IRR may not be
able to give
correct ranking.

Risk analysis

The process of comparing the risk and returns to select the most profitable
investment is
known as risk – return analysis
Methods or traditional techniques

Risk-adjusted discount rate

Under the risk-adjusted discount rate technique some adjustment will be made
in the discount
rate. This is done according to the degree of risk associated with the project. If
the risk is high
the discount rate is raised (adding risk premium to discount rate)
Risk adjusted discount rate is equal to risk-free rate of return + risk premium for
investing in
a risky project. Risk free rate is the rate at which the future cash inflows should
be discounted if there had been no risk. Risk premium rate is the extra return
expected by investors over the normal rate (i.e., risk free rate) on account of
project being risky. A higher discount rate will be used for more risky projects
and a lower rate for less risky projects.

Working Capital Management is process which is designed to ensure that an

organization operates efficiently by monitoring & utilizing its current assets and
current liabilities to the best effect. Primary objective is to enable a company
maintaining sufficient cash flows in order to meet its day-to-day operating
expenses and its short-term obligations.
The concept of working capital can also be explained through two angles.

Management of working capital is an essential task of the finance manager. He

has
to ensure that the amount of working capital available is neither too large nor
too
small for its requirements.
A large amount of working capital would mean that the company has idle funds.
Since funds have a cost, the company has to pay huge amount as interest on
such
funds that are used to invest in surplus working capital. Another way to look at
it is
that there is an opportunity cost involved where the company could have
invested
the surplus funds in long term investments and earned some return on the same.

OPERATING OR WORKING CAPITAL CYCLE

A useful tool for managing working capital is the operating cycle.
The operating cycle analyses the accounts receivable, inventory and accounts
payable cycles in terms of number of days. For example:
 Accounts receivables are analyzed by the average number of days it takes to
collect an account.
 Inventory is analyzed by the average number of days it takes to turn over the
sale of a product (from the point it comes in the store to the point it is
converted to cash or an account receivable).
 Accounts payables are analyzed by the average number of days it takes to
pay a supplier invoice.

Operating Cycle = R + W + F + D – C

MANAGEMENT OF RECEIVABLES
Management of receivables refers to planning and controlling of 'debt' owed to
the firm from customer on account of credit sales. It is also known as trade
credit
management.
The basic objective of management of receivables (debtors) is to optimise the
return on investment on these assets.

There are basically three aspects of management of receivables:

1. Credit Policy: A balanced credit policy should be determined for effective
management of receivables. Decision of Credit standards, Credit terms and
collection efforts is included in Credit policy. It involves a trade-off between
the profits on additional sales that arise due to credit being extended on the
one hand and the cost of carrying those debtors and bad debt losses on the
other.
2. Credit Analysis: This requires the finance manager to determine as to how
risky it is to advance credit to a particular party. This involves due diligence
or reputation check of the customers with respect to their credit worthiness.
3.Control of Receivable: This requires finance manager to follow up debtors
and decide about a suitable credit collection policy. It involves both laying
down of credit policies and execution of such policies.

CASH MANAGEMENT
Cash management is a crucial aspect of working capital management, as it
involves optimizing the company's cash flows to ensure that there is enough
liquidity to meet its short-term obligations while maximizing returns on surplus
cash. Effective cash management helps a company maintain financial stability,
reduce financing costs, and take advantage of investment opportunities.
KEY COMPONENTS
1.Cash Forecasting: This involves estimating future cash inflows and outflows
to anticipate cash needs accurately. Cash forecasting helps in planning for short-
term borrowing or investing excess cash to earn returns.
2.Optimizing Cash Conversion Cycle: The cash conversion cycle (CCC)
represents the time it takes for a company to convert its investments in
inventory and other resources into cash flows from sales. Efficient management
of inventory, accounts receivable, and accounts payable can shorten the CCC,
freeing up cash for other uses.
3.Managing Accounts Receivable: Timely collection of accounts receivable is
crucial to maintaining healthy cash flows. Implementing credit policies, offering
discounts for early payments, and actively following up on overdue payments
can help accelerate cash inflows.
4.Controlling Accounts Payable: Managing accounts payable effectively
involves negotiating favorable payment terms with suppliers without
jeopardizing relationships. Delaying payments to suppliers within acceptable
limits can help conserve cash for longer periods.
5.Optimizing Inventory Levels: Maintaining optimal inventory levels minimizes
the amount of cash tied up in unsold goods while ensuring that enough
inventory is available to meet customer demand. Techniques such as just-in-
time (JIT) inventory management can help reduce inventory holding costs and
improve cash flow.
6.Short-term Investments: Investing excess cash in short-term, low-risk
instruments such as money market funds or certificates of deposit can generate
additional income while ensuring liquidity.
7.Managing Cash Balances: Maintaining adequate cash balances is essential to
meet day-to-day operational needs and unforeseen expenses. Balancing liquidity
requirements with the opportunity cost of holding idle cash is crucial for
optimizing cash balances.
8.Cash Flow Budgeting: Developing cash flow budgets helps in planning for
future cash needs and identifying potential cash shortfalls. It enables proactive
management of cash resources to ensure that the company can meet its financial
obligations at all times.
9.Use of Technology: Leveraging cash management tools and software can
streamline cash flow processes, improve visibility into cash positions, and
automate routine tasks such as invoicing and payment processing.
10.Monitoring and Performance Evaluation: Regular monitoring of cash flows
against budgeted targets and key performance indicators (KPIs) allows for
timely identification of cash flow issues and opportunities for improvement.
Adjustments to cash management strategies can be made based on
performance evaluations.
Float Management:
Float refers to the time delay between when a payment is initiated and when it is
cleared from the bank account. Managing float effectively involves minimizing
the time it takes for funds to be deposited and maximizing the time funds
remain in the company's account before being debited. Techniques such as
electronic funds transfer (EFT) and lockbox services can help optimize float.

The Baumol's model of cash management, also known as the Baumol's EOQ
model, is a cash management technique developed by economist William
Baumol. The model helps businesses determine the optimal cash balance to hold
for transaction purposes, taking into account the trade-off between holding cash
and the costs of converting securities into cash.

Interpretation:
•The optimal cash balance (C∗) represents the amount of cash that minimizes
the total cost of holding cash and the cost of converting securities into cash for a
given period.
•The model suggests that as the cost of converting securities into cash
(transaction cost) decreases or the opportunity cost of holding cash (interest
rate) increases, the optimal cash balance decreases.
•Conversely, if the transaction cost increases or the interest rate decreases, the
optimal cash balance increases.
Decision-making:
•Businesses can use the Baumol's model to determine the optimal cash balance
needed to minimize the total cost of holding cash and transaction costs.
•By comparing the costs associated with holding cash and the costs of
converting securities into cash, businesses can make informed decisions about
their cash management strategies.
Limitations:
•The Baumol's model assumes constant cash flows and transaction costs, which
may not always be realistic in practice.
•It does not consider factors such as uncertainty in cash flows, variability in
transaction costs, or the risk associated with holding cash.
•The model also assumes that the opportunity cost of holding cash is constant
over the entire time period, which may not hold true in volatile
economic conditions.

MOD IV

Introduction:
The term dividend refers to that portion of after-tax profits distributed among
the company's shareholders. It is the reward paid to the shareholders for their
investments in the company's shares. In short, the dividend is the part of profits
distributed among the shareholders. The dividend is paid in cash. It is paid out
of profit after depreciation and tax.

Factors or determinants of dividend policy

Internal factors:
 stability and size of earnings  Liquidity of funds  Investment opportunities
and shareholder’s preference  Attitude of management towards control  Past
dividend rates  Ability to borrow  Need to repay debt

External factors:
 Trade cycle  Legal requirements  Corporate tax  General state of economy
 Conditions in the capital market  Government policy

Types of dividends

1. Cash dividend: This is the most popular form of dividend. It is the dividend
paid to shareholders in cash. The cash dividend may be of the following two
types:
(a) Regular or final dividend is the dividend declared and paid at the end of the
trading period
After the final accounts have been prepared
(b) Interim dividend: It is the dividend declared before the declaration of the
final dividend. This is declared at any time between the two annual general
meetings.

2. Stock dividend: Companies not having sufficient cash generally pay

dividends in the form of shares by capitalising the past reserves and profits.
Such shares are called bonus shares.

3. Scrip dividend: In case a company does not have sufficient funds to pay
dividends in cash, it may issue transferable promissory notes for a shorter
maturity period for amounts due to shareholders. This is called scrip dividend.

4. Bond dividend: In rare cases, dividends are paid in the form of debentures or
bonds or notes for a long-term period bearing interest at a fixed rate. A
company issues bonds by way of dividends when it does not have enough funds
to pay cash dividends.
5. Property dividend: Sometimes dividend is paid in the form of assets instead
of paying dividend in cash.

Theories of Dividend Decisions

MM Hypothesis

The market value of the shares is not affected by the dividend payment. Hence
shareholders would be indifferent between dividend and retention of earnings.
As far as shareholders are concerned whether the company pays dividend or
retains earnings, it would not affect them. MM dividend irrelevance hypothesis
also implies that the shareholders are indifferent between dividends and capital
gains. When a shareholder gets a dividend, he can either spend for consumption
or invest it. On the other hand, if the dividend is not paid, even then the market
value of shares will increase. This happens because retained earnings increase
and the company does not raise funds either through equity or debt.
Assumptions of MM Theory:
1. There are perfect capital markets. 2. Investors behave rationally. 3. There are
either no taxes or there are no differences in the tax rates applicable to capital
gains and dividends 4. There are no floatation and transaction costs.

Walter's Dividend Model

Prof. James E. Walter has developed dividend model. In this theory Walter
argues that dividend decision (dividend policy of a firm is relevant. Hence this
is a theory of relevance, This means that dividend policy has an impact on
market price of the share. Thus dividend policy affects the value of the firm.
According to Walter, the investment policy investment decision of a firm cannot
be separated from its dividend policy. The dividend policy of a firm depends
upon the relationship between r and ke. If r> ke (i.e., in case of a growth firm)
the firm should have zero pay-out (i.e., no dividend) and reinvest the entire
profits to earn more than the investors, If however, r = ke (i.e., in case of a
normal firm), the shareholders will be indifferent whether the firm pays
dividends or retains the profits. In such a case, the return to the firm from
reinvesting the retained earnings will be just equal to the earnings available to
shareholders on their investment of dividend income.

a) If r> ke the payout ratio should be zero (ie., 100% retention ratio)
b) If r< ke the payout ratio should be 100% (ie zero retention ratio)
c) If r= ke the dividend is Irrelevant and the dividend policy is not expected to
affect the market value of the share.

Assumptions of Walter's Model

1.The firm does not use external sources of funds (only retained earnings). It
does not use debt or fresh equity shares
2. The IRR (1.o., firm's rate of earning) and cost of capital (I.e., shareholders
expected rate of return) are constant.
3. Earnings and dividends remain constant
4. The firm has a very long life.

Gordon's Model:

1. M. Gordon has also given a model on the line of Walter. He suggested

that dividends are relevant and it will affect the value of the firm. He argued that
the value of a rupee of dividend income is more than the value of a rupec of
capital gain. This is on account of uncertainty of future and discounting future
dividends by shareholders at a higher rate. According to Gordon the market
value of a share is equal to the present value of future infinite stream of
dividends. Gordon argues that investors prefer current dividends rather than
capital gains, Dividends are more predictable than capital gains. Investors value
current dividends more highly than an expected future capital gain, Gordon's
model is also known as bird in hand argument. It is called so because this model
is based on the assumption that shareholders prefer to receive current dividend
rather than distant capital gain.
Assumptions:

1. The firm is an all equity firm. 2. Retained earnings are the only source of
financing the investment programme 3. The rate of return on the firm's
investment (r) is constant. 4. The growth rate of the firm 'g is the product of its
retention ratio b' and its rate of return to i.e., g = b × r 5. Cost of capital is
constant and it is more than the growth rate.

Dividend policies in practice

A company’s dividend policy dictates the amount of dividends paid out by the
company to its shareholders and the frequency with which the dividends are
paid out. When a company makes a profit, they need to decide on what to do
with it. They can either retain the profits in the company (retained earnings on
the balance sheet), or they can distribute the money to shareholders in the form
of dividends.

1. Regular Dividend Policy- Companies following this policy distribute

dividends to their shareholders regularly, regardless of their yearly profits or
losses. It’s a consistent and predictable approach, ensuring shareholders receive
a dividend at specified intervals.
2. Irregular Dividend Policy- Under this policy, companies do not have a
fixed pattern for dividend distribution. They distribute dividends only when they
have surplus profits. The payouts are unpredictable and depend on the
company’s financial health at any given time.
3. Stable Dividend Policy- Companies with this policy commit to paying a
certain amount as dividends every year, irrespective of their actual profits. This
provides shareholders with a sense of reliability, knowing they’ll receive a set
dividend amount annually.
4. No Dividend Policy- Companies adopting this policy retain all their
earnings and do not distribute any dividends to shareholders. They usually
reinvest these earnings to fuel growth, expansion, or other business activities.

Module V

ROI

Return on investment (ROI) is a ratio that measures the profitability of an

investment by comparing the gain or loss to its cost. It helps assess the
potential return of investments on things like stocks or business ventures. ROI
is usually presented as a percentage and can be calculated using a specific
formula.

BENEFITS of ROI

Ease of calculation. Few figures are needed to complete the calculation, all of
which should be available in financial statements or balance sheets.
Comparative analysis capability. Because of its widespread use and ease of
calculation, more comparisons can be made for investment returns between
organizations.
Measurement of profitability. ROI relates to net income for investments made
in a specific business unit. This provides a better measure of profitability by
company or team.

Economic Value Added

Economic Value Added is a measure of a company's financial performance

based on the residual income left after deducting the cost of capital from its
operating profit (adjusted for taxes on a cash basis).
The theory of Economic Value Added posits that businesses are only truly
profitable when they create wealth for their shareholders, and this wealth is
above the cost of the capital invested in them. EVA encourages managers to
consider all the costs involved, including the cost of equity capital.

The formula for calculating EVA is:

EVA = NOPAT - (Invested Capital * WACC)

Where:

 NOPAT = Net operating profit after taxes

 Invested capital = Debt + capital leases + shareholders' equity
 WACC = Weighted average cost of capital

ADVANTAGES:
It encourages a focus on long-term, wealth-creating investments and
discourages short-term profit-driven decisions.

By also considering the cost of equity capital, it provides a more complete

picture of the company's finances.

It aligns management and shareholder interests as both become focused on

generating the highest EVA.

Market Value Added

Market Value Added (MVA) is a measurement of the wealth a company has
been able to generate for its stakeholders since its founding.

Market value added (MVA) is a calculation that shows the difference between
the market value of a company and the capital contributed by all investors, both
bondholders and shareholders. In other words, it is the market value of debt and
equity minus all capital claims held against the company.
The formula is as follows:

MVA = Market Value of Shares - Book Value of Shareholders' Equity

The Market Value of shares incorporates the value of the company's equity and
debt., it is also known as the enterprise value. To determine the market value of
shares, we need to multiply the outstanding shares by the current market
price per share.

These advantages include:

1. It Increases attractiveness to investors: A company with a higher Market
Value Added (MVA) is attractive to investors, indicating health and prosperity.
High MVA signifies safer investments, appealing to those seeking secure
opportunities.
2. It promotes high returns for investors: Investors with stakes in a high
Market Value Added (MVA) company enjoy substantial returns, while the
company's reputation attracts future interest, ensuring continued success and
profitability.
3. It boosts the survival chances of the firm: While business fortunes are
unpredictable, a high Market Value Added (MVA) suggests strong prospects,
reflecting competent management and a resilient business model poised for
future growth.

Shareholders Value Creation

Shareholder Value Creation refers to the process of increasing the value of a

company for its shareholders over time. It involves implementing strategies and
making decisions that result in higher stock prices, increased dividends, or both.
Key components of shareholder value creation include generating sustainable
profits, managing capital efficiently, and making strategic investments that yield
positive returns. By focusing on activities that enhance shareholder wealth,
companies can attract and retain investors, strengthen their competitive position,
and ultimately achieve long-term success in the financial markets.