tag:blogger.com,1999:blog-44831741036289674962023-11-16T07:51:00.504-08:00Financial Management NotesFinancial Management NotesUnknownnoreply@blogger.comBlogger18125tag:blogger.com,1999:blog-4483174103628967496.post-75282427867717947832018-12-11T23:19:00.001-08:002018-12-11T23:19:13.041-08:00What is Capital Market and Source of Fund to Raise Capital<b>Capital markets</b> involve two parties on either end of a financial transaction. On one side, there are investors with capital who want to earn a return on their <b>money</b>. On the other, there are the companies, governments, or individuals who need to raise money.<img alt="Capital markets" class="alignnone wp-image-70 size-full" height="500" src="https://fmfunda.files.wordpress.com/2018/05/capital-market-chart782537567.jpg" title="Capital markets chart" width="800" />The capital market, allow these two groups to come together so that both can meet their goals. Capital markets are an essential part of many countries’ economies,making it possible for<b> businesses</b> to grow, for governments to provide essential services, and for individuals to invest and build their assets.<br />
<br />
The bigger and more robust a country’s capital markets are, the more <b>investment </b>vehicles there typically are and the larger the potential investment capital that is available to fuel growth. At the same time, most capital markets are regulated, by the government, the markets themselves, or by both.<br />
<br />
The goal is to increase investor confidence, and, by extension, investor participation. Achieving it often depends on the perception that everyone has equal access to good information and the best prices.<br />
<ul>
<li><h3>
<em><b>What is capital market?</b></em></h3>
</li>
</ul>
Capital markets are the mechanism that allows the exchange of money between companies and investors, companies and banks, and investors and banks as each party seeks to raise capital or <b>put capital </b>to work.<br />
<br />
While companies generally rely on their sales to keep their businesses going and on profits to underwrite new growth, there are times when a company might need a large amount of capital, perhaps to expand operations or cover operating losses. The capital markets are a place to raise that money, letting companies offer ownership or promise repayment to investors in exchange for capital.<br />
<br />
The capital markets also enable individuals to buy a home, pay for college, or start a business. They can take a loan from a bank that lends its depositors’ money to borrowers in exchange for the promise of future repayment and interest.<br />
It might help to think of the bank in this case as the investor, providing an individual with capital. In both cases, the availability of capital can contribute to economic growth. Expanding businesses typically create new jobs, putting more money into circulation.<br />
<br />
Home buyers spend money to remodel and furnish their properties, creating or sustaining jobs. Of course, in any economy there are periods when investment capital dries up and the economy slows down — or when too much capital encourages inflation. Left unchecked by government or industry oversight, either situation could create serious problems.<br />
<blockquote class="tr_bq">
<u><span style="color: red;"><span style="font-size: large;"><b>Read Also :</b></span></span></u></blockquote>
<blockquote class="tr_bq">
<blockquote class="tr_bq">
<ul>
<li><a href="http://www.fmfunda.com/2018/05/time-value-money.html" target="_blank">Time value Of Money</a></li>
<li><a href="http://www.fmfunda.com/2018/04/wealth-profit-maximisation.html" target="_blank">Wealth & Profit Maximization</a></li>
<li><a href="http://www.fmfunda.com/2018/04/cost-of-capital.html" target="_blank">Cost Of Capital</a></li>
</ul>
</blockquote>
</blockquote>
The capital market offer companies many different ways to<b> raise funds</b> from many different investors, including individuals and large institutions. Usually, the first options an entrepreneur explores are private <b>sources of funds</b>. This part of the capital market may provide limited amounts of money, but allows companies to remain privately held and founders to retain control over their operations.<br />
<br />
One private option is a corporate loan or line of credit from a bank. The process of qualifying is similar to what you might be familiar with if you’ve arranged a mortgage or large loan.<br />
Based on a company’s financial history and prospects, a bank may determine that the company is likely to repay the loan plus interest and advances the company the money.<br />
<br />
Another private option is to tap friends and family — private individuals who have some affiliation with the company or its officers and are willing to take investment risk for a share of future profits.<br />
A third choice is venture capital, or the assets of private investors channeled through a professional investment firm that may add funds to a start-up or maturing company in exchange for a piece of ownership, some say over operations, and a share in the profits.<br />
<br />
<h4>
<b>Public sources of funds</b></h4>
When companies need a greater amount of <b>capital</b> than their earnings or private sources can provide, they may turn to the public capital markets. In the U.S., that means going to Wall Street — shorthand for the financial markets. Issuing stock and bonds are the primary public ways of raising capital.<br />
<br />
A company that issues stock sells shares of ownership in the company and becomes publicly held. That means the company has a fiscal responsibility to its shareholders, who have a vote in how the company is run and a right to benefit from the company’s success.<br />
<br />
Once a company is publicly held it can also issue bonds to borrow <b>money from investors</b>, taking on the responsibility to repay the capital at some point in the future and pay interest for its use. Public sources of funds in the capital markets generally involve far greater sums than private sources. But using this money means that a company takes on a number of new responsibilities in exchange for the cash infusion.<br />
<br />
<h4>
<b>When companies are raising funds:</b></h4>
There are benefits to using a combination of methods. A company might take a loan when starting up, or work with venture capitalists that invest in the company. Several years later they may go public by issuing stock to expand into new markets, and then issue bonds at some time after that to cover the cost of upgrading equipment.<br />
<br />
The availability of several methods to raise funds is appealing to companies because it means they can continue to tap new <b>sources of money</b> over time. And by choosing several ways to raise funds, it’s possible to balance the advantages and disadvantages of each method. For example, a publicly held company may issue bonds to raise additional funds because issuing more stock would dilute the value of existing stock, upsetting current shareholders.<br />
<br />
Companies can also look to <b>international capital markets</b>. Some countries may offer better opportunities for raising capital than others, since there may be more potential investors in one country than in another. For example, a company in a small or developing nation might face a limited domestic capital market, so it could choose to offer shares to the much larger pool of investors through American Depositary Receipts (ADRs) traded in the United States, or Global Depositary Receipts (GDRs) traded in markets around the world.<br />
<br />
On the other hand, a European company might raise capital internationally by issuing <b>bonds</b> in a country with lower interest rates than it might have to pay at home, reducing the cost of raising the capital.Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-1721681470345923502018-11-24T04:30:00.000-08:002018-11-24T04:30:27.209-08:00Capital Structure in Financial Management<h2>
What is a capital structure?</h2>
Capital means funds employed in business for a period of twelve months and above. Capital excludes short-term funds employed in funds, i.e., working capital. Working capital is employed for a short time and hence ignored. <strong>Capital structure</strong> gives us the various components of capital both debt capital and share capital.<br />
<br />
In short, capital structure tells us about how much funds have been brought into business and in what form? It gives us the relationship between debt and equity, known as debt to equity relationship.<br />
<h3>
What is the need for a capital structure?</h3>
Why do we need a capital structure? Cant we do without it? In other words, cant we only have equity or debt instead of both the components? We can, especially equity.<br />
<br />
One can have a business enterprise only with equity funds without taking any loans. However, the financial risk that he will be taking would be tremendous, without anybody to share it with.<br />
<br />
Referring to debt,we cannot have a business enterprise only with debt. It is impossible as no lender would be willing to give entire amount by way of loan.<br />
<br />
Any lender wants the owner to put in some money by way of equity share capital so that the balance funds can be given in the form of loans. The market norm for lending is debt to equity not to exceed 2:1. There would be very few exceptions when this would be higher than 2:1.<br />
<br />
To sum up, any business enterprise would have what is known as capital structure. It is advisable for a business enterprise to have both debt and equity components in its capital structure although it is possible to run the business entirely on equity. Further as we have seen in the on leverages, it is beneficial to have a mix of debt and equity as it increases the Earnings Per Share (EPS) to the shareholders.<br />
<br />
At the same time, having regard to increasing risk due to increasing debt, it is better to be within the lending norms of 2:1. (Example Rs. 100 lacs by ways of equity and Rs. 200 lacs by way of debt).<br />
<h4>
Components of a capital structure exclusion of current liabilities and reasons thereof</h4>
<b>Share capital:</b><br />
<ul>
<li>Equity share capital</li>
<li>Retained earnings</li>
<li>Preference share capital</li>
</ul>
<b>Debt capital</b>:<br />
<ul>
<li>Debentures</li>
<li>Loans</li>
<li>Fixed deposits from the public</li>
<li>Medium term acceptances for capital goods</li>
<li>Bonds</li>
<li>Unsecured loans from promoters, friends and relatives</li>
<li>Deferred Payment Guarantees</li>
<li>Hire Purchase Financing</li>
</ul>
(The above list is not exhaustive. It is only illustrative.)<br />
<br />
<b>Exclusion of current liabilities and reasons thereof</b><br />
<ul>
<li>They are employed in business for a short period and cannot be considered as part of capital,</li>
<li>Some of them do not have any cost attached to them advances received, provision for outstanding expenses, provision for tax, creditors outstanding etc. Whereas all the items of debt capital have interest cost attached to them.</li>
<li>In a healthy business enterprise, they are fully covered by current assets and met out of current assets example creditor gets paid out of realisation of sale bill outstanding as a debtor.</li>
</ul>
Hence strictly speaking, current liabilities are not considered as capital<br />
<h3>
<b>Factors affecting capital structure or determinants of capital structure</b></h3>
<ul>
<li>The profitability of the organisation the higher the profits more the chances for debt capital because of ability to service higher debt both by way of interest and repayment of principal amount. This is reflected in a very critical ratio called Interest coverage ratio i.e EBIT/I. The higher the ratio, the more the chances of debt in the capital structure.</li>
</ul>
<br />
<ul>
<li>Reliable cash flows the more they are reliable the more the lenders are willing to give debt capital to the enterprise. Once debt is taken cash outflows get fixed for the future. Accordingly the reliability of firms cash flows assumes great significance here.</li>
</ul>
<br />
<ul>
<li>Degree of risk associated with the enterprise the higher the risk less the chances of debt capital and more the chances of equity. Example IT idustry (at least in the late 90s in India) run predominantly on equity.</li>
</ul>
<br />
<ul>
<li>Managements risk aversion attitude conservative managements take less of external debt and try to utilise internal accruals to maximum extent and equity to the extent necessary; on the contrary aggressive managements go in for debt to a larger extent. Examples Sundaram group of companies in Chennai in general and Sundaram Claytons in particular conservative attitude towards debt and debt to equity ratio being less than 1:1. On the contrary, Essar oils have very high debt to equity ratio close to 3:1.</li>
</ul>
<br />
<ul>
<li>Whether the business enterprise enjoys tax concessions in a big way like till recently the IT industry? Owing to high level of exports the IT sector was enjoying 100% tax concession on the exports profits. There was no difference in cost of debt (interest) and cost of equity (primarily dividend) in the absence of taxes. Such enterprises are indifferent to debt and have more of equity only.</li>
</ul>
<br />
<ul>
<li>Availability of different kinds of debt instruments like deep discounted bonds, floating rate notes (where the rate of interest is adjusted to the market rates) etc. that are attractive to the enterprises to go in for maximum debt within the debt to equity ratio norms specified by the lenders or the market. These instruments have entered the market only in the 90s and hence the debt market is getting more and more attractive and limited companies have started using them instead of only depending upon institutional finance.</li>
</ul>
<br />
<ul>
<li>Attitude of the promoters towards financial and management control - if this is high, first preference would be given for debt and then preference shares. Last preference would be given for public equity where financial control gets diluted because of larger number of shareholders and managerial control is likely to be affected.</li>
</ul>
<br />
<ul>
<li>Nature of the industry more competitive = higher equity and less debt; More monopolistic = less equity and more debt. Further depending upon the nature of industry the lenders do have different lending norms. This means that the leverage ratios in a particular industry are more or less uniform. These serve as the benchmark for determining the capital structure for any unit in the industry</li>
</ul>
Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-21900313644353294462018-11-01T11:10:00.000-07:002018-12-13T00:45:11.865-08:00Correlation between the returns of two different securities in PortfolioWe should not ignore the relationship or correlation between the returns of two different securities in <strong>Portfolio</strong>. This correlation however has no impact on the portfolios expected return.<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOnADY8DufJ1R44CY6hDrlF2w47SfRDASwOggpG4IBaD3t6n6WcOiyp79MjhYjd6KILGkf6OGdF3vY85PZN9U6HZIw5uyi7UgLtRq-TUrVO3Drr9FSCJHmPficguRhAILnFNNe8FfrARLw/s1600/return+of+securities+in+portfolio.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img alt="return of securities in portfolio" border="0" data-original-height="400" data-original-width="800" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOnADY8DufJ1R44CY6hDrlF2w47SfRDASwOggpG4IBaD3t6n6WcOiyp79MjhYjd6KILGkf6OGdF3vY85PZN9U6HZIw5uyi7UgLtRq-TUrVO3Drr9FSCJHmPficguRhAILnFNNe8FfrARLw/s1600/return+of+securities+in+portfolio.jpg" title="return of securities in portfolio" /></a></div>
<br />
The portfolio expected return is a straightforward weighted average of returns on the individual securities; the <strong>portfolio standard deviation</strong> is not the weighted average of individual security standard deviations.<br />
<br />
<h2>
Let's understand correlation between securities in Portfolio:</h2>
Suppose we have two stocks A and B in our portfolio. During a given period the return of A increases say by 1% while that of B increases by 0.5% in the same period.<br />
<br />
This means that both are moving positively in the direction of increasing returns. This is described as positive correlation. However the quantum of increase is not the same in both the cases.<br />
<br />
Hence this is imperfect but positive correlation. In case the quantum of increase is 1% in both the cases, then the correlation is said to be positive and perfect correlation.<br />
<br />
If the returns move in the opposite direction, say one increasing and the other decreasing, then the correlation is negative. Still the relationship could be perfect in the sense that the quantum of increase in return say in the case of A is the same in the case of B but in the opposite direction. This means that while stock A has increased its return, stock B has lost its return by the same percent.<br />
<br />
Let us try to put these in the form of equations.<br />
“Δ” represents the increase in return and (“Δ”) (within brackets-indicate that the return is decreasing).<br />
<br />
Keeping these in mind let us attempt the following:<br />
Δ of stock A = 1% for a given period = Δ of stock B = perfect and positive correlation<br />
<br />
Δ of stock A = 1% for a given period; Δ of stock B = greater than or less than 1% but the return has increased and not decreased = positive but imperfect correlation<br />
<br />
Δ of stock A = 1% for a given period; (“Δ”) of stock B = 1%. Then stock A and stock B are said to have perfect but negative correlation.<br />
<br />
Δ of stock A = 1% for a given period; (“Δ”) of stock B less than or more than 1%. Then stock A and stock B are said to have imperfect and negative correlation.<br />
<br />
We have consciously omitted the fifth possibility of both the stocks A and B losing to the same percent during a given period.<br />
<br />
Any portfolio would avoid such stocks unless the future is going to be completely different in which case the past is not the basis on which stock selection is being made.<br />
<br />
We have also tried to present these concepts in as simple a manner as possible. You are advised to go through these repeatedly to grasp the essence of the underlying concept in correlation between one stock and another. This is required because the concept of correlation is the fundamental based on which the selection of stocks for a portfolio is done. You will appreciate that positive correlation between two stocks would mean increased risk especially if the relationship is perfect. Negative correlation stocks are not desirable.<br />
<br />
What is then left is positive but imperfect correlation. The risk-averse investors would invariably choose such stocks as show positive relationship between them (or among them in view of the number of stocks in a portfolio being more than 2, which is usually the case) but not perfect relationship. Then only the risk in a portfolio is reduced. For a given period, same degree of movement in return on different stocks in the same direction only increases the risk in a portfolio.<br />
<br />
Now going back to the standard deviation of a portfolio, we will appreciate that it is not merely the weighted average of the standard deviation numbers for each stock in the portfolio. Suppose there are five stocks in a portfolio. We can appreciate that there are quite a few possible combinations of these five stocks depending upon the proportion of investment in each of them; for each combination, the weighted average of the standard deviation numbers has to be etermined first and then the ultimate average standard deviation should be found out for all possible combinations.<br />
<br />
This involves a very complicated calculation and hence not presented here. However before we end this topic it should be mentioned that the complicated calculation is worth the time invested in, as the ultimate result is reduction in the total risk of the portfolio. This is the very objective of a portfolio.<br />
<br />
<b>Kinds of risk - diversifiable and non-diversifiable</b><br />
<br />
<b><i><u>Diversifiable or non-systemic risks</u></i></b><br />
<br />
A portfolio aims at minimising the risk and optimising the returns. Any portfolio chooses the constituent stocks based on certain parameters and one of the important parameters is the correlation among the various stocks. A portfolio diversifies the risk by choosing stocks of:<br />
<ul>
<li>Different sectors</li>
<li>Different units in the same sector</li>
<li>Different aturities and different instruments including money market.</li>
</ul>
Are there different kinds of risk associated with securities? Yes. Diversifiable and non-diversifiable risks. By choosing different sectors etc. we are diversifying the risks. This means that sector specific or industry specific or instrument specific or maturity specific risks are diversifiable.<br />
<br />
Let's explain this through examples.<br />
<br />
Your portfolio could contain stocks of Cement, Textiles, Software and Pharmaceuticals. This is called sector diversification. You will choose such sectors as are not having perfect correlation.<br />
<br />
Your portfolio could contain stocks of ACC, Larsen & Toubro and Dalmia Cements. This is called unit diversification in the same sector. You will choose again such units as are not having perfect correlation.<br />
<br />
Your portfolio could contain one-year investment (bond or debenture), more than one-year investment and long-term investment too. This is called maturity diversification. Here the relationship will rarely be perfect.<br />
<br />
Your portfolio could contain investment into equity shares, debt instruments and money market instruments. This is called instruments diversification. Here too the relationship will not be perfect as these relate to different segments of the Financial Markets.<br />
<br />
All the above are examples of diversifiable risks. One can use detailed analytical study of the past trends and knowledge about the various sectors and specific units for true diversification of stocks in a portfolio. Such diversifiable risks are often referred to as non-systemic risks or specific risks as such risks are not thrown in by the system.<br />
<br />
<b><i><u>Non-diversifiable or systemic risks</u></i></b><br />
Suppose we do all the above and arrive at a very good portfolio. The US and their allies decide to bomb IRAQ. All hell breaks loose. All the markets internationally are nervous.<br />
<br />
Can you and I do something about it besides feeling helpless about the whole thing? Such kind of risks could be specific to a country or economy or universal in its impact.<br />
<br />
The universality of market risks depends upon the degree of integration of different countries into the global system. The more they are integrated the higher will be the degree of uniformity of impact due to US bombing IRAQ. We cannot diversify this kind of risk at least within a country or system, although global investors are in a better position to diversify the country specific risk by pulling out of the country and reinvesting the amount in less risky markets.<br />
<br />
Typical example of a market risk in India Sensex crashing from 6000 odd points in early 2000 to less than 3000 points in 2002. The markets becoming nervous on news of Indo-Pak war is another example.<br />
<br />
<b>Total risk of a portfolio = market risk of the portfolio + specific risk of the portfolio </b>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-73300438788312367172018-11-01T10:58:00.000-07:002018-11-01T10:58:06.101-07:00What is Cash Budget and its Purpose,Objectives and Need What is Cash Budget and its Purpose,Objectives and Need : The net cash position of a firm as it moves from one budgeting sub period to another is highlighted by the<b> cash budget</b>. Cash budget is a statement showing the estimated cash inflows and cash outflows over the planning horizon.<br />
<h2>
<b><u>The various purpose of cash budget are</u></b>:</h2>
<ul>
<li>To coordinate the timing of cash need.</li>
<li>It pinpoints the period when there is likely to be excess cash.</li>
<li>It enables the firm which has sufficient cash to take the advantage of cash discount on its account payable to pay the obligations when due to formulate the dividend policy.</li>
<li>It help to arrange needed funds so that the most favourable terms and prevents the accumulation of excess funds.</li>
</ul>
The principle aim of cash budget as a tool to predict <b>cash flows</b> over a given period of time is to ascertain whether at any point of time there is likely to be an excess or shortage of cash.<br />
<br />
The preparation of cash budgets involves various steps and is called the element of cash budgeting system. The first element is selection of period of time to be covered by the entire budget. It is referred to as the planning horizon which mean the time span and the sub period within that time span and the sub period within that time span over which the cash flows are to be protected.<br />
<br />
The second element of cash budget is the selection of the factors that have a bearing on cash flows. The items included in the cash budget are only cash items. The factors that generate cash flows are generally divided for the purposes of preparing cash budget into two broad categories: (a) operating (b) financial.<br />
<br />
While the former category includes cash flows generated by the operations of the firms and are known as operating cash flows.<br />
<h2>
<b><u>Cash Budget And Cash Flows Statement</u></b></h2>
Cash budget is a statement showing the estimated cash inflows and cash outflows over the planning horizon. In other words, The net cash position of a firm as it moves from one budgeting sub period to another is highlighted by the cash budget.<br />
Cash Flow Statement generally prepared annually, which shows the sources and the uses of cash during that period. It measures the changes in the financial position on each basis.<br />
<h2>
<b><u>Cash Budget Objectives</u></b></h2>
<ul>
<li>To coordinate the timing of cash need.</li>
<li>It pinpoints the period when there is likely to be excess cash.</li>
<li>It enables the firm which has sufficient cash to take the advantage of cash discount on its account payable to pay the obligations when due to formulate the dividend policy.</li>
<li>It help to arrange needed funds so that the most favourable terms and prevents the accumulation of excess funds.</li>
</ul>
<b>Cash Flow Statement Objectives</b><br />
<ul>
<li>Cash Flow Statement is useful for the management to assess its ability to meet the obligation to trade creditors and to pay bank loan to pay interest to debenture holders and dividend to its shareholders.</li>
<li>Cash Flow Statement can also be prepared month wise which is useful in presenting the information of excess cash in some months and shortage of cash in other months.</li>
</ul>
<h2>
<b><u>Need For Preparing A Cash Budget</u></b></h2>
The principle aim of preparing a cash budget, as a tool to predict cash flows over a period of time is to ascertain whether at any point of time there is likely to be an express or shortage of cash.<br />
<br />
The preparation of cash budget involved various steps. They may be described as the elements of the cash budgeting system.<br />
<br />
<b>Cost of Capital</b><br />
The cost of capital is the rate of return the company has to pay to various suppliers of funds in the company. There are variations in the costs of capital due to the fact that different kinds of investment carry different levels risk which is compensated for by different levels of return on the investment.<br />
<br />
<b>Opportunity Cost of Capital</b><br />
When an organization faces shortage of capital and it has to invest capital in more than one project, then the company will meet the problem by rationing the capital to projects whose returns are estimated to be more. The firm might decide to estimate the opportunity cost of capital in other projects.<br />
<br />
<b>Financial Leverage</b><br />
This ratio indicates the effects on earnings by rise of fixed cost funds. It refers to the use of debt in the capital structure. Financial leverage arises when a firm deploys debt funds with fixed charge.<br />
<br />
<b>Operating Leverage</b><br />
Operating leverage is concerned with the operation of any firm. The cost structure of any firm gives rise to operating leverage because of the existence of fixed nature of costs. This leverage relates to the sales and profit variations. Sometimes a small fluctuation in sales would have a great impact on profitability. This is because of the existence of fixed cost elements in the cost structure of a product.<br />
<br />
<b>Combined Leverage</b><br />
The operating leverage has its effects on operating risk and is measured by the<br />
percentage change in EBIT due to percentage change in sales. The financial<br />
leverage has its effects on financial risk and is measured by the percentage change in EPS due to percentage change in EBIT. Since both these leverages are closely concerned with ascertaining the ability to cover fixed charges, if they are combined, the result is total leverage and the risk associated with combined leverage is known as total risk.Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-63929361839095064892018-11-01T05:31:00.000-07:002019-08-29T00:41:53.801-07:00Ratio Analysis : Advantages and Limitations in Financial Management<b>Ratio Analysis : Advantages and Limitations in Financial Management</b><br />
<h2>
What is Ratio Analysis :</h2>
Ratio analysis is the method or process by which the relationship of items or groups of items in the financial statements are computed, determined and presented.<br />
<br />
Ratio analysis is an attempt to derive quantitative measures or guides concerning the financial health and profitability of the business enterprise. Ratio analysis can be used both in trend and static analysis.<br />
<br />
There are several ratios at the disposal of the analyst but the group of ratios he would prefer depends on the purpose and the objectives of the analysis.<br />
<br />
Accounting ratios are effective tools of analysis. They are indicators of managerial and overall operational efficiency. Ratios, when properly used are capable of providing useful information.<br />
Ratio analysis is defined as the systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined the term ratio refers to the numerical or quantitative relationship between items/ variables.<br />
<br />
This relationship can be expressed as:<br />
<br />
1) Fraction<br />
<br />
2) Percentages<br />
<br />
3) Proportion of numbers<br />
These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratio does not add any information in the figures of profit or sales.<br />
What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them.<br />
<h2>
<b>ADVANTAGE OF RATIO ANALYSIS :</b></h2>
<ul>
<li>Ratios simplify and summarize numerous accounting data in a systematic manner so that the simplified data can be used effectively for analytical studies.</li>
<li>Ratios avoid distortions that may result the study of absolute data or figures.</li>
<li>Ratios analyze the financial health, operating efficiency and future prospects by inter-relating the various financial data found in the financial statement.</li>
<li>Ratios are invaluable guides to management. They assist the management to discharge their functions of planning, forecasting, etc. efficiently.</li>
<li>Ratios study the past and relate the findings to the present. Thus useful inferences are drawn which are used to project the future.</li>
<li>Ratios are increasingly used in trend analysis.</li>
<li>Ratios being measures of efficiency can be used to control efficiency and profitability of a business entity.</li>
<li>Ratio analysis makes inter-firm comparisons possible. i.e. evaluation of interdepartmental performances.</li>
<li>Ratios are yard stick increasingly used by bankers and financial institutions in evaluating the credit standing of their borrowers and customers.</li>
</ul>
<h2>
<b>LIMITATIONS OF RATIO ANALYSIS</b>:</h2>
An investor should caution that ratio analysis has its own limitations. Ratios should be used with extreme care and judgment as they suffer from certain serious drawbacks.<br />
<br />
<b><i>Some of them are listed below</i></b>:<br />
<br />
1. Rations can sometimes be misleading if an analyst does not know the reliability andsoundness of the figures from which they are computed and the financial position of the business at other times of the year.<br />
A business enterprise for example may have an acceptable current ratio of 3:1 but a larger part of accounts receivables comprising a great portion of the current assets may be uncollectible and of no value. When these are deducted the ratio might be 2:1.<br />
<br />
2. It is difficult to decide on the proper basis for comparison. Ratios of companies have meaning only when they are compared with some standards. Normally, it is suggested that ratios should be compared with industry averages. In India, for example, no systematic and comprehensive industry ratios are complied.<br />
<br />
3. The comparison is rendered difficult because of differences in situations of 2 companies are never the same. Similarly the factors influencing the performance of a company in one year may change in another year.<br />
Thus, the comparison of the ratios of two companies becomes difficult and meaningless when they are operation in different situations.<br />
<br />
4. Changes in the price level make the interpretations of the ratios Invalid.<br />
<br />
The interpretation and comparison of ratios are also rendered invalid by the changing value of money.<br />
<br />
The <a href="https://www.indianaccounting.in/">accounting</a> figures presented in the financial statements are expressed in monetary unit which is assumed to remain constant. In fact, prices change over years and as a result.<br />
<br />
Assets acquired at different dates will be expressed at different values in the balance sheet. This makes comparison meaningless.<br />
<br />
For e.g. two firms may be similar in every respect except the age of the plant and machinery. If one firm purchased its plant and machinery at a time when prices were very low and the other purchased when prices were high, the equal rates of return on investment of the two firms cannot be interpreted to mean that the firms are equally profitable.<br />
<br />
The return of the first firm is overstated because its plant and machinery have a low book value.<br />
<br />
5. The differences in the definitions of items, accounting, policies in the balance sheet and the income statement make the interpretation of ratios difficult.<br />
<br />
In practice difference exists as to the meanings and accounting policies with reference to stock valuation, depreciation, operation profit,current assets etc.<br />
<br />
Should intangible assets be excluded to calculate the rate of return on investment? If intangible assets have to be included, how will they be valued? Similarly, profit means different things to different people.<br />
<br />
6. Ratios are not reliable in some cases as they many be influenced by window/ dressing in the balance sheet.<br />
<br />
7. The ratios calculated at a point of time are less informative and defective as they suffer from short-term changes. The trend analysis is static to an extent.<br />
<br />
The balance sheet prepared at different points of time is static in nature. They do not reveal the changes which have taken place between dates of two balance sheets. The statements of changes in financial position reveal this information, bur these statements are not available to outside analysts.<br />
<br />
8. The ratios are generally calculated from past financial statements and thus are no indicator of future. The basis to calculate ratios are historical financial statements. The financial analyst is more interested in what happens in future.Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-46851210600102408852018-05-10T00:12:00.000-07:002018-12-13T00:16:51.557-08:00Relevance of time value of money in financial decision makingThe recognition of the<b> time value of money</b> and risk is extremely vital in financial decision making. If the timing and risk of cash flows are not considered, the firm may make decisions which may allow it to miss its objectives of maximizing the owners welfare.<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivMc0Cf7eyZmz1Datc-Sc_sBwLTlg5tSjbN9YWAFsGFtU94Jp2bA98eYvx2NvGLBDaLXTX_MFe45POon_DveWmFN_gyKDH5JSgiPfSGVnyMqoZbT68us02NgiB64Mnh2tGDJuyNXmdtxp4/s1600/time+value+of+money.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img alt="Time value of money" border="0" data-original-height="300" data-original-width="800" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivMc0Cf7eyZmz1Datc-Sc_sBwLTlg5tSjbN9YWAFsGFtU94Jp2bA98eYvx2NvGLBDaLXTX_MFe45POon_DveWmFN_gyKDH5JSgiPfSGVnyMqoZbT68us02NgiB64Mnh2tGDJuyNXmdtxp4/s1600/time+value+of+money.jpg" title="Time value of money" /></a></div>
<br />
We prefer todays money to that of tomorrow due to our pressing needs for consumption and cost of abstinence form the present consumption, fall in the value of money tomorrow due to inflation and possible use of money when exchanged for tomorrows money.<br />
<br />
Thus, when we lend money, we forego all the advantages of liquidity, ready usability, safety etc. we abstain from present consumption when lent to somebody or invested. All these will lead to what is called the time preference for money. To compensate for that, future money will have to be discounted to the present time.<br />
<br />
Tomorrows <b>money </b>or money a year hence has to be discounted to the present day by discount rate suitable as a reward for the above sacrifices. This is called discounting, used for cash flows or dividends to be received in future and to be calculated for the present.<br />
<br />
Similarly an investment of today, if it is to be returned after a year or so, todays money has to be compounded by a discount rate to equate to the future funds likely to be available in return. This is called <b>compounding</b>. Compounding and <a href="http://www.fmfunda.com/2017/11/discounting-formula.html" target="_blank"><b>discounting</b></a> are thus tow major methods of analyzing the time value of money.<br />
<br />
<br />
<b>Time preference rate</b>: the time preference for money is generally expressed by an internal rate. It is a risk free rate.<br />
<br />
Required Rate of Return = Risk free rate + Risk premium<br />
<br />
The risk free rate compensates for time while risk premium compensates for Risk.<br />
<blockquote class="tr_bq">
<b><span style="color: red;"><span style="font-size: large;">Read Also :</span></span></b></blockquote>
<br />
<li style="text-align: left;"><b><a href="http://www.fmfunda.com/2012/12/financial-statement-analysis.html" target="_blank"><span style="font-size: small;">Functions of Financial Officer</span></a></b></li>
<br />
<b> </b><br />
<br />
<li style="text-align: left;"> <b><a href="http://www.fmfunda.com/2012/12/financial-statement-analysis.html" target="_blank"><span style="font-size: small;">Financial Statement Analysis</span></a></b></li>
<br />
<b> </b><br />
<br />
<li style="text-align: left;"><b> <a href="http://www.fmfunda.com/2018/05/financial-ratios-decision-making.html" target="_blank"><span style="font-size: small;">Financial Ratios relevant in Decision Making</span></a></b><span style="font-size: small;"><b> </b></span></li>
<br />
<br />
<b>Compound value and compound interest: </b> investments involve more than one period. The interest that is paid on the principal as well as on any interest earned but not withdrawn during the earlier periods is called compound interest. The process of finding the future value of a payment or series of payments when applying the concept of compound interest is known as compounding.<br />
<br />
<br />
Compound value of a lump sum:<br />
<br />
Future sum = principal + interest<br />
<br />
A finance manager is required to make decisions on investment, financing and dividend in view of the company's objectives.<br />
<br />
The decisions as purchase of assets or procurement of funds i.e. the investment/financing decisions affect the cash flow in different <b>time periods</b>. 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.<br />
<br />
In the theory of finance, the interest factor is one of the crucial and exclusive concept, known as the time value of money.<br />
<br />
<br />
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.<br />
<br />
<b><u>Reasons of time preference of money</u></b> :<br />
<br />
1) <b>Risk</b> :<br />
There is uncertainty about the receipt of money in future.<br />
<br />
2) <b>Preference for present consumption</b> :<br />
Most of the persons and companies have a preference for present consumption may be due to urgency of need.<br />
<br />
3) <b>Investment opportunities</b> :<br />
Most of the persons and companies have preference for present money because of availabilities of opportunities of investment for earning additional cash flows.<br />
<br />
<b><u>Importance of time value of money</u></b> :<br />
<br />
<br />
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.<br />
<br />
The cash flows arising at different points of time can be made comparable by using any one of the following :<br />
<ul>
<li>by compounding the present money to a future date i.e. by finding out the value of present money.</li>
<li>by discounting the future money to present date i.e. by finding out the present value(PV) of future money.</li>
</ul>
<br />
1) <b><u>Techniques of compounding</u></b> :<br />
<br />
<br />
i) <b>Future value (FV) of a single cash flow</b> :<br />
The future value of a single cash flow is defined as :<br />
<br />
<img alt="Future-value-of-single-cashflow" class="alignnone wp-image-57 size-full" height="129" src="https://fmfunda.files.wordpress.com/2018/05/future-value-of-single-cashflow-1782268006.jpg" title="Time value of money" width="720" /><br />
<br />
<br />
<br />
Where, FV = future value<br />
PV = Present value<br />
r = rate of interest per annum<br />
n = number of years for which compounding is done.<br />
<br />
<br />
If, any variable i.e. PV, r, n varies, then FV also varies. It is very tedious to calculate the value of (1 + r)^n, so different combinations are published in the form of tables.<br />
<br />
These may be referred for computation, otherwise one should use the knowledge of logarithms.<br />
<br />
ii) <b>Future value of an annuity</b> :<br />
<br />
<br />
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.<br />
<br />
In general terms the future value of an annuity is given as :<br />
<br />
<img alt="Future-value-of-annuity" class="alignnone wp-image-59 size-full" height="149" src="https://fmfunda.files.wordpress.com/2018/05/future-value-of-annuity-1871683108.jpg" title="Time value of money" width="720" /><br />
<br />
<br />
<br />
Where,<br />
FVAn = Future value of an annuity which has duration of n years.<br />
A = Constant periodic flow<br />
r = Interest rate per period<br />
n = Duration of the annuity<br />
<br />
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.<br />
<br />
A published table is available for various combination of the rate of interest 'r' and the time period 'n'.<br />
<br />
2) <b><u>Techniques of discounting</u></b> :<br />
<br />
i) <b>Present value of a single cash flow</b> :<br />
The present value of a single cash flow is given as :<br />
<br />
<img alt="Present value of single cash flow" class="alignnone wp-image-53 size-full" height="231" src="https://fmfunda.files.wordpress.com/2018/05/present-value-of-single-cashflow-1773733889.jpg" title="Time value of money" width="800" /><br />
<br />
Where,<br />
FVn = Future value n years hence<br />
r = rate of interest per annum<br />
n = number of years for which discounting is done.<br />
<br />
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 <img class="wp-image-55 size-thumbnail alignleft" data-temp-aztec-id="ab0b363a-464c-4066-a21c-85a81fff884c" height="100" src="https://fmfunda.files.wordpress.com/2018/05/present-value-of-single-cashflow_1525719197769-2117823665.jpg" width="100" />are available.<br />
<br />
ii) <b>Present value of an annuity</b> :<br />
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 :<br />
<br />
<img alt="Present value of an annuity" class="alignnone wp-image-52 size-full" height="214" src="https://fmfunda.files.wordpress.com/2018/05/present-value-of-annuity119333725.jpg" title="Time value of money" width="800" /><br />
<br />
Where,<br />
PVAn = Present value of annuity which has duration of n years<br />
A = Constant periodic flow<br />
r = Discount rate.Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-72533375461530901012018-05-08T03:42:00.001-07:002018-05-13T07:12:22.259-07:00Financial leverage and Operating leverageThe term <b>leverage</b> generally, refers to a relationship between 2 interrelated variables.<br />
<br />
In financial analysis, it represents the influence of one <b>financial variable</b> over some other related financial variable. These financial variables may be costs, output, sales revenue, EBIT (Earnings Before Interest and Tax), EPS (Earnings Per Share), etc.<br />
<br />
<h2>
<b>Type of leverage</b> : </h2>
Commonly used leverages are of the following type:<br />
<br />
1) <u><b>Operating Leverage</b></u> :<br />
It is defined as the "firm's ability to use fixed operating costs to magnify effects of changes in sales on its EBIT ". When there is an increase or decrease in sales level the EBIT also changes. The effect of changes in sales on the level EBIT is measured by operating leverage.<br />
<br />
Operating leverage =<br />
<br />
% Change in EBIT / % Change in sales<br />
<br />
Or,<br />
<div style="text-align: left;">
=[Increase in EBIT/EBIT] / [Increase in sales/sales]</div>
<b><br />
</b> <u><b>Significance of operating leverage</b></u> :<br />
Analysis of operating leverage of a firm is useful to the financial manager. It tells the impact of changes in sales on operating income. A firm having higher D.O.L. (Degree of Operating Leverage) can experience a magnified effect on EBIT for even a small change in sales level.<br />
<br />
Higher D.O.L. can dramatically increase operating profits. But, in case of decline in sales level, EBIT may be wiped out and a loss may be operated. As operating leverage, depends on fixed costs, if they are high, the firm's operating risk and leverage would be high.<br />
<br />
If operating leverage is high, it automatically means that the break-even point would also be reached at a high level of sales. Also, in case of high operating leverage, the margin of safety would be low. Thus, it is preferred to operate sufficiently above the break-even point to avoid the danger of fluctuations in sales and profits.<br />
<br />
2) <u><b>Financial Leverage</b></u> :<br />
It is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT/Operating profits, on the firm's earnings per share. The <b>financial leverage</b> occurs when a firm's capital structure contains obligation of fixed charges e.g. interest on debentures, dividend on preference shares, etc. along with owner's equity to enhance earnings of equity shareholders.<br />
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The fixed financial charges do not vary with the <b>operating profits</b> or EBIT. They are fixed and are to be repaid irrespective of level of operating profits or EBIT. The ordinary shareholders of a firm are entitled to residual income i.e. earnings after fixed financial charges. Thus, the effect of changes in operating profit or EBIT on the level of EPS is measured by financial leverage.<br />
<br />
Financial leverage =<br />
<br />
% change in EPS/% change in EBIT<br />
or,<br />
= (Increase in EPS/EPS)/{Increase in EBIT/EBIT}<br />
<br />
The <b>financial leverage is favourable</b> when the firm earns more on the investment/assets financed by sources having fixed charges.<br />
<br />
It is obvious that shareholders gain a situation where the company earns a high rate of return and pays a lower rate of return to the supplier of long term funds, in such cases it is called 'trading on equity'.<br />
<br />
The financial leverage at the levels of EBIT is called degree of financial leverage and is calculated as ratio of EBIT to profit before tax.<br />
<br />
Degree of financial leverage = EBIT/Profit before tax<br />
<br />
Shareholders gain in a situation where a company has a high rate of return and pays a lower rate of interest to the suppliers of long term funds. The difference accrues to the shareholders.<br />
<br />
However, where rate of return on investment falls below the rate of interest, the shareholders suffer, as their earnings fall more sharply than the fall in the return on investment.<br />
<br />
Financial leverage helps the finance manager in designing the appropriate <b>capital structure</b>. One of the objective of planning an appropriate capital structure is to maximise return on equity shareholders' funds or maximise EPS.<br />
<br />
Financial leverage is double edged sword i.e. it increases EPS on one hand, and financial risk on the other. A high financial leverage means high fixed costs and high financial risk i.e. as the debt component in capital structure increases, the financial risk also increases i.e. risk of insolvency increases. The finance manager thus, is required to trade off i.e. to bring a balance between risk and return for determining the appropriate amount of debt in the capital structure of a firm.<br />
<blockquote class="tr_bq">
<u><span style="color: red;"><span style="font-size: large;"><b>Read Also :</b></span></span></u></blockquote>
<blockquote class="tr_bq">
<blockquote class="tr_bq">
<ul>
<li><a href="http://www.fmfunda.com/2018/05/time-value-money.html" target="_blank">Time value Of Money</a></li>
<li><a href="http://www.fmfunda.com/2018/05/financial-ratios-decision-making.html" target="_blank">Financial Ratios</a></li>
<li><a href="http://www.fmfunda.com/2018/04/cost-of-capital.html" target="_blank">Cost Of Capital</a> </li>
</ul>
</blockquote>
</blockquote>
Thus, analysis of financial leverage is an important tool in the hands of the finance manager who are engaged in financing the capital structure of business firms, keeping in view the objectives of their firm.<br />
<br />
3) <u><b>Combined leverage</b></u> :<br />
Operating leverage explains operating risk and financial leverage explains the financial risk of a firm. However, a firm has to look into overall risk or total risk of the firm i.e. operating risk as also financial risk.<br />
<br />
Hence, the combined leverage is the result of a combination of operating and financial leverage. The combined leverage measures the effect of a % change in sales on % change in EPS.<br />
<br />
Combined Leverage =<br />
<br />
Operating leverage * Financial leverage<br />
<br />
= (% change in EBIT/% change in sales) * (% change in EPS/% change in EBIT)<br />
<br />
= % change in EPS/% change in sales<br />
<br />
The ratio of contribution to earnings before tax, is given by a combined effect of <b>financial and operating leverage</b>. A high operating and high financial leverage is very risky, even a small fall in sales would affect tremendous fall in EPS.<br />
<br />
A company must thus, maintain a proper balance between these 2 leverage. A high operating and low financial leverage indicates that the management is careful as higher amount of risk involved in high operating leverage is balanced by low financial leverage.<br />
<br />
But, a more preferable situation is to have a low operating and a <b>high financial leverage</b>. A low operating leverage automatically implies that the company reaches its break-even point at a low level of sales, thus, risk is diminished. A highly cautious and conservative manager would keep both its operating and financial leverage at very low levels. The approach may, mean that the company is losing profitable opportunities.<br />
<br />
The study of leverages is essential to define the risk undertaken by the shareholders. Earnings available to shareholders fluctuate on account of 2 risks, viz. operating risk i.e. variability of <b>EBIT</b> may arise due to variability of sales or/and expenses.<br />
<br />
In a given environment, <b>operating risk</b> cannot be avoided. The variability of EPS or return on equity depends on the use of financial leverage and is termed as financial risk. A firm financed totally by equity finance has no financial risk, hence it cannot be avoided by eliminating use of borrowed funds.<br />
<br />
Thus, a company has to consider its likely profitability position set before deciding upon the capital mix of the company, as it has far reaching implications on the financial position of the company.<br />
<br />
<u><b>Effect of leverage on capital turnover and working capital ratio</b></u><br />
<br />
An increase in sales improves the net profit ratio, raising the Return on Investment (R.O.I) to a higher level. This however, is not possible in all situations, a rise in capital turnover is to be supported by adequate capital base.<br />
<br />
Thus, as capital turnover ratio increases, working capital ratio deteriorates, thus, management cannot increase its capital turnover ratio beyond a certain limit. The main reasons for a fall in ratios showing the working capital position due to increase in turnover ratios is that as the activity increases without a corresponding rise in working capital, the working capital position becomes tight.<br />
<br />
As the sales increases, both current assets and current liabilities also increases but not in proportion to current ratio. If current ratio and acid test ratio are high, it is apparent that the capital turnover ratio can be increased without any problem.<br />
<br />
However, it may be very risky to increase capital turnover ratio when, the <b>working capital</b> position is not satisfactory.Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-63139010934348680582018-05-04T09:21:00.000-07:002018-05-13T03:16:46.440-07:00Financial Ratios relevant in Decision MakingA popular technique of analyzing the performance of a business concern is that of <b>financial ratio</b> analysis, it, as a tool of<b> <a href="http://www.fmfunda.com/2012/12/introduction-to-financial-management.html" target="_blank">financial management</a> </b>is of crucial significance.<br />
<br />
Its importance lies in the fact that it presents facts on a comparative basis and enables drawing of inferences as regards a firm's performance.<br />
<br />
It is relevant in assessing the firm's performance in the below mentioned aspects :<br />
<h2>
I) <b><u>Financial ratios for evaluation of performance :</u></b></h2>
<br />
<b><i>Liquidity position</i></b> : <b>Ratio analysis</b> assists in drawing conclusions as regards the firm's liquidity position. It would be satisfactory if the firm is able to meet its current obligations when they become due.<br />
<br />
A firm can be said to have the ability to meet its short-term liabilities if it has sufficient liquidity to pay interest on its short-maturing debt, usually within a year as also the principal. This ability is reflected in the liquidity ratios of the firm and liquidity ratios are useful in credit analysis by banks and other suppliers of short-term loans.<br />
<br />
<b><i>Long-term solvency</i></b> : Ratio analysis is equally helpful for assessing a firm's <b>long-term financial viability</b>. This aspect of the <b>financial position</b> of a borrower is of concern to the long-term creditors, security analysts and the present and potential owners of a business.<br />
<br />
The long-term solvency is measured by the leverage/capital structure and <b>profitability ratios</b> focusing on earning power and operating efficiency and ratio analysis reveals the strength and weaknesses of a firm in respect thereto.<br />
<br />
The leverage ratios, for example, indicates whether a firm has a reasonable proportion of various sources of finance or whether heavily loaded with debt in which case its solvency is exposed to serious strain. In the same manner, various profitability ratios reveal whether or not the firm is able to offer adequate return to its owners consistent with the risk involved.<br />
<br />
<b><i>Operating efficiency</i></b> : Ratio analysis throws light on the degree of efficiency in the management and utilization of its assets. Various activity ratios measure this kind of operational efficiency, a firm's solvency is, in the ultimate analysis, dependent on the sales revenues generated by the use of its assets - total as well as its components.<br />
<br />
<b><i>Over-all-profitability</i></b> : Unlike outside parties, that are interested in one aspect of the financial position of a firm, the management is constantly concerned about the overall profitability of the enterprise i.e. they are concerned about the firm's ability to meet its short-term and long-term obligations to its creditors, to ensure reasonable return to its owners and secure optimum utilization of the firm's assets. It is possible if an integrated view is taken and all the ratios are considered together.<br />
<blockquote class="tr_bq">
<u><span style="color: red;"><span style="font-size: large;"><b>Read Also :</b></span></span></u></blockquote>
<blockquote class="tr_bq">
<blockquote class="tr_bq">
<ul>
<li><a href="http://www.fmfunda.com/2018/05/time-value-money.html" target="_blank">Time value Of Money</a></li>
<li><a href="http://www.fmfunda.com/2018/04/wealth-profit-maximisation.html" target="_blank">Wealth & Profit Maximization</a></li>
<li><a href="http://www.fmfunda.com/2018/04/cost-of-capital.html" target="_blank">Cost Of Capital</a> </li>
</ul>
</blockquote>
</blockquote>
<br />
<br />
<b><i>Inter-firm comparison</i></b> : Ratio analysis not only throws light on the firm's financial position but also serves as a stepping stone to remedial measures. It is made possible by inter-firm comparison/comparison with industry average.<br />
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It should be reasonably expected that the firm's performance is in broad conformity with that of the industry to which it belongs. An inter-firm comparison demonstrates the relative position vis-à-vis its competitors. If the results are at variance either with the industry average or with that of the competitors, the firm can seek to identify the probable reasons and in its light, take remedial measures.<br />
<br />
Ratios not only perform post-mortem of operations, but also serves as barometer for future, they have predictory value and are helpful in forecasting and planning future business activities and helps in <b><a href="http://www.fmfunda.com/2012/12/capital-budgeting.html" target="_blank">budgeting</a>.</b><br />
<br />
<h2>
II) <b><u>Financial ratios for budgeting</u></b> :</h2>
<br />
In this field ratios are able to provide a great deal of assistance, budget is only an estimate of future activity based on past experience, in the making of which the relationship between different spheres of activities are invaluable.<br />
<br />
It is usually possible to estimate budgeted figures using financial ratios. Ratios also can be made use of for measuring actual performance with budgeted figures and indicate directions in which adjustments should be made either in the budget or in performance to bring them closer to each other.<br />
<h2>
<b><u>Limitations of financial ratios are as follows :</u></b></h2>
<ul>
<li>Diversified product lines : Many businesses operate a large number of divisions in quite different industries. In such cases ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.</li>
</ul>
<ul>
<li>Financial data are badly distorted by inflation : Historical cost values may be substantially different from true values, such distortions in financial data are also carried in financial ratios.</li>
</ul>
<ul>
<li>Seasonal factors may also influence financial data.</li>
</ul>
<ul>
<li>To give good shape to the financial ratios used popularly : The business may make some year-end adjustments, such window-dressing can change the character of financial ratios that would be different had there been no change.</li>
</ul>
<ul>
<li>Differences in accounting policies and accounting period make the accounting data of 2 firms non-comparable as also the accounting ratios.</li>
</ul>
<ul>
<li>There is no standard set of ratios against which a firm's ratios may be compared, sometimes, if a firm decides to be above average then, industry average becomes a low standard. On the other hand, for a below average firm, industry averages become too high as standards to achieve.</li>
</ul>
<ul>
<li>It is difficult to generalize whether a particular ratio is good or bad, for instance, a low current ratio may be 'bad' from the view point of low liquidity, while a high current ratio may be 'bad' as it may result from inefficient working capital management.</li>
</ul>
<blockquote class="tr_bq">
</blockquote>
<ul>
<li>Financial ratios are inter-related and not independent, when viewed in isolation one ratio may highlight efficiency but, as a set of ratios it may speak differently. Such interdependence among the ratios can be taken care of through multivariate analysis. Financial ratios provide clues but not conclusions.</li>
</ul>
<br />
These are tools in the hands of experts as there is no standard ready-made interpretation of financial ratios.Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-53714191878028367222018-05-02T01:17:00.000-07:002018-05-13T03:18:40.086-07:00Methods to Calculate Cost of CapitalThe <b><a href="https://fmfunda.blogspot.in/2018/04/cost-of-capital.html" target="_blank">cost of capital</a></b> is a significant factor in designing the capital structure of an undertaking, as basic reason of running of a business undertaking is to earn return at least equal to the cost of capital.<br />
<br />
Commercial undertaking has no relevance if, it does not expect to earn its cost of capital. Thus cost of capital constitutes an important factor in various business decisions. For example, in analysing financial implications of capital structure proposals, cost of capital may be taken as the discounting rate.<br />
<br />
Obviously, if a particular project gives an internal rate of return higher than its cost of capital, it should be an attractive opportunity.<br />
<br />
Following are the <a href="http://www.fmfunda.com/2018/05/methods-calculate-cost-of-capital.html" target="_blank">cost of capital</a> acquired from various sources :<br />
<br />
<b><span style="color: red;">A) Cost of debt</span></b> :<br />
The explicit cost of debt is the interest rate as per contract adjusted for tax and the cost of raising debt.<br />
<ul>
<li><span style="color: blue;"><b><i>Cost of irredeemable debentures</i></b></span> :</li>
</ul>
Cost of debentures not redeemable during the life time of the company,<br />
<br />
Kd = (I/NP) * (I - T)<br />
<br />
Where,<br />
<br />
Kd = Cost of debt after tax<br />
I = Annual interest rate<br />
NP = Net proceeds of debentures<br />
T = Tax rate<br />
<br />
However, debt has an implicit cost also, that arises due to the fact that if the debt content rises above the optimal level, investors would start considering the company to be too risky and, thus, their expectations from equity shares will rise. This rise, in the cost of equity shares is actually the implicit cost of debt.<br />
<ul>
<li><span style="color: blue;"><b><i>Cost of redeemable debentures</i></b></span> :</li>
</ul>
If the debentures are redeemable after the expiry of a fixed period the cost of debentures would be :<br />
<br />
Kd = <u>I(1 - t) + [(RV - NP)]/N</u><br />
[(RV + NP)/2]<br />
<br />
Where,<br />
I = Annual interest payment<br />
NP = Net proceeds of debentures<br />
RV = Redemption value of debentures<br />
t = tax rate<br />
N = Life of debentures<br />
<br />
<span style="color: red;"><b>B) Cost of preference shares</b></span> :<br />
In case of preference shares, the dividend rate can be taken as its cost, as it is this amount that the company intends to pay against the preference shares.<br />
<br />
As, in case of debt, the issue expenses or discount/premium on issue/redemption is also to be taken into account.<br />
<ul>
<li><span style="color: blue;"><b><i>Cost of irredeemable preference shares</i></b></span> :</li>
</ul>
Cost of irredeemable preference shares = PD/PO<br />
<br />
Where,<br />
PD = Annual preference dividend<br />
PO = Net proceeds of an issue of preference shares<br />
<ul>
<li><span style="color: blue;"><b><i>Cost of redeemable preference shares</i></b></span> :</li>
</ul>
If the preference shares are redeemable after the expiry of a fixed period, the cost of preference shares would be.<br />
<br />
Kp = <u>PD + [(RV - NP)]/N</u><br />
[(RV + NP)/2]<br />
Where,<br />
PD = Annual preference dividend<br />
NP = Net proceeds of debentures<br />
RV = Redemption value of debentures<br />
N = Life of debentures<br />
<br />
However, since dividend of preference shares is not allowed as deduction from income for income tax purposes, there is no question of tax advantage in the case of cost of preference shares.<br />
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It would, thus, be seen that both in case of debt and preference shares, cost of capital is calculated by reference to the obligations incurred and proceeds received. The net proceeds received must be taken into account in working cost of capital.<br />
<br />
<b><span style="color: red;">C) Cost of ordinary or equity shares</span></b> :<br />
Calculation of the cost of ordinary shares involves a complex procedure, because unlike debt and preference shares there is no fixed rate of interest or dividend against ordinary shares.<br />
<br />
Hence, to assign a certain cost to equity share capital is not a question of mere calculation, it requires an understanding of many factors basically concerning the behaviour of investors and their expectations.<br />
<br />
As, there can be different interpretations of investor's behaviour, there are many approaches regarding calculation of cost of equity shares. The 4 main approaches are :<br />
<br />
<span style="color: blue;"><b><i>1. D/P ratio (Dividend/Price) approach</i></b></span> :<br />
<br />
This emphasizes that dividend expected by an investor from a particular share determines its cost. An investor who invests in the ordinary shares of a particular company, does so in the expectation of a certain return. In other words, when an investor buys ordinary shares of a certain risk, he expects a certain return, The expected rate of return is the cost of ordinary share capital. Under this approach, thus, the cost of ordinary share capital is calculated on the basis of the present value of the expected future stream of dividends.<br />
For example, the market price of the equity shares (face value Rs. 10) of a particular company is Rs. 15. If it has been paying a dividend of 20 % and is expected to maintain the same, its cost of equity shares at face value is 0.2 * 10/15 = 13.3%, since it is the maximum rate of dividend, at which the investor will buy share at the present value. However, it can also be argued that the cost of equity capital is 20 % for the company, as it is on this expectation that the market price of shares is maintained at Rs. 15.<br />
<br />
Cost of equity shares of a company is that rate of dividend that maintains the present market price of shares. As the objective of financial management is to maximise the wealth of shareholders, it is rational to assume that the company must maintain the present market value of its share by paying 20 % dividend, which then is its cost of equity capital. Thus, the relationship between dividends and market price shows the expectation of the investors and thereby cost of equity capital.<br />
This approach co-relates the basic factors of return and investment from view point of investor. However, it is too simple as it pre-supposes that an investor looks forward only to dividends as a return on his investment.<br />
<br />
The expected stream of dividends is of importance to an investor but, he looks forward to capital appreciation also in the value of shares. It may lead us to ignore the growth in capital value of the share. Under, this approach, a company which declares a higher amount of dividend out of a given quantum of earnings will be placed at a premium as compared to a company which earns the same amount of profits but utilises a major part of the same in financing its expansion programmes.<br />
<br />
Thus, D/P approach may not be adequate to deal with the problem of determining the cost of ordinary share capital.<br />
<br />
<span style="color: blue;"><b><i>2. E/P (Earnings/Price) ratio approach</i></b></span> :<br />
<br />
The advocates of this approach co-relates the earnings of the company with the market price of its shares. As per it, the cost of ordinary share capital would be based on the expected rate of earnings of a company.<br />
<br />
The argument is that each investor expects a certain amount of earnings, whether distributed or not from the company in whose shares he invests, thus, an investor expects that the company in which he is going to subscribe for share should have at least 20 % of earning, the cost of ordinary share capital can be construed on this basis.<br />
<br />
Suppose, a company is expected to earn 30 % the investor will be prepared to pay Rs 150 (30/20 * 100) for each of Rs. 100 share. This approach is similar to the dividend price approach, only it seeks to nullify the effect of changes in dividend policy.<br />
<br />
This approach also does not seem to be a complete answer to the problem of determining the cost of ordinary share as it ignores the factor of capital appreciation or depreciation in the market value of shares.<br />
<br />
<span style="color: blue;"><b><i>3. D/P + growth approach</i></b></span> :<br />
<br />
The dividend/price + growth approach emphasises what an investor actually expects to receive from his investment in a particular company's ordinary share in terms of dividend plus the rate of growth in dividend/earnings.<br />
<br />
This growth rate in dividend (g) is taken to be good to the compound growth rate in earnings per share.<br />
<br />
Ke = [D1/P0] + g<br />
<br />
Where,<br />
Ke = Cost of capital<br />
D1= Dividend for the period 1<br />
P0 = Price for the period 0<br />
g = Growth rate<br />
<br />
D/P + g approach seems to answer the problem of expectations of investor satisfactorily, however, it poses one problem that is how to quantify expectation of investor relating to dividend and growth in dividend.<br />
<br />
<span style="color: blue;"><b><i>4. Realised yield approach</i></b></span> :<br />
<br />
It is suggested that many authors that the yield actually realised for a period of time by investors in a particular company may be used as an indicator of cost of capital.<br />
<br />
In other words, this approach takes into consideration the basic factor of the D/P + g approach but, instead of using the expected values of the dividends and capital appreciation, past yields are used to denote the cost of capital. This approach is based upon the assumption that the past behaviour would be repeated in future and thus, they may be used to measure the cost of ordinary capital.<br />
<br />
Which approach to use ? In case of companies with stable income and stable dividend policies the D/P approach may be a good way of measuring the cost of ordinary share capital.<br />
<br />
In case of companies whose earnings accrue in cycles, it would be better if the E/P approach is used, but representative figures should be taken into account to include complete cycle. In case of growth companies, where expectations of growth are more important, cost of ordinary share capital may be determined as the basis of the D/P + g approach.<br />
<br />
In the case of companies enjoying a steady growth rate and a steady rate of dividend, the realised value approach may be useful. The basic factor behind determination of cost of ordinary share capital is to measure expectation of investors from ordinary shares of that particular company.<br />
<br />
Thus, the whole question of determining the cost of ordinary shares hinges upon the factors which go into the expectations of a particular group of investors in the company of a particular risk class.<br />
<br />
<b><span style="color: red;">D) Cost of reserves</span></b> :<br />
<br />
The profits retained by a company and used in the expansion of business also entail cost. Many people tend to feel that reserves have no cost. However, it is not easy to realised that by depriving the shareholders of a part of the earnings, a cost is automatically incurred on reserves.<br />
<br />
This may be termed as the opportunity cost of retained earnings. Suppose, these earnings are not retained and are passed on to shareholders, suppose further that shareholders invest the same in new ordinary shares.<br />
<br />
This expectation of the investors from new ordinary shares should be the opportunity cost of reserves. In other words, if earnings were paid out as dividends and simultaneously an offer for right shares was made shareholders would have subscribed to the right share on the expectation of a certain return.<br />
<br />
This return may be taken as the indicator of the cost of reserves. People do not calculate the cost of capital of retained earnings as above. They take cost of retained earnings as the same as that of equity shares. However, if the cost of equity shares is determined on the basis of realized value approach or D/P + g approach, the question of working out a separate cost of reserves is not relevant since cost of reserves is automatically included in the cost of equity share capital.<br />
<br />
<span style="color: red;"><b>E) Cost of depreciation funds</b></span> :<br />
<br />
Depreciation funds, cannot be construed as not having any cost. Logically speaking, they should be treated on the same footing as reserves when it comes to their use, though while calculating the cost of capital these funds may not be considered.Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-12093433203357177352018-04-29T12:01:00.000-07:002018-05-13T14:59:24.096-07:00Cash Management<b>Miller Orr Cash Management Model</b><br />
<br />
According to this model the net cash flow is completely stochastic. When changes in cash balance occur randomly, the application of control theory serves a useful purpose.<br />
<br />
The Miller Orr model is one of such control limit models. This model is designed to determine the time and size of transfers between an investment account and cash account. In this model control limits are set for cash balances.<br />
<br />
These limits may consist of h as upper limit, z as the return point and zero as the lower limit.<br />
<br />
<img alt="Cash management model" class="alignnone wp-image-26 size-full" height="300" src="https://fmfunda.files.wordpress.com/2018/04/cash-management-model2097162895.jpg" title="Cash management" width="800" /><br />
<br />
When the cash balance reaches the upper limit, the transfer of cash equal to h, z is invested in marketable securities account. When it touches the lower limit, a transfer from marketable securities account to cash account is made.<br />
<br />
During the period when cash balance stays between (h, z) and (z, 0) i.e. high and low limits, no transactions between cash and marketable securities account is made. The high and low limits of cash balance are set up on the basis of fixed cost associated with the securities transaction, the opportunities cost of holding cash and degree of likely fluctuations in cash balances.<br />
<br />
These limits satisfy the demands for cash at the lowest possible total costs. The formula for calculation of the spread between the control limits is:<br />
<br />
<img alt="Cash management model by miller" class="alignnone wp-image-34 size-full" height="200" src="https://fmfunda.files.wordpress.com/2018/04/miller-cash-management-model_1525021993598-424473628.jpg" title="Cash management" width="500" /><br />
<br />
<hr />
<br />
<b>Baumols Model of Cash Management</b><br />
<br />
William J. Baumol developed a model for optimum cash balance which is normally used in inventory management.<br />
<br />
The optimum cash balance is the trade-off between cost of holding cash (opportunity cost of cash held) and the transaction cost (i.e. cost of converting marketable securities in to cash).<br />
<br />
Optimum cash balance is reached at a point where the two opposing costs are equal and where the total cost is minimum.<br />
<br />
This can be explained with the following diagram:<br />
<br />
<img alt="Cash balance" class="alignnone size-full wp-image-27" height="300" src="https://fmfunda.files.wordpress.com/2018/04/cash-balance-1838431379.jpg" title="Cash management" width="800" /><br />
<br />
<img alt="Optimum cash balance" class="alignnone wp-image-31 size-full" height="300" src="https://fmfunda.files.wordpress.com/2018/04/optimum-cash-balance1875114363.jpg" title="Cash management" width="800" /><br />
<br />
The model is based on the following assumptions:<br />
<ul>
<li>Cash needs of the firm are known with certainty.</li>
<li>The cash is used uniformly over a period of time and it is also known with certainty.</li>
<li>The holding cost is known and it is constant.</li>
<li>The transaction cost also remains constant.</li>
</ul>
<span style="font-size: 28px; font-weight: 900;">Recent Development in Cash Management:</span><br />
<br />
Now-a-days, electronic delivery and payment system are becoming increasingly important because of increased competition and the demand for more efficient and convenient capabilities.<br />
<br />
(i) <b>Electronic Fund Transfer</b>: With the developments which took place in the Information technology, the present banking system is switching over to the computerization of banks branches to offer efficient banking services and cash management services to their customers. The network will be linked to the different branches, banks. This will help the customers in the following ways:<br />
<br />
♦ Instant updation of accounts.<br />
<br />
♦ The quick transfer of funds.<br />
<br />
♦ Instant information about foreign exchange rates.<br />
<br />
(ii) <b>Zero Balance Account</b>: For efficient cash management some firms employ an extensive policy of substituting marketable securities for cash by the use of zero balance accounts. Every day the firm totals the cheques presented for payment against the account. The firm transfers the balance amount of cash in the account if any, for buying marketable securities. In case of shortage of cash the firm sells the marketable securities.<br />
<br />
(iii) <b>Money Market Operations</b>: One of the tasks of treasury function of larger companies is the investment of surplus funds in the money market. The chief characteristic of money market banking is one of size. Banks obtain funds by competing in the money market for the deposits by the companies, public authorities, High Net worth Investors (HNI), and other banks. Deposits are made for specific periods ranging from overnight to one year. The rates can fluctuate quite dramatically, especially for the shorter-term deposits. Surplus funds can thus be invested in money market easily.<br />
<br />
(iv) <b>Petty Cash Imprest System</b>: For better control on cash, generally the companies use petty cash imprest system wherein the day-to-day petty expenses are estimated taking into account past experience and future needs and generally a week’s requirement of cash will be kept separate for making petty expenses. Again, the next week will commence with the predetermined balance. This will reduce the strain of the management in managing petty cash expenses and help in managing cash efficiently.<br />
<br />
(v) <b>Management of Temporary Cash Surplus</b><br />
<br />
Temporary cash surpluses can be profitably invested in the following:<br />
<br />
♦ Short-term deposits in Banks and financial institutions.<br />
<br />
♦ Short-term debt market instruments.<br />
<br />
♦ Long-term debt instruments.<br />
<br />
♦ Shares of Blue chip listed companies.<br />
<br />
(vi) <b>Electronic Cash Management System</b>: Electronically, transfer of data as well as funds play a key role in any cash management system. Various elements in the process of cash management are linked through a satellite. Certain networked cash management system may also provide a very limited access to third parties like parties having very regular dealings of receipts and payments with the company etc. A finance company accepting deposits from public through sub-brokers may give a limited access to sub-brokers to verify the collections made through him for determination of his commission among other things.<br />
<br />
<b>Benefits</b>: Good cash management is a conscious process of knowing:<br />
<br />
♦ When, where and how a company’s cash needs will arise.<br />
<br />
♦ Knowing what are the best sources of meeting at a short notice additional cash requirement.<br />
<br />
♦ Maintaining good and cordial relations with bankers and other creditors.<br />
<br />
<i><b>Scientific cash management results</b></i> in:<br />
<br />
♦ Significant saving in time.<br />
<br />
♦ Decrease in interest costs.<br />
<br />
♦ Less paperwork.<br />
<br />
♦ Greater accounting accuracy.<br />
<br />
♦ More control over time and funds.<br />
<br />
♦ Supports electronic payments.<br />
<br />
♦ Faster transfer of funds from one location to another, where required.<br />
<br />
♦ Speedy conversion of various instruments into cash.<br />
<br />
Even a multinational organization having subsidiaries worldwide, can pool everything internationally so that the company offset the debts with the surplus monies from various subsidiaries.<br />
<br />
The ultimate purpose of scientific cash management is to ensure solvency, liquidity and profitability of the organization as a whole.<br />
<br />
(vii) <b>Virtual Banking</b>: Broadly virtual banking denotes the provision of banking and related services through extensive use of information technology without direct recourse to the bank by the customer. The origin of virtual banking in the developed countries can be traced back to the seventies with the installation of Automated Teller Machines (ATMs). Subsequently, driven by the competitive market environment as well as various technological and customer pressures, other types of virtual banking services have grown in prominence throughout the world.<br />
<br />
<b><i>Significant Developments</i></b>:<br />
<br />
Following are some of the significant developments:<br />
<br />
♦ Introduction of computerized settlement of clearing transactions<br />
<br />
♦ Use of Magnetic Ink Character Recognition (MICR) technology<br />
<br />
♦ Provision of inter-city clearing facilities and high value clearing facilities<br />
<br />
♦ Electronic Clearing Service Scheme (ECSS)<br />
<br />
♦ Electronic Funds Transfer (EFT) scheme<br />
<br />
♦ Centralised Funds Management System (CFMS)<br />
<br />
♦ Securities Services System (SSS)<br />
<br />
♦ Real Time Gross Settlement System (RTGS)<br />
<br />
<b>Advantages</b><br />
<br />
The advantages of virtual banking services are as follows:<br />
<br />
♦ Lower cost of handling a transaction.<br />
<br />
♦ The increased speed of response to customer requirements.<br />
<br />
♦ The lower cost of operating branch network along with reduced staff costs leads to cost efficiency.<br />
<br />
♦ Virtual banking allows the possibility of improved and a range of services being made available to the customer rapidly, accurately and at his convenience.Unknownnoreply@blogger.com2tag:blogger.com,1999:blog-4483174103628967496.post-85138646147265327572018-04-28T22:21:00.000-07:002018-05-10T11:44:42.174-07:00Cost of CapitalThe cost of capital of a firm is the minimum rate of return which the firm must earn on its investments in order to satisfy the expectations of investors who provide funds to the firm.<br />
<br />
<img alt="Cost of capital" class="alignnone size-full wp-image-18" height="300" src="https://fmfunda.files.wordpress.com/2018/04/cost-of-capital-604398309.jpg" title="Cost of capital" width="800" /><br />
It is the weighted average of the cost of various sources of finance used by it. The method of computing the cost of capital is to compute the cost of each type of capital and then find the weighted average of all types of costs of capital.<br />
<br />
In other words, two steps are involved in determination of cost of capital of a firm:<br />
<br />
(i) computation of cost of different sources of capital,and<br />
<br />
(ii) determining overall cost of capital of the firm by weighted average or total cost divided by total fund.<br />
<br />
<br />
<b><u>WEIGHTED AVERAGE COST OF CAPITAL (WACC)</u></b><br />
<br />
The capital funding of a company is made up of two components: debt and equity. The cost of capital is the expected return to equity owners (or shareholders) and to debt holders, so weighted average cost of capital tells the return that both stakeholders, equity owners and lenders can expect.<br />
<br />
WACC, in other words, represents the investors’ opportunity cost of taking on the risk of putting money into a company. This is the weighted average cost of capital.<br />
<br />
Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital.<br />
<br />
The composite or overall cost of capital of a firm is the weighted average of the costs of various sources of funds. Weights are taken to be proportion of each source of funds in the capital structure. While, making financial decisions this overall or weighted cost is used. Each investment is financed from a pool of funds which represents the various sources from which funds have been raised.<br />
<br />
Any decision of investment thus, has to be made with reference to the overall cost of capital and not with reference to cost of a specific source of fund used in that investment decisions.<br />
<br />
The weighted average cost of capital (WACC) is calculated by :<br />
1) Calculating cost of specific sources of funds, e.g. cost of debt, etc.<br />
2) Multiplying the cost of each source by its proportion in capital structure.<br />
3) Adding the weighted component costs to get the firm's WACC. Thus, WACC is ,<br />
<br />
K0 = K1W1 + K2W2 +.............<br />
Where,<br />
K1, K2 are component costs and W1, W2 are weights. <br />
<br />
The weights to be used can be either book value weights or market value weights. Book value weights are easier to calculate and can be applied consistently. Market value weights are supposed to be superior to book value weights as component costs are opportunity costs and market values reflect economic values. However, these weights fluctuate frequently and fluctuations are wide in nature.<br />
<br />
Securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, WACC is used as the discount rate applied to future cash flows for deriving a business’s net present value.<br />
<br />
WACC can be used as a hurdle rate against which to assess return on investment capital performance. It also plays a key role in economic value added (EVA) calculations.<br />
<br />
Investors use WACC as a tool to decide whether or not to invest. The WACC represents the minimum rate of return at which a company produces value for its investors.<br />
<br />
Therefore, WACC serves as a useful reality check for investors.<br />
<br />
<b><u>Marginal Cost of Capital</u></b><br />
<br />
The marginal cost of capital may be defined as the cost of raising an additional rupee of capital. Since the capital is raised in substantial amount in practice marginal cost is referred to as the cost incurred in raising new funds.<br />
<br />
Marginal cost of capital is derived, when the average cost of capital is calculated using the marginal weights. The marginal weights represent the proportion of funds the firm intends to employ.<br />
<br />
To calculate the marginal cost of capital, the intended/proposed financing proportion should be applied as weights to marginal component costs. The marginal cost of capital should, therefore, be calculated in the composite sense.<br />
<br />
When a firm raises funds in proportional manner and the component's cost remains unchanged, there will be no difference between average cost of capital (of the total funds) and the marginal cost of capital. The component costs may remain constant upto certain level of funds raised and then start increasing with amount of funds raised.<br />
<br />
For example, the cost of debt may remain 7% (after tax) till Rs. 10 lakhs of debt is raised, between Rs. 10 lakhs and Rs. 15 lakhs, the cost may be 8% and so on. Same is the case with equity capital. When the components cost start rising, the average cost of capital will rise and the marginal cost of capital will however, rise at a faster rate.<br />
<br />
<b>Modigliani and Miller approach to Cost of Capital:</b><br />
<br />
Modigliani and Miller’s argue that the total cost of capital of a particular corporation is independent of its methods and level of financing.<br />
<br />
According to them a change in the debt equity ratio does not affect the cost of capital. This is because a change in the debt equity ratio changes the risk element of the company which in turn changes the expectations of the shareholders from the particular shares of the company. Hence they contend that leverages has little effect on the overall cost of capital or on the market price.<br />
<br />
<i><b>Modigliani and Miller made the following assumptions and the derivations there from:</b></i><br />
<br />
(i) Capital markets are perfect. Information is costless and readily available to all investors, there are no transaction costs; and all securities are infinitely divisible. Investors are assumed to be rational and to behave accordingly.<br />
<br />
(ii) The average expected future operating earnings of a firm are represented by a subjective random variable. It is assumed that the expected values of the probability distributions of all investors are the same. Implied in the MM illustration is that the expected values of the probability distributions of expected operating earnings for all future periods are the same as present operating earnings.<br />
<br />
(iii) Firms can be categorised into “equivalent return” classes. All firms within a class have the same degree of business risk.<br />
<br />
(iv) The absence of corporate income taxes is assumed.<br />
<br />
<b><u>Their three basic propositions are</u></b> :<br />
<br />
(i) The total market value of a firm and its cost of capital are independent of its capital structure. The total market value of the firm is given by capitalizing the expected stream of operating earnings at a discount rate considered appropriate for its risk class.<br />
<br />
(ii) The cost of equity (ke) is equal to capitalization rate of pure equity stream plus a premium for financial risk. The financial risk increases with more debt content in the capital structure. As a result, ke increases in a manner to offset exactly the use of less expensive source of funds.<br />
<br />
(iii) The cut-off rate for investment purposes is completely independent of the way in which the investment is financed. This proposition alongwith the first implies a complete separation of the investment and financing decisions of the firm.<br />
<br />
<b>Conclusion</b>:<br />
<br />
The theory propounded by them is based on the prevalence of perfect market conditions which are rare to find. Corporate taxes and personal taxes are a reality and they exert appreciable influence over decision making whether to have debt or equity.<br />
<br />
Relationship between the financial leverage and firm’s required rate of return to equity shareholders with corporate taxes is given by the following relation:<br />
<br />
rE = r0 + D/E(1-TC)(rO-rB)<br />
<br />
Where,<br />
<br />
rE = required rate of return to equity shareholders<br />
<br />
r0 = required rate of return for an all equity firm<br />
<br />
D = Debt amount in capital structure<br />
<br />
E = Equity amount in capital structure<br />
<br />
TC = Corporate tax rate<br />
<br />
rB = required rate of return to lendersUnknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-84385101313983320352018-04-28T04:29:00.000-07:002018-05-05T00:28:55.719-07:00Wealth and Profit maximisation in Financial Management<b><u>Wealth maximisation and Profit maximisation objectives of <a href="http://fmfunda.blogspot.com/2012/12/introduction-to-financial-management.html" target="_blank">financial management</a>.</u></b><br />
<br />
Efficient <a href="http://www.fmfunda.com/2017/11/financial-management-scope.html" target="_blank">financial management</a> requires the existence of some objectives or goals because judgement as to whether or not a financial decision is efficient must be made in the light of some objective.<br />
<img alt="Profit vs wealth maximisation" class="alignnone wp-16 size-full" height="300" src="https://fmfunda.files.wordpress.com/2018/04/wealth-vs-profit-1887840456.jpg" title="Profit wealth maximisation" width="800" /><br />
<br />
<b>Profit Maximization</b>:It has traditionally been argued that the objective of a company is to earn profit, hence the objective of financial management is profit maximisation.<br />
<br />
This implies that the finance manager has to make his decisions in a manner so that the profits of the concern are maximised. Each alternative, therefore, is to be seen as to whether or not it gives maximum profit.This implies that the <a href="http://www.fmfunda.com/2017/12/functions-of-financial-officer.html" target="_blank">finance manager</a> has to make his decisions in a manner so that the profits of the concern are maximised.<br />
<br />
Each alternative, therefore, is to be seen as to whether or not it gives maximum profit.However, profit maximisation cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise.<br />
<br />
Profit maximisation as an objective is too narrow. It fails to take into account the social considerations as also the obligations to various interests of workers, consumers, society, as well as ethical trade practices.<br />
<br />
If these factors are ignored, a company cannot survive for long. Profit maximisation at the cost of social and moral obligations is a short sighted policy.<br />
<br />
<b>Wealth / Value Maximisation</b>: It is the duty of the finance manager to see that the shareholders get good returns on the shares. Hence, the value of the share should increase in the share market. The share value is affected by many things.<br />
<br />
If a company is able to make good sales and build a good name for itself, in the industry, the company’s share value goes up.<br />
If the company makes a risky investment, people may lose confidence in the company and the share value will come down.<br />
<br />
So, this means that the finance manager has the power to influence decisions regarding finances of the company.<br />
<br />
The decisions should be such that the share value does not decrease. Thus, wealth or value maximisation is the most important goal of financial management.<br />
<br />
<br />
If a company is able to make good sales and build a good name for itself, in the industry, the company’s share value goes up.<br />
<br />
If the company makes a risky investment, people may lose confidence in the company and the share value will come down. So, this means that the finance manager has the power to influence decisions regarding finances of the company.<br />
<br />
The decisions should be such that the share value does not decrease. Thus, wealth or value maximisation is the most important goal of financial management.<br />
<br />
<br />
Many companies have several other goals for the welfare of the society, like improving community life, supporting education and research, solving societal problems, etc. But wealth maximisation means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly.<br />
<br />
<br />
If the company follows the goal of wealth maximisation, it means that the company will promote only those policies that will lead to an efficient allocation of resources.<br />
But wealth maximisation means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly.<br />
<br />
If the company follows the goal of wealth maximisation, it means that the company will promote only those policies that will lead to an efficient allocation of resources.<br />
To achieve wealth maximization, the finance manager has to take careful decision in respect of Investment, Financing and Dividend payout.<br />
<br />
<b><u>Profit versus Wealth Maximization Principle of the Firm</u></b><br />
<br />
The company may pursue profit maximisation goal but that may not result into creation of shareholder value. The profits will be maximized if company grows through diversification and expansion. But all growth may not be profitable.<br />
<br />
Only that growth is profitable where <b>ROA > <a href="http://fmfunda.blogspot.com/2018/04/cost-of-capital.html" target="_blank">WACC</a> </b>or <b>ROE > K</b><b>E</b> or Firms invest in positive NPV profits.<br />
<br />
However, profit maximisation cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise like the term profit is vague, profit maximisation has to be attempted with a realisation of risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow.<br />
<br />
If profit is given undue importance, a number of problems can arise like the term profit is vague, profit maximisation has to be attempted with a realisation of risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow.<br />
<br />
Whereas, on the other hand, wealth maximisation, as an objective, means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly.<br />
<br />
If the company follows the goal of wealth maximisation, it means that the company will promote only those policies that will lead to an efficient allocation of resources.<br />
<br />
The maximisation of a firm’s value as reflected in the market price of a share is viewed as a proper goal of a firm. The profit maximisation can be considered as a part of the wealth maximisation strategy.<br />
<br />
<b><u>Limitations of Profit Maximization <a href="http://fmfunda.blogspot.in/2017/11/financial-management-scope.html" target="_blank">Objective of Financial Management</a></u></b><br />
<ul>
<li>Time factor is ignored.</li>
</ul>
<ul>
<li>It is vague because it is not clear whether the term relates to economic profit, accounting profit, profit after tax or before tax.</li>
</ul>
<ul>
<li>The term maximization is also ambiguous.</li>
</ul>
<ul>
<li>It ignores the risk factor.</li>
</ul>
Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-14565244690756080992017-12-08T22:55:00.000-08:002018-02-11T00:00:13.986-08:00Functions of Financial Officer<br />
<div class="QA" style="line-height: normal;">
<span style="color: blue;"><span style="font-family: "arial" , "helvetica" , sans-serif;"><span style="font-size: large;"><b><span lang="EN-GB">Functions of a Chief
Financial Officer / Finance Manager</span></b></span></span></span></div>
<div class="QA" style="line-height: normal;">
<br /></div>
<div class="NoHang" style="line-height: normal;">
<span style="font-family: "arial" , "helvetica" , sans-serif;"><span lang="EN-GB">The twin aspects
viz procurement and effective utilization of funds are the crucial tasks, which
the CFO/Finance Manager faces. The Chief Finance Officer / Finance Manager is
required to look into financial implications of any decision in the firm. Thus
all decisions involving management of funds comes under the purview of CFO / Finance
Manager. These are namely</span></span></div>
<div class="NoHang" style="line-height: normal;">
<br /></div>
<div class="BODYTEXT" style="line-height: normal;">
<span style="font-family: "arial" , "helvetica" , sans-serif;"><span style="mso-char-type: symbol; mso-symbol-font-family: Symbol;">-</span><span lang="EN-GB"><span style="mso-tab-count: 1;"> </span>Estimating requirement of funds</span></span></div>
<div class="BODYTEXT" style="line-height: normal;">
<span style="font-family: "arial" , "helvetica" , sans-serif;"><span style="mso-char-type: symbol; mso-symbol-font-family: Symbol;">-</span><span lang="EN-GB"><span style="mso-tab-count: 1;"> </span>Decision regarding capital structure</span></span></div>
<div class="BODYTEXT" style="line-height: normal;">
<span style="font-family: "arial" , "helvetica" , sans-serif;"><span style="mso-char-type: symbol; mso-symbol-font-family: Symbol;">-</span><span lang="EN-GB"><span style="mso-tab-count: 1;"> </span>Investment decisions</span></span></div>
<div class="BODYTEXT" style="line-height: normal;">
<span style="font-family: "arial" , "helvetica" , sans-serif;"><span style="mso-char-type: symbol; mso-symbol-font-family: Symbol;">-</span><span lang="EN-GB"><span style="mso-tab-count: 1;"> </span>Dividend decision</span></span></div>
<div class="BODYTEXT" style="line-height: normal;">
<span style="font-family: "arial" , "helvetica" , sans-serif;"><span style="mso-char-type: symbol; mso-symbol-font-family: Symbol;">-</span><span lang="EN-GB"><span style="mso-tab-count: 1;"> </span>Cash management</span></span></div>
<div class="BODYTEXT" style="line-height: normal;">
<span style="font-family: "arial" , "helvetica" , sans-serif;"><span style="mso-char-type: symbol; mso-symbol-font-family: Symbol;">-</span><span lang="EN-GB"><span style="mso-tab-count: 1;"> </span>Evaluating financial performance</span></span></div>
<div class="BODYTEXT" style="line-height: normal;">
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<span style="color: blue;"><span style="font-size: large;"><b>Role / responsibilities of Finance Manager in the Changing
Scenario of Financial Management in India</b></span></span></div>
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<br /></div>
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<span style="font-size: 11pt;">In the modern enterprise, the finance
manager occupies a key position and his role is becoming more and more
pervasive and significant in solving the finance problems. The traditional role
of the finance manager was confined just to raising of funds from a number of sources,
but the recent development in the socio-economic and political scenario
throughout the world has placed him in a central position in the business organization. He is now responsible for shaping the fortunes of the enterprise,
and is involved in the most vital decision of allocation of capital like
mergers, acquisitions, etc. He is working in a challenging environment which
changes continuously.</span></div>
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<br /></div>
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<span style="font-size: 11pt;">Emergence of financial service sector and
development of internet in the field of information technology has also brought
new challenges before the Indian finance managers. Development of new financial
tools, techniques, instruments and products and emphasis on public sector
undertakings to be self-supporting and their dependence on capital market for fund
requirements have all changed the role of a finance manager. His role,
especially, assumes significance in the present day context of liberalization,
deregulation and globalization.</span></div>
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<br /></div>
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<span style="font-size: 11pt;">The chief financial officer of an
organisation plays an important role in the company’s goals, policies, and
financial success. </span></div>
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<br /></div>
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<span style="color: blue;"><span style="font-size: 11pt;"><b>His main responsibilities include:</b></span></span></div>
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<span style="font-size: 11pt;"><b>(a)</b><span style="mso-tab-count: 1;"> </span><i style="mso-bidi-font-style: normal;"><b>Financial analysis and planning</b>:</i> Determining
the proper amount of funds to be employed in</span></div>
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<span style="font-size: 11pt;"> the firm.</span></div>
<div class="MsoNormal" style="mso-layout-grid-align: none; text-align: justify; text-autospace: none;">
<span style="font-size: 11pt;"><b>(b)<span style="mso-tab-count: 1;"> </span></b><i style="mso-bidi-font-style: normal;"><b>Investment decisions</b>:</i> Efficient
allocation of funds to specific assets.</span></div>
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<span style="font-size: 11pt;"><b>(c)</b><i style="mso-bidi-font-style: normal;"> <b>Financial
and capital structure decisions</b>:</i> Raising funds on favorable terms as possible,
i.e. Determining the composition of Liabilities.</span><span style="font-family: "arial" , "helvetica" , sans-serif;"><span lang="EN-GB"><span style="font-size: 11pt;"></span></span></span></div>
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<span lang="EN-GB" style="mso-bidi-font-family: "Arial Narrow"; mso-bidi-font-size: 11.0pt;"><b>(d)</b><span style="mso-bidi-font-style: normal;"> <b>Management of financial resources</b></span> (such
as working capital).</span></div>
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<span style="font-size: 11pt;"><b>(e)</b><i style="mso-bidi-font-style: normal;"> <b>Risk Management</b>:</i> Protecting assets.</span></div>
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<br /></div>
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<div class="BODYTEXT" style="line-height: normal;">
<span style="color: red;"><b><i style="mso-bidi-font-style: normal;"><u><span lang="EN-GB" style="font-size: 9.5pt;">Note</span></u></i><i style="mso-bidi-font-style: normal;"><span lang="EN-GB" style="font-size: 9.5pt;">: Chief Financial Officer (CFO) and Finance Manager
are one and the same, and can be used inter-changeably.</span></i></b></span></div>
<br />
<br />Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-32012317731705647322017-11-21T22:46:00.003-08:002017-11-21T22:46:59.698-08:00Discounting Formula<div class="MsoNormal" style="margin-left: .25in; mso-line-height-alt: 0pt;">
<b><u><span style="font-family: "arial" , "sans-serif"; font-size: 16.0pt;"><span style="color: red;">Concept of discounting</span><o:p></o:p></span></u></b></div>
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<br /></div>
<div class="MsoNormal" style="line-height: 136%; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 136%;">Present value of Rupees is in present term whereas future value of
rupees is in future term. In future value of rupees required rate of return is
included. To sacrifice the current consumption for certain period we would
require compensation for sacrificing current consumption it is known as
required rate of return.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 7.35pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 145%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 145%;">The value of assets is the present value of
future cash flows discounted at the appropriate required rate of return.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 5.85pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 177%; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 11.5pt; line-height: 177%;">In financial management we would take decision based on future cash flow
whereas investment will be at present so all the future cash flow discount are
required rate to bring in present term.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 2.5pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"><span style="color: blue;">Intrinsic value = PV of the
future cash flow discounted at Re.</span><o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.7pt; mso-line-height-rule: exactly;">
<br /></div>
<br />
<div class="MsoNormal" style="line-height: 135%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 135%;">While discounting future cash flow would be
discounted with the rate applicable for that year, if rate is different of each
year, then successive cash flow would be discounted first with rate applicable
for previous year then finally rate applicable for such year. For example 3</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 7.5pt; line-height: 135%;">rd</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 135%;"> year cash flow would be
discounted first with the rate applicable for 1</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 7.5pt; line-height: 135%;">st</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 135%;"> year then 2</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 7.5pt; line-height: 135%;">nd</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 135%;"> year then finally with the discount rate of 3</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 7.5pt; line-height: 135%;">rd</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 135%;"> year.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 135%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 135%;"><br /></span></b></div>
<div class="MsoNormal" style="margin-left: .25in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 16.0pt;"><span style="color: red;">Inflation
in capital budgeting</span><o:p></o:p></span></b></div><script async src="//pagead2.googlesyndication.com/pagead/js/adsbygoogle.js"></script>
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<div class="MsoNormal" style="margin-left: .25in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 16.0pt;"><span style="color: red;"><br /></span></span></b></div>
<div class="MsoNormal" style="line-height: 158%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 11.5pt; line-height: 158%;">There should be consistency between Nature of
cash flow and discount rate. Nominal cash flow discount with nominal rate and
real cash flow discount with real rate, etc. if cash flow is ex inflation then
incorporate inflation in future cash flow in consecutive term. That to
incorporate inflation in cash of third year, inflation affect 1, 2 and 3</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 6.5pt; line-height: 158%;">rd</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 11.5pt; line-height: 158%;"> year should be
incorporated.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 4.95pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 138%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 138%;">While incorporating inflation in cash flow
successive cash flaw with accumulate inflation cumulatively. For example 3</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 7.5pt; line-height: 138%;">rd</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 138%;"> year cash will include
inflation of for 1</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 7.5pt; line-height: 138%;">st</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 138%;"> year then 2</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 7.5pt; line-height: 138%;">nd</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 138%;"> year then finally with the inflation rate of 3</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 7.5pt; line-height: 138%;">rd</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 138%;"> year.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 7.2pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="margin-left: .25in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 16.0pt;"><span style="color: red;">Frequency
of compounding</span><o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 15.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Effective annual yield compounded
annually<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Rate = (1+ rate)</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 7.5pt;">n</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">-1<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.8pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Money market yield
compounded n time in a year.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Holding Period yield<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.8pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="margin-left: .25in; mso-line-height-alt: 0pt;">
</div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Bond equivalent yield
compounded half yearly.<o:p></o:p></span></b></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"><br /></span></b></div>
<div class="Section1">
<div class="MsoNormal" style="margin-left: .25in; mso-line-height-alt: 0pt;">
<b><u><span style="font-family: "arial" , "sans-serif"; font-size: 16.0pt;"><span style="color: red;">Concept of continuous compounding (Exponential)</span><o:p></o:p></span></u></b></div>
<div class="MsoNormal" style="line-height: 15.8pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 145%;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 145%;">Rate
change in real time that is compounded every moment. Without taking factor of
exponential rate follow below step.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 5.85pt; mso-line-height-rule: exactly;">
<br /></div>
<table border="0" cellpadding="0" cellspacing="0" class="MsoNormalTable" style="border-collapse: collapse; mso-padding-alt: 0in 0in 0in 0in; mso-table-layout-alt: fixed;">
<tbody>
<tr style="height: 17.05pt;">
<td style="height: 17.05pt; padding: 0in 0in 0in 0in; width: 57.0pt;" valign="bottom" width="76"><div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Step 1<o:p></o:p></span></b></div>
</td>
<td style="height: 17.05pt; padding: 0in 0in 0in 0in; width: 119.0pt;" valign="bottom" width="159"><div class="MsoNormal" style="margin-left: 28.0pt; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">(X).000244017206<o:p></o:p></span></b></div>
</td>
</tr>
<tr style="height: 29.65pt;">
<td style="height: 29.65pt; padding: 0in 0in 0in 0in; width: 57.0pt;" valign="bottom" width="76"><div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Step 2<o:p></o:p></span></b></div>
</td>
<td style="height: 29.65pt; padding: 0in 0in 0in 0in; width: 119.0pt;" valign="bottom" width="159"><div class="MsoNormal" style="margin-left: 28.0pt; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">(+) 1<o:p></o:p></span></b></div>
</td>
</tr>
<tr style="height: 29.75pt; mso-yfti-lastrow: yes;">
<td style="height: 29.75pt; padding: 0in 0in 0in 0in; width: 57.0pt;" valign="bottom" width="76"><div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Step 3<o:p></o:p></span></b></div>
</td>
<td style="height: 29.75pt; padding: 0in 0in 0in 0in; width: 119.0pt;" valign="bottom" width="159"><div class="MsoNormal" style="margin-left: 25.0pt; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , sans-serif; font-size: 17.3333px;">X=</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"> 12
times<o:p></o:p></span></b></div>
</td>
</tr>
</tbody></table>
<div class="MsoNormal" style="line-height: 12.6pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="margin-left: .25in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Dirty
power x</span><span style="font-family: "arial" , sans-serif;"><span style="font-size: xx-small;">^</span></span><span style="font-family: "arial" , sans-serif;"><span style="font-size: xx-small;">1/n</span></span></b></div>
<div class="MsoNormal" style="line-height: 14.8pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Make a factor then follow
below steps<o:p></o:p></span></b></div>
</div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"><br clear="all" style="mso-break-type: section-break; page-break-before: auto;" />
</span></b>
</div>
<div class="Section2">
<div class="MsoNormal" style="line-height: 15.4pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 10.5pt;">Step 1<o:p></o:p></span></b></div>
<b><span style="font-family: "arial" , "sans-serif"; font-size: 10.5pt;"><br clear="all" />
</span></b>
<br />
<div class="MsoNormal" style="line-height: 15.4pt; mso-line-height-rule: exactly;">
<span style="font-family: "times new roman" , "serif"; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";"><o:p></o:p></span></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 11.5pt;">√ 12 times<o:p></o:p></span></b></div>
</div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 11.5pt;"><br clear="all" style="mso-break-type: section-break; page-break-before: auto;" />
</span></b>
</div>
<div class="Section3">
<div class="MsoNormal" style="line-height: 16.55pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 10.5pt;">Step 2<o:p></o:p></span></b></div>
<b><span style="font-family: "arial" , "sans-serif"; font-size: 10.5pt;"><br clear="all" />
</span></b>
<br />
<div class="MsoNormal" style="line-height: 16.55pt; mso-line-height-rule: exactly;">
<span style="font-family: "times new roman" , "serif"; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";"><o:p></o:p></span></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.5pt;">- 1<o:p></o:p></span></b></div>
</div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.5pt;"><br clear="all" style="mso-break-type: section-break; page-break-before: always;" />
</span></b>
</div>
<div class="MsoNormal" style="line-height: 15.25pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 10.5pt;">Step 3<o:p></o:p></span></b></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 10.5pt;"><br clear="all" />
</span></b>
</div>
<div class="MsoNormal" style="line-height: 15.25pt; mso-line-height-rule: exactly;">
<span style="font-family: "times new roman" , "serif"; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";"><o:p></o:p></span></div>
<div class="MsoNormal">
</div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 11.5pt;">Divide by power<o:p></o:p></span></b></div>
<div class="Section1">
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 10.5pt;">Step 4<o:p></o:p></span></b></div>
<b><span style="font-family: "arial" , "sans-serif"; font-size: 10.5pt;"><br clear="all" />
</span></b>
<br />
<div class="MsoNormal" style="line-height: 19.5pt; mso-line-height-rule: exactly;">
<span style="font-family: "times new roman" , "serif"; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";"><o:p></o:p></span></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 11.0pt;">+ 1<o:p></o:p></span></b></div>
</div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 11.0pt;"><br clear="all" style="mso-break-type: section-break; page-break-before: auto;" />
</span></b>
</div>
<div class="Section2">
<div class="MsoNormal" style="line-height: 17.0pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 10.5pt;">Step 5<o:p></o:p></span></b></div>
<b><span style="font-family: "arial" , "sans-serif"; font-size: 10.5pt;"><br clear="all" />
</span></b>
<br />
<div class="MsoNormal" style="line-height: 17.0pt; mso-line-height-rule: exactly;">
<span style="font-family: "times new roman" , "serif"; mso-bidi-font-family: Arial; mso-fareast-font-family: "Times New Roman";"><o:p></o:p></span></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; mso-fareast-font-family: Arial;">x</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 6.0pt;">=</span></b><b><span style="font-family: "arial" , "sans-serif"; mso-fareast-font-family: Arial;"> 12
times<o:p></o:p></span></b></div>
</div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 10.0pt;"><br clear="all" style="mso-break-type: section-break; page-break-before: always;" />
</span></b>
</div>
<div class="MsoNormal" style="line-height: 17.55pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , sans-serif;"><span style="color: red; font-size: large;">Annuity and its application</span><span style="font-size: 13pt;"><o:p></o:p></span></span></b></div>
<div class="MsoNormal" style="line-height: 14.8pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 154%; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.0pt; line-height: 154%;">Annuity is the sum of discounting factor. It is used to derive present
of future cash flow if all the cash flow is equal. It is also used to derive
equal future instalment of present value cash flow either by dividing with
annuity factor or multiplied with capital recovery factor.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 5.2pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Capital recovery factor =
1/ annuity factor,<o:p></o:p></span></b></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"><br /></span></b></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"><span style="color: blue;">Application of normal
distribution</span><o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.8pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="margin-left: .25in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"># Ln<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="margin-left: .25in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Without
taking factor of exponential rate follow below step.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
</div>
<table border="0" cellpadding="0" cellspacing="0" class="MsoNormalTable" style="border-collapse: collapse; margin-left: .5in; mso-padding-alt: 0in 0in 0in 0in; mso-table-layout-alt: fixed;">
<tbody>
<tr style="height: 17.05pt;">
<td style="height: 17.05pt; padding: 0in 0in 0in 0in; width: 57.0pt;" valign="bottom" width="76"><div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Step 1<o:p></o:p></span></b></div>
</td>
<td style="height: 17.05pt; padding: 0in 0in 0in 0in; width: 116.0pt;" valign="bottom" width="155"><div class="MsoNormal" style="margin-left: 25.0pt; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">x</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 7.5pt;">=</span></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"> 12
times<o:p></o:p></span></b></div>
</td>
</tr>
<tr style="height: 19.7pt;">
<td style="height: 19.7pt; padding: 0in 0in 0in 0in; width: 57.0pt;" valign="bottom" width="76"><div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Step 2<o:p></o:p></span></b></div>
</td>
<td style="height: 19.7pt; padding: 0in 0in 0in 0in; width: 116.0pt;" valign="bottom" width="155"><div align="right" class="MsoNormal" style="margin-right: 66.5pt; mso-line-height-alt: 0pt; text-align: right;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">- 1<o:p></o:p></span></b></div>
</td>
</tr>
<tr style="height: 19.8pt; mso-yfti-lastrow: yes;">
<td style="height: 19.8pt; padding: 0in 0in 0in 0in; width: 57.0pt;" valign="bottom" width="76"><div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Step 3<o:p></o:p></span></b></div>
</td>
<td style="height: 19.8pt; padding: 0in 0in 0in 0in; width: 116.0pt;" valign="bottom" width="155"><div class="MsoNormal" style="margin-left: 25.0pt; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">÷ .000244017206<o:p></o:p></span></b></div>
</td>
</tr>
</tbody></table>
<div class="MsoNormal" style="line-height: 10.0pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 10.0pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 10.0pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 14.45pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , sans-serif;"><span style="color: red; font-size: large;">Perpetuity and its
application</span><span style="font-size: 13pt;"><o:p></o:p></span></span></b></div>
<div class="MsoNormal" style="line-height: 14.8pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 145%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 145%;">It is used in case of no growth wherein a
certain cash flow is expected to continue for uncertain future period.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 5.85pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">IV= A/i<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Future value<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.8pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
</div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">It is reverse of present
value.<o:p></o:p></span></b></div>
Unknownnoreply@blogger.com7tag:blogger.com,1999:blog-4483174103628967496.post-45070432941248110242017-11-21T22:31:00.000-08:002018-04-30T10:06:57.474-07:00Financial management Scope<div class="MsoNormal" style="margin-left: .5in; mso-line-height-alt: 0pt;">
<b><u><span style="font-family: "arial" , "sans-serif"; font-size: 16.0pt;"><span style="color: red;">Object of financial management</span><o:p></o:p></span></u></b></div>
<div class="MsoNormal" style="line-height: 15.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 138%; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 138%;">Objective of financial management is to maximise shareholder wealth, it
is measure by market capital of the company. Market capital is represented by
number of share multiplied with share price.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 6.95pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="margin-left: 1.0in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"><span style="color: red;">Market
capital = Number of share x Market share price</span><o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.8pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
</div>
<div class="MsoNormal" style="line-height: 135%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 135%;">Shareholder is the owner of the company they
appoint management the company, manager should manages the company in the best
interest of shareholder. Management acquire fund at optimum cost and utilise it
with the minimum risk to earn maximum return and distribute dividend to
shareholder or retained earnings for further investment to generate maximum
possible return.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="margin-left: .5in; mso-line-height-alt: 0pt;">
<b><u><span style="font-family: "arial" , "sans-serif"; font-size: 16.0pt;"><span style="color: red;"><a href="http://fmfunda.blogspot.com/2018/04/cost-of-capital.html" target="_blank">Cost of capital</a></span><o:p></o:p></span></u></b></div>
<div class="MsoNormal" style="line-height: 15.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 119%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.5pt; line-height: 119%;">THE cost of capital of a firm is the minimum
rate of return which the firm must earn on its investments in order to satisfy
the expectations of investors who provide funds to the firm. </span></b></div>
<div class="MsoNormal" style="line-height: 119%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.5pt; line-height: 119%;">It is the weighted
average of the cost of various sources of finance used by it. The method of
computing the cost of capital is to compute the cost of each type of capital
and then find the weighted average of all types of costs of capital. </span></b></div>
<div class="MsoNormal" style="line-height: 119%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.5pt; line-height: 119%;"><br /></span></b></div>
<div class="MsoNormal" style="line-height: 119%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.5pt; line-height: 119%;">In other
words, two steps are involved in determination of cost of capital of a firm: </span></b></div>
<div class="MsoNormal" style="line-height: 119%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.5pt; line-height: 119%;"><br /></span></b></div>
<div class="MsoNormal" style="line-height: 119%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.5pt; line-height: 119%;">(i) computation of cost of different sources of capital, and </span></b></div>
<div class="MsoNormal" style="line-height: 119%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.5pt; line-height: 119%;">(ii) determining
overall cost of capital of the firm by weighted average or total cost divided by
total fund.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 119%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.5pt; line-height: 119%;"><br /></span></b></div>
<div class="MsoNormal">
<b><u><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Kc-</span></u></b><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"> kc
would be weighted average of effective cost of debt and equity<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Kc = weight of debt x
post-tax cost of debt + weight of equity x cost of equity.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.8pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Kc= wd x post-tax kd + we x
ke<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.55pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"><span style="color: blue;">Cost of debt is to be
calculated as follows.</span><o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 19.35pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Irredeemable debt:<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 19.25pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="margin-left: 84.0pt; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Annual
interest (1 - Tax rate)<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 2.2pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Cost of debt =————————————------×
100<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 2.1pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="margin-left: 94.0pt; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Net
proceeds of debt<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 2.2pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 135%; margin-right: 1.0pt; text-align: justify;">
</div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">For debt redeemable after
certain period<o:p></o:p></span></b></div>
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<br /></div>
<div class="MsoNormal" style="margin-left: .75in; mso-line-height-alt: 0pt; mso-list: l1 level1 lfo2; tab-stops: .75in; text-indent: -35.9pt;">
<!--[if !supportLists]--><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">(iii)<span style="font-family: "times new roman"; font-size: 7pt; font-stretch: normal; font-weight: normal; line-height: normal;">
</span></span></b><!--[endif]--><b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Earning price ratio.</span></b><br />
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"><br /></span></b>
<b><span style="font-family: "arial" , "sans-serif"; font-size: 17.3333px;">Price is how many times of Earning Per Share.</span></b><br />
<b><span style="font-family: "arial" , "sans-serif"; font-size: 17.3333px;"><br /></span></b>
<b><span style="font-family: "arial" , "sans-serif"; font-size: 17.3333px;"> Price= Earning Per Share X P/E ratio</span></b></div>
<div class="MsoNormal" style="line-height: 129%; margin-bottom: .0001pt; margin-bottom: 0in; margin-left: .75in; margin-right: 224.0pt; margin-top: 0in;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 11.5pt; line-height: 129%;"><br /></span></b></div>
<div class="MsoNormal" style="margin-left: .75in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">P/E
ratio = 1/ke, Ke = 1/PE ratio.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 19.45pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="margin-left: .25in; mso-line-height-alt: 0pt;">
<b><u><span style="font-family: "arial" , "sans-serif"; font-size: 16.0pt;">Component of interest (Required rate of return)<o:p></o:p></span></u></b></div>
<div class="MsoNormal" style="line-height: 15.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="margin-left: .75in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 11.0pt;">Rf ( Risk free real rate )= it is compensation for sacrifice of current
consumption</span></b></div>
<div class="MsoNormal" style="margin-left: .75in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 11.0pt;"><br /></span></b></div>
<div class="MsoNormal" style="margin-left: .75in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 11.0pt;">Inflation premium = it is compensation for loss of Purchasing Power</span></b></div>
<div class="MsoNormal" style="margin-left: .75in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;"><br /></span></b></div>
<div class="MsoNormal" style="margin-left: .75in; mso-line-height-alt: 0pt;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Risk Premium = it is
compensation for bearing risk.</span></b></div>
<div class="MsoNormal" style="line-height: 14.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">All rate should be taken in
to factor while calculation in below.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Risk free nominal rate = Rf
( Risk free real rate ) x Inflation Premium<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.8pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">Risk adjusted rate = Rf (
Risk free real rate ) x Risk Premium<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 14.7pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 12.0pt;">Risk adjusted nominal rate
= Rf ( Risk free real rate ) x Inflation Premium x Risk Premium<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 15.95pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal" style="line-height: 138%; margin-right: 1.0pt; text-align: justify;">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt; line-height: 138%;">When we invest in a inflation protected security
we donot demand inflation premium i.e, rate would be Rf real. When we invest in
a corporate security, there is default risk involved therefor we demand risk
premium.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="line-height: 6.95pt; mso-line-height-rule: exactly;">
<br /></div>
<div class="MsoNormal">
<b><span style="font-family: "arial" , "sans-serif"; font-size: 13.0pt;">All interest rate are
combine in multiplication fashion except CAPM, RADR & Spread.<o:p></o:p></span></b></div>
<div class="MsoNormal" style="margin-left: .75in; mso-line-height-alt: 0pt;">
<span style="font-family: "times new roman" , serif;"> </span><b><span style="font-family: "arial" , "sans-serif"; font-size: 11.0pt;"> </span></b></div>
Unknownnoreply@blogger.com1tag:blogger.com,1999:blog-4483174103628967496.post-85776581767165071942012-12-27T23:04:00.000-08:002018-05-13T03:34:52.455-07:00Capital Budgeting<span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">The term <b>capital
budgeting</b> means planning for capital assets. <b>Capital budgeting decision </b>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. </span><br />
<br />
<span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">It includes the <b><a href="http://www.fmfunda.com/2012/12/financial-statement-analysis.html" target="_blank">financial analysis</a></b> 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. </span><br />
<br />
<span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">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. </span><br />
<br />
<span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">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 : </span><script async="" src="//pagead2.googlesyndication.com/pagead/js/adsbygoogle.js"></script>
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<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">1) <u>substantial
expenditure</u> : </span></b></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">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. </span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">2) <u>long
time period</u> : </span></b></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">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. </span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">3) <u>irreversibility</u>
: </span></b></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">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. </span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">4) <u>complex
decision</u> : </span></b></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">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. </span><br />
<blockquote class="tr_bq">
<u><span style="color: red;"><span style="font-size: large;"><b>Read Also :</b></span></span></u></blockquote>
<blockquote class="tr_bq">
<blockquote class="tr_bq">
<ul>
<li><a href="http://www.fmfunda.com/2018/05/time-value-money.html" target="_blank">Time value Of Money</a></li>
<li><a href="http://www.fmfunda.com/2018/05/financial-ratios-decision-making.html" target="_blank">Financial Ratios</a></li>
<li><a href="http://www.fmfunda.com/2018/04/cost-of-capital.html" target="_blank">Cost Of Capital</a> </li>
</ul>
</blockquote>
</blockquote>
</div>
<div style="margin: 0.75pt 0in;">
<u style="color: blue;"><b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">various types of capital investment decisions</span></b></u><span style="font-family: "arial narrow"; letter-spacing: 1pt;"> </span></div>
<div style="margin: 0.75pt 0in;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;"></span></b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">there are various ways
to classify capital budgeting decisions, generally they are</span><span style="font-family: "arial narrow";"> </span>
</div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">classified
as :</span><span style="font-family: "arial narrow";"> </span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;"><span style="color: blue;">1) </span><u style="color: blue;">on
the basis of the firm's existence</u> : </span></b></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">
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: </span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">i) <u>replacement
and modernisation decisions</u> : </span></b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">replacement and modernization 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 modernization , however, both these decisions are cost reduction
decisions. </span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">ii) <u>Expansion
decision</u> : </span></b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">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. </span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">iii) <u>Diversification
decisions</u> :</span></b> <span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">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.</span><span style="font-family: "arial narrow";">
</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;"><span style="color: blue;">2) </span><u style="color: blue;">on
the basis of decision situation</u> : </span></b></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">i) <u>mutually
exclusive decisions</u> : </span></b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">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. </span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">ii) <u>Accept-Reject
decisions</u> : </span></b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">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.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">iii) <u>Contingent
decisions</u> : </span></b></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "arial narrow"; letter-spacing: 1.0pt;">contingent decisions are dependable proposals, investment in one requires investment in
another. </span></div>
Unknownnoreply@blogger.com1tag:blogger.com,1999:blog-4483174103628967496.post-68563046429094489962012-12-19T14:12:00.000-08:002018-05-13T03:41:13.681-07:00Financial Statement Analysis<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">The basis of <b>financial analysi</b>s, 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. </span><br />
<br />
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">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. </span><br />
<br />
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">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. </span><br />
<br />
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">The
<a href="http://www.fmfunda.com/2017/12/functions-of-financial-officer.html" target="_blank"><b>financial manager</b></a> 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. </span><script async="" src="//pagead2.googlesyndication.com/pagead/js/adsbygoogle.js"></script>
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<br />
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;"> </span><br />
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;"><b>Financial
Statement Analysis</b> 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,</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">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. </span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">2) To arrange information in a way to highlight significant
relationships.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">3) Interpretation and drawing of inferences and conclusion. Thus,
financial analysis is the process of selection, relation and evaluation of the
accounting data/information.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b style="color: blue;"><u><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">Purposes of Financial Statement Analysis</span></u></b><b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;"><span style="color: blue;"> </span>: </span></b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">Financial
Statement Analysis is the meaningful interpretation of 'Financial Statements'
for 'Parties Demanding <b>Financial Information</b>', such as :</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">1) The Government may be interested in knowing the comparative energy
consumption of some private and public sector cement companies.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">2) A nationalised bank may may be keen to know the possible debt
coverage out of profit at the time of lending. </span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">3) Prospective investors may be desirous to know the actual and
forecasted yield data.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">4) Customers want to know the business viability prior to entering into
a long-term contract.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">
There are other purposes also, in general, the purpose of financial statement
analysis aids decision making by users of accounts. </span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<blockquote class="tr_bq">
<u><span style="color: red;"><span style="font-size: large;"><b>Read Also :</b></span></span></u></blockquote>
<blockquote class="tr_bq">
<blockquote class="tr_bq">
<ul>
<li><a href="http://www.fmfunda.com/2018/05/time-value-money.html" target="_blank">Time value Of Money</a></li>
<li><a href="http://www.fmfunda.com/2018/05/financial-ratios-decision-making.html" target="_blank">Financial Ratios</a></li>
<li><a href="http://www.fmfunda.com/2018/04/cost-of-capital.html" target="_blank">Cost Of Capital</a> </li>
</ul>
</blockquote>
</blockquote>
</div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b style="color: blue;"><u><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">Steps for financial statement analysis</span></u></b><b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;"> :</span></b></div>
<div style="margin-bottom: .75pt; margin-left: .5in; margin-right: 0in; margin-top: .75pt; mso-list: l13 level1 lfo1; tab-stops: list .5in; text-indent: -.25in;">
<span style="font-family: "symbol"; font-size: 10.0pt;"><span style="mso-list: Ignore;">·<span style="font: 7.0pt "Times New Roman";">
</span></span></span><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">Identification of the user's purpose</span> </div>
<div style="margin-bottom: .75pt; margin-left: .5in; margin-right: 0in; margin-top: .75pt; mso-list: l13 level1 lfo1; tab-stops: list .5in; text-indent: -.25in;">
<span style="font-family: "symbol"; font-size: 10.0pt;"><span style="mso-list: Ignore;">·<span style="font: 7.0pt "Times New Roman";">
</span></span></span><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">Identification of data source, which part of the annual
report or other information is required to be analysed to suit the purpose</span>
</div>
<div style="margin-bottom: .75pt; margin-left: .5in; margin-right: 0in; margin-top: .75pt; mso-list: l13 level1 lfo1; tab-stops: list .5in; text-indent: -.25in;">
<span style="font-family: "symbol"; font-size: 10.0pt;"><span style="mso-list: Ignore;">·<span style="font: 7.0pt "Times New Roman";">
</span></span></span><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">Selecting the techniques to be used for such analysis</span></div>
<div style="margin: 0.75pt 0in 0.75pt 0.5in; text-indent: -0.25in;">
<span style="font-family: "century gothic"; font-size: 10pt; letter-spacing: 1pt;"> </span>
</div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">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.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b style="color: blue;"><u><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">Types of Financial statement analysis</span></u></b><b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;"> : </span></b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">The
main objective of financial analysis is to determine the financial health
of a business enterprise, which may be of the following types :</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">1) <u>External analysis</u> :</span></b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;"> It is performed by outside
parties, such as trade creditors, investors, suppliers of long term debt, etc.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">2) <u>Internal analysis</u> :</span></b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;"> It is performed by
corporate finance and accounting department and is more detailed than external
analysis.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">3) <u>Horizontal analysis</u> :</span></b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;"> This analysis compares
financial statements viz. profit and loss account and balance sheet of previous
year with that of current year.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">4) <u>Vertical analysis</u> : </span></b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">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.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">5) <u>Trend analysis</u> : </span></b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">Trend analysis compares
ratios of different components of financial statements related to different
period with that of the base year.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">6) <u>Ratio Analysis</u> : </span></b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">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.</span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">7) <u>Funds flow statemen</u>t : </span></b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">This statement provides a
comprehensive idea about the movement of finance in a business unit during a
particular period of time.<b> </b></span></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<br /></div>
<div style="margin-bottom: .75pt; margin-left: 0in; margin-right: 0in; margin-top: .75pt;">
<b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">8) <u>Break-even analysis</u> : </span></b><span style="font-family: "century gothic"; font-size: 10.0pt; letter-spacing: 1.0pt;">This type of analysis refers
to the interpretation of financial data that represent operating activities. </span></div>
Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4483174103628967496.post-68847454586749975492012-12-19T14:08:00.000-08:002018-05-13T03:36:34.614-07:00Introduction to Financial Management<b><u>Introduction of financial management : Basics and Definitions </u></b><br />
The primary task of an Accountant is to deal with funds, 'Management of Funds' is an important aspect of <b>financial management </b>in a business undertaking or any other institution like hospital, art society, and so on.<br />
<br />
The term 'Financial Management' has been defined differently by different authors.<br />
According to Solomon "Financial Management is concerned with the efficient use of an important economic resource, namely capital funds."<br />
<br />
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."<br />
<br />
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.<br />
<br />
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."<br />
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Thus, there are 2 <b>basic aspects of financial management</b> :<br />
<br />
1) <b>procurement of funds :</b><br />
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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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).<br />
<br />
The mechanism of procuring funds is to be modified in the light of requirements of foreign investors. Procurement of funds inter alia includes:<br />
<ul>
<li>Identification of sources of finance</li>
<li>Determination of finance mix</li>
<li>Raising of funds</li>
<li>Division of profits between dividends and retention of profits i.e. internal fund generation.</li>
</ul>
2) <b>Effective use of such funds</b> :<br />
The finance manager is also responsible for effective utilisation 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.<br />
<br />
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.<br />
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For this, the finance manager must possess sound knowledge of techniques of <b><a href="http://fmfunda.blogspot.in/2012/12/capital-budgeting.html" target="_blank">capital budgeting</a></b> 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.<br />
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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.Unknownnoreply@blogger.com1