Thursday, December 27, 2012

Capital Budgeting

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The term capital budgeting means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives. The finance manager has various tools and techniques by means of which he assists the  management in taking a proper capital budgeting decision. Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate. Also as business is a part of society, it is its moral responsibility to undertake only those projects that are socially desirable. Capital budgeting decision is an important, crucial and critical business decision due to :

1) substantial expenditure :
capital budgeting decision involves the investment of substantial amount of funds and is thus it is necessary for a firm to make such decision  after a thoughtful consideration, so as to result in profitable use of scarce resources. Hasty and incorrect decisions would not only result in huge losses but would also account for failure of the firm.

2) long time period :
capital budgeting decision has its effect over a long period of time, they affect the future benefits and also the firm and influence the rate and direction of growth of the firm.

3) irreversibility :
most of such decisions are irreversible, once taken, the firm may not been in a position to reverse its impact. This may be due to the reason, that it is difficult to find a buyer for second-hand capital items.

4) complex decision :
capital investment decision involves an assessment of future events, which in fact are difficult to predict, further, it is difficult to estimate in quantitative terms all benefits or costs relating to a particular investment decision. 

various types of capital investment decisions
there are various ways to classify capital budgeting decisions, generally they are
classified as :

1) on the basis of the firm's existence :
              capital budgeting decisions are taken by both newly incorporated and existing firms. New firms may  require to take decision in respect of selection of plant to be installed, while existing firms may require to take decision to meet the requirements of new environment or to face challenges of competition. These decisions may be classified into:

i) replacement and modernisation decisions : replacement and modernisation decisions aims to improve operating efficiency and reduce costs. Usually, plants require replacement due to they been economically dead i.e. no more economic life left or on they becoming technologically outdated. The former decision is of replacement and latter one of modernisation , however, both these decisions are cost reduction decisions.

ii) Expansion decision : existing successful firms may experience growth in demand of the product and may experience shortage or delay in delivery due to inadequate production facilities and thus, would consider proposals to add capacity to existing product lines.

iii) Diversification decisions : these decisions require evaluation proposals to diversify into new product lines, new markets, etc. to reduce risk of failure by dealing in different products or operating in several markets. expansion and diversification decisions are revenue expansion decisions.

2) on the basis of decision situation :

i) mutually exclusive decisions : decisions are said to be mutually exclusive when two or more alternative proposals are such that acceptance of one would exclude the acceptance of the other.

ii) Accept-Reject decisions : the accept-eject decisions occurs when proposals are independent and do not compete with each other. The firm may accept or reject a proposal on the basis of a minimum return on the required investment. All those proposals which have a higher return than certain desired rate of return are accepted and rest rejected.

iii) Contigent decisions :
contigent decisions are dependable proposals, investment in one requires investment in another.
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Wednesday, December 19, 2012

Relevance of time value of money in financial decision making


A finance manager is required to make decisions on investment, financing and dividend in view of the company's objectives. The decisions as purchase of assets or procurement of funds i.e. the investment/financing decisions affect the cash flow in different time periods. Cash outflows would be at one point of time and inflow at some other point of time, hence, they are not comparable due to the change in rupee value of money. They can be made comparable by introducing the interest factor. In the theory of finance, the interest factor is one of the crucial and exclusive concept, known as the time value of money.

             Time value of money means that worth of a rupee received today is different from the same received in future. The preference for money now as compared to future is known as time preference of money. The concept is applicable to both individuals and business houses.

Reasons of time preference of money :

1) Risk :
There is uncertainty about the receipt of money in future.

2) Preference for present consumption :
Most of the persons and companies have a preference for present consumption may be due to urgency of need.

3) Investment opportunities :
Most of the persons and companies have preference for present money because of availabilities of opportunities of investment for earning additional cash flows.

Importance of time value of money
The concept of time value of money helps in arriving at the comparable value of the different rupee amount arising at different points of time into equivalent values of a particular point of time, present or future. The cash flows arising at different points of time can be made comparable by using any one of the following :
- by compounding the present money to a future date i.e. by finding out the value of present money.
- by discounting the future money to present date i.e. by finding out the present value(PV) of future money.

1) Techniques of compounding :
i) Future value (FV) of a single cash flow :
The future value of a single cash flow is defined as :

FV = PV (1 + r)n

Where, FV = future value
PV = Present value
r = rate of interest per annum
n = number of years for which compounding is done.
If, any variable i.e. PV, r, n varies, then FV also varies. It is very tedious to calculate the value of
 (1 + r)so different combinations are published in the form of tables. These may be referred for computation, otherwise one should use the knowledge of logarithms.

ii) Future value of an annuity :
An annuity is a series of periodic cash flows, payments or receipts, of equal amount. The premium payments of a life insurance policy, for instance are an annuity. In general terms the future value of an annuity is given as :

FVAn = A * ([(1 + r)n - 1]/r)

FVAn = Future value of an annuity which has duration of n years.                            
A = Constant periodic flow
r = Interest rate per period             
n = Duration of the annuity
Thus, future value of an annuity is dependent on 3 variables, they being, the annual amount, rate of interest and the time period, if any of these variable changes it will change the future value of the annuity. A published table is available for various combination of the rate of interest 'r' and the time period 'n'.

2) Techniques of discounting :

 i) Present value of a single cash flow :
The present value of a single cash flow is given as :

PV = FVn (    1  )n
                  1 + r

FVn = Future value n years hence
r = rate of interest per annum
n = number of years for which discounting is done.
 From above, it is clear that present value of a future money depends upon 3 variables i.e. FV, the rate of interest and time period. The published tables for various combinations of  (    1  )n
                                                                                                                                                            1 + r
are available.

ii) Present value of an annuity :
Sometimes instead of a single cash flow, cash flows of same amount is received for a number of years. The present value of an annuity may be expressed as below :

PVAn = A/(1 + r)1 + A/(1 + r)2 + ................ + A/(1 + r)n-1 + A/(1 + r)n 

           = A [1/(1 + r)1 + 1/(1 + r)2 + ................ + 1/(1 + r)n-1 + 1/(1 + r)n ]

           =  A [ (1 + r)n - 1]
                        r(1 + r)n

PVA= Present value of annuity which has duration of n years
A = Constant periodic flow
r  = Discount rate.
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Financial Statement Analysis

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The basis of financial analysis, planning and decision making is financial information. A firm prepares final accounts viz. Balance Sheet and Profit and Loss Account providing information for decision making. Financial information is needed to predict, compare and evaluate the firm's earning ability. Profit and Loss account shows the concern's operating activities and the Balance Sheet depicts the balance value of the acquired assets and of liabilities at a particular point of time. However, these statements do not disclose all of the necessary and relevant information. For the purpose of obtaining the material and relevant information necessary for ascertaining of financial strengths and weaknesses of an enterprise, it is essential to analyse the data depicted in the financial statement. The financial manager have certain analytical tools that help in financial analysis and planning. In addition to studying the past flow, the financial manager can evaluate future flows by means of funds statement based on forecasts. 

            Financial Statement Analysis is the process of identifying the financial strength and weakness of a firm from the available accounting data and financial statements. It is done by properly establishing relationship between the items of balance sheet and profit and loss account as,

1)  The task of financial analysts is to determine the information relevant to the decision under consideration from total information contained in the financial statement.

2) To arrange information in a way to highlight significant relationships.

3) Interpretation and drawing of inferences and conclusion. Thus, financial analysis is the process of selection, relation and evaluation of the accounting data/information.

Purposes of Financial Statement Analysis : Financial Statement Analysis is the meaningful interpretation of 'Financial Statements' for 'Parties Demanding Financial Information', such as :

1) The Government may be interested in knowing the comparative energy consumption of some private and public sector cement companies.

2) A nationalised bank may may be keen to know the possible debt coverage out of profit at the time of lending.

3) Prospective investors may be desirous to know the actual and forecasted yield data.

4) Customers want to know the business viability prior to entering into a long-term contract.
              There are other purposes also, in general, the purpose of financial statement analysis aids decision making by users of accounts.

Steps for financial statement analysis :
·         Identification of the user's purpose
·         Identification of data source, which part of the annual report or other information is required to be analysed to suit the purpose
·         Selecting the techniques to be used for such analysis
              As such analysis is purposive, it may be restricted to any particular portion of the available financial statement, taking care to ensure objectivity and unbiasedness. It covers study of relationships with a set of financial statements at a point of time  and with trends, in them, over time. It covers a study of some comparable firms at a particular time or of a particular firm over a  period of time or may cover both.

Types of Financial statement analysis : The main objective  of financial analysis is to determine the financial health of a business enterprise, which may be of the following types :

1) External analysis : It is performed by outside parties, such as trade creditors, investors, suppliers of long term debt, etc.

2) Internal analysis : It is performed by corporate finance and accounting department and is more detailed than external analysis.

3) Horizontal analysis : This analysis compares financial statements viz. profit and loss account and balance sheet of previous year with that of current year.

4) Vertical analysis : Vertical analysis converts each element of the information into a percentage of the total amount of statement so as to establish relationship with other components of the same statement.

5) Trend analysis : Trend analysis compares ratios of different components of financial statements related to different period with that of the base year.

6) Ratio Analysis : It establishes the numerical or quantitative relationship between 2 items/variables of financial statement so that the strengths and weaknesses of a firm as also its historical performance and current financial position may be determined.

7) Funds flow statement : This statement provides a comprehensive idea about the movement of finance in a business unit during a particular period of time. 

8) Break-even analysis : This type of analysis refers to the interpretation of financial data that represent operating activities.
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Introduction to Financial Management

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Meaning of Financial Management :
              The primary task of a Chartered Accountant is to deal with funds, 'Management of Funds' is an important aspect of financial management in a business undertaking or any other institution like hospital, art society, and so on. The term 'Financial Management' has been defined differently by different authors.
             According to Solomon "Financial Management is concerned with the efficient use of an important economic resource, namely capital funds."  Phillippatus has given a more elaborate definition of the term, as , "Financial Management, is concerned with the managerial decisions that results in the  acquisition and financing of short  and long term credits for the firm."  Thus, it deals with the situations that require selection of specific problem of size and growth of an enterprise. The analysis of these decisions is based on the expected inflows and outflows of funds and their effect on managerial objectives. The most acceptable definition of financial management is that given by S.C.Kuchhal as, "Financial management deals with procurement of funds and their effective utilisation in the business." 

Thus, there are 2 basic aspects of financial management :
1) procurement of funds :
            As funds can be obtained from different sources thus, their procurement is always considered as a complex problem by business concerns. These funds procured from different sources have different characteristics in terms of risk, cost and control that a manager must consider while procuring funds.  The funds should be procured at minimum cost, at a balanced risk and control factors.
            Funds raised by issue of equity shares are the best from risk point of view for the company, as it has no repayment liability except on winding up of the company, but from cost point of view, it is most expensive, as dividend expectations of shareholders are higher than prevailing interest rates and dividends are appropriation of profits and not allowed as expense under the income tax act. The issue of new equity shares may dilute the control of the existing shareholders.
            Debentures are comparatively cheaper since the interest is paid out of profits before tax. But, they entail a high degree of risk since they have to be repaid as per the terms of agreement; also, the interest payment has to be made whether or not the company makes profits.
            Funds can also be procured from banks and financial institutions, they provide funds subject to certain restrictive covenants. These covenants restrict freedom of the borrower to raise loans from other sources. The reform process is also moving in direction of a closer monitoring of 'end use' of resources mobilised through capital markets. Such restrictions are essential for the safety of funds provided by institutions and investors. There are other financial instruments used for raising finance  e.g. commercial paper, deep discount bonds, etc. The finance manager has to balance the availability of funds and the restrictive provisions tied with such funds resulting in lack of flexibility.
            In the globalised competitive scenario, it is not enough to depend on available ways of finance but resource mobilisation is to be undertaken through innovative ways or financial products that may meet the needs of investors. Multiple option convertible bonds can be sighted as an example, funds can be raised indigenously as also from abroad. Foreign Direct Investment (FDI) and Foreign Institutional Investors (FII) are two major sources of finance from abroad along with American Depository Receipts (ADR's) and Global Depository Receipts (GDR's). The mechanism of procuring funds is to be modified in the light of requirements of foreign investors. Procurement of funds inter alia includes :

- Identification of sources of finance
- Determination of finance mix
- Raising of funds
- Division of profits between dividends and retention of profits i.e. internal fund generation.
2) effective use of such funds :
The finance manager is also responsible for effective utilization of funds. He must point out situations where funds are kept idle or are used improperly. All funds are procured at a certain cost and after entailing a certain amount of risk. If the funds are not utilised in the manner so that they generate an income higher than cost of procurement, there is no meaning in running the business. It is an important consideration in dividend decisions also, thus, it is crucial to employ funds properly and profitably. The funds are to be employed in the manner so that the company can produce at its optimum level without endangering its financial solvency. Thus, financial implications of each decision to invest in fixed assets are to be properly analysed.  For this, the finance manager must possess sound knowledge of techniques of capital budgeting and must keep in view the need of adequate working capital and ensure that while firms enjoy an optimum level of working capital they do not keep too much funds blocked in inventories, book debts, cash, etc.
        Fixed assets are to financed from medium or long term funds, and not short term funds, as fixed assets cannot be sold in short term i.e. within a year, also a large amount of funds would be blocked in stock in hand as the company cannot immediately sell its finished goods.

Scope of financial management :
            A sound financial management  is essential in all type of financial organization - whether profit oriented or not, where funds are involved and also in a centrally planned economy as also in a capitalist set-up. Firms, as per the commercial history, have not liquidated because their technology was obsolete or their products had no or low demand or due to any other factor, but due to lack of financial management. Even in boom period, when a company makes high profits, there is danger of liquidation, due to bad financial management. The main cause of liquidation of such companies is over-trading or over-expanding without an adequate financial base.
          Financial management optimises the output from the given input of funds and attempts to use the funds in a most productive manner. In a country like India, where resources are scarce and demand on funds are many, the need for proper financial management is enormous. If proper techniques are used most of the enterprises can reduce their capital employed and improve return on investment. Thus, as men and machine are properly managed, finances are also to be well managed.
        In newly started companies, it is important to have sound financial management, as it ensures their survival, often such companies ignores financial management at their own peril. Even a simple act, like depositing the cheques on the day of their receipt is not performed. Such organisations pay heavy interest charges on borrowed funds, but are tardy in realising their own debtors. This is due to the fact they lack realisation of the concept of time value of money, it is not appreciated that each value of rupee has to be made use of and that it has a direct cost of utilisation. It must be realised that keeping rupee idle even for a day, results into losses. A non-profit organisation may not be keen to make profit, traditionally, but it does need to cut down its cost and use the funds at its disposal to their optimum capacity. A sound sense of financial management has to be cultivated among our bureaucrats, administrators, engineers, educationists and public at large. Unless this is done, colossal wastage of the capital resources cannot be arrested.

Objectives of financial management :
              Efficient financial management requires existence of some objectives or goals because judgment as to whether or not a financial decision is efficient is to be made in light of some objective. The two main objectives of financial management are :

1) Profit Maximisation :
It is traditionally being argued, that the objective of a company is to earn profit, hence the objective of financial management is profit maximisation. Thus, each alternative, is to be seen by the finance manager from the view point of profit maximisation. But, it cannot be the only objective of a company, it is at best a limited objective else a number of problems would arise. Some of them are :

a)   The term profit is vague and does not clarify what exactly it means. It conveys different meaning to different people.

b)    Profit maximisation has to be attempted with a realisation of risks involved. There is direct relation between risk and profit; higher the risk, higher is the profit. For maximising profit, risk is altogether ignored, implying that finance manager accepts highly risky proposals also. Practically, risk is a very important factor to be balanced with profit objective.

c)   Profit maximisation is an objective not taking into account the time pattern of returns.
E.g. Proposal X gives returns higher than that by proposal Y but, the time period is say, 10 years and 7 years respectively. Thus, the overall profit is only considered not the time period, nor the flow of profit.

d)   Profit maximisation as an objective is too narrow, it fails to take into account the social considerations and obligations to various interests of workers, consumers, society, as well as ethical trade practices. Ignoring these factors, a company cannot survive for long. Profit maximisation at the cost of social and moral obligations is a short sighted policy.

2) Wealth maximisation :
              The companies having profit maximisation as its objective, may adopt policies yielding exorbitant profits in the short run which are unhealthy for the growth, survival and overall interests of the business. A company may not undertake planned and prescribed shut-downs of the plant for maintenance, and so on for maximising profits in the short run. Thus, the objective of a firm should be to maximise its value or wealth.
              According to Van Horne, "Value of a firm is represented by the market price of the company's common stock.......the market price of a firm's stock represents the focal judgment of all market participants as to what the value of the particular firm is. It takes into account present as also prospective future earnings per share, the timing and risk of these earning, the dividend policy of the firm and many other factors having a bearing on the market price of stock. The market price serves as a performance index or report card of the firm's progress. It indicates how well management is doing on behalf of stockholders." Share prices in the share market, at a given point of time, are the result of a mixture of many factors, as general economic outlook, particular outlook of the companies under consideration, technical factors and even mass psychology, but, taken on a long term basis, they reflect the value, which various parties, put on the company.
Normally this value is a function, of :
- the likely rate of earnings per share of the company; and
- the capitalisation rate.

The likely rate of earnings per share (EPS) depends upon the assessment as to the profitably a company is going to operate in the future or what it is likely to earn against each of its ordinary shares.
            The capitalisation rate reflects the liking of the investors of a company. If a company earns a high rate of earnings per share through its risky operations or risky financing pattern, the investors will not look upon its share with favour. To that extent, the market value of the shares of such a company will be low. An easy way to determine the capitalisation rate is to start with fixed deposit interest rate of banks, investor would want a higher return if he invests in shares, as the risk increases. How much higher return is expected, depends on the risks involved in the particular share which in turn depends on company policies, past records, type of business and confidence commanded by the management. Thus, capitalisation rate is the cumulative result of the assessment of the various shareholders regarding the risk and other qualitative factors of a company. If a company invests its funds in risky ventures, the investors will put in their money if they get higher return as compared to that from a low risk share.
            The market value of a share is thus, a function of earnings per share and capitalisation rate.  Since the profit maximisation criteria cannot be applied in real world situations because of its technical limitation the finance manager of a company has to ensure that his decisions are such that the market value of the shares of the company is maximum in the long run. This implies that the financial policy has to be such that it optimises the EPS, keeping in view the risk and other factors. Thus, wealth maximisation is a better objective for a commercial undertaking as compared to return and risk.
            There is a growing emphasis on social and other obligations of an enterprise. It cannot be denied that in the case of undertakings, especially those in the public sector, the question of wealth maximisation is to be seen in context of social and other obligations of the enterprise.
            It must be understood that financial decision making is related to the objectives of the business. The finance manager has to ensure that there is a positive impact of each financial decision on the furtherance of the business objectives. One of the main objective of an undertaking may be to "progressively build up the capability to undertake the design and development of aircraft engines, helicopters, etc." A finance manager in such cases will allocate funds in a way that this objective is achieved although such an allocation may not necessarily maximise wealth.

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