Definition of Financial Management | o Definition: The term Financial Management can be defined as “the management of flow of funds in a firm”. It deals with the financial decision making of a firm. Scope of Financial Management Sound financial management is essential in all types of— organizations whether it be profit or nonprofit. Financial management is essential in a planned Economy as well as in a capitalist set-up as it involves efficient use of the resources. From time to time it is observed that many firms have been— liquidated not because theirtechnology was obsolete or because their products were not in demand or their labour was not skilled and motivated, but that there was a mismanagement of financial affairs. Even in a boom period, when a company make high profits there is also a fear of liquidation because of bad financial management. Financial management optimizes the output from the given input of— funds. In a country like India where resources are scarce and the demand for funds are many, the need of proper financial management is required. In case of newly started companies with a high growth rate it is more important to have sound financial management since finance alone guarantees their survival. Financial management is very important in case of non-profit— organizations, which do not pay adequate attentions to financial management. How ever a sound system of financial management has to be— cultivated among bureaucrats, administrators, engineers, educationalists and public at a large. Short-term and long-term objectives of Financial Management Short-term objective The short-term objective of Financial Management is to procure financial resources at an affordable cost thereby increasing the return to the shareholders in the form of Earnings Per Share (EPS). EPS comprises two elements namely Dividend per share (DPS) and Retained Earnings per share (REPS or Reserves per share). This objective is often times referred to as “profit maximisation”. This is known as the short-term objective as it is done on a continuous, year-to-year basis. One or more of the following measures can achieve this: Monitoring of costs on a continuous basis through budgets Suitable cost reduction techniques wherever the costs are high Minimisation of cost of borrowed capital from outside through financial discipline Proper mix of equity and debt (known as financial leverage – for further details please refer to Chapter on – Operating and financial leverages Control over liquidity available in the organisation so as to minimise the cost of carrying too much cash etc. Long-term objective The long-term objective of financial management is to increase the wealth of the shareholders. The term “wealth” refers to various business assets of the enterprise that are free of debt. This means that this wealth belongs to the equity shareholders. It is often reflected in the “book value” of the share as reflected in the balance sheet. | ||
IMPORTANT FUNCTIONS OF THE FINANCIAL MANAGER | The important function of the financial manager in a modern business consists of the following: 1. Provision of capital: To establish and execute programmes for the provision of capital required by the business. 2. Investor relations: to establish and maintain an adequate market for the company securities and to maintain adequate liaison with investment bankers, financial analysis and share holders. 3. Short term financing: To maintain adequate sources for company’s current borrowing from commercial banks and other lending institutions. 4. Banking and Custody: To maintain banking arrangement, to receive, has custody of accounts. 5. Credit and collections: to direct the granting of credit and the collection of accounts due to the company including the supervision of required arrangements for financing sales such as time payment and leasing plans. 6. Investments: to achieve the company’s funds as required and to establish and co-ordinate policies for investment in pension and other similar trusts. 7. Insurance: to provide insurance coverage as required. 8. Planning for control: To establish, co-ordinate and administer an adequate plan for the control of operations. 9. Reporting and interpreting: To compare information with operating plans and standards and to report and interpret the results of operations to all levels of management and to the owners of the business. 10. Evaluating and consulting: To consult with all the segments of management responsible for policy or action concerning any phase of the operation of the business as it relates to the attainment of objectives and the effectiveness of policies, organization structure and procedures. 11. Tax administration: to establish and administer tax policies and procedures. 12. Government reporting: To supervise or co-ordinate the preparation of reports to government agencies. 13. Protection of assets: To ensure protection of assets for the business through internal control, internal auditing and proper insurance coverage. | ||
Finance Functions | o Investment Decision: 1. Financial Management provides framework for firms to take the decisions of allocating scare resources among competitive uses. 2. The decision making includes those that creates revenues and profits as well as those that save money. 3. These decisions also called “capital budgeting” decisions. o Financing Decisions: 1. It deals with the financing pattern of the firm. 2. In this the management decides how they should raise resources. 3. The two main sources of finance for any firm are – Share holders funds and Borrowed funds. o Dividend Decisions: 1. It deals with the appropriation of after tax profits. 2. These profits are available to be distributed among the share holders or can be retained by the firm for reinvestment with in the firm. | ||
Objective or Goal of FM | o The most fundamental objective of FM is wealth maximization. The following are the main objectives which leads to wealth maximisation in the long run: - 1.The main responsibility of FM to ensure that the funds which have mobilised through various resources must be put to best use leading to value addition. 2. To generate higher returns on investment so that then it need not depend on external borrowings, and same time it can reward it share holders in terms of Dividend. 3. To survive means to stay alive. The problem of survival arises due to increased competition, change in consumer behaviour and technology, labour problem and so on. 4. To ensure availability of adequate cash flow to meet its working expenses such as payment of raw materials, wages, salaries, etc. A healthy cash flow improves an organisations survival chances. 5. To achieve Break-Even point as early as possible so that it can began to make profits sooner or later in the future. 6. To earn minimum profits in the short term to cover up the cost of capital, weather dividend paid or not. It also motivates management to work hard. 7. To ensure proper co-ordination among Finance as well as other departments in the organisation. 8. To bring goodwill for the firm. | ||
EXPLAIN THE ROLE OF FINANCE HEAD AS CONFLICT MANAGER | Conflict of goal between management and owners: Agency problem A characteristic feature of corporate enterprise is the separation between ownership and management as a corollary of which the latter enjoys substantial autonomy in regard to the affairs of the firm. With widely diffused ownership, scattered and ill-organised shareholders hardly exercise any control/influence on management, which may be inclined to act in its own interests rather than those of the owners. However shareholders as owners of the enterprise have the right to change the management. Due to the threat of being dislodged for poor performance, the management would have a natural inclination to achieve a minimum acceptable level of performance to satisfy the shareholders requirements/ goals, while focussing primarily on their own personal goals. Thus in furtherance of their objective of survival, management would aim at satisfying instead of maximising shareholders’ wealth. However, the conflicting goals of management objective of survival and maximising owners value/wealth can be harmonised. The shareholders delegate the decision-making authority to professional management on the premise that the latter will work in the best interest of the former, that is, management is an agent of the owners. In order to ensure that management would take optimal decisions compatible with the shareholders’ interest of value maximisation and minimise agency problems in terms of conflicts of interest, two remedial measures commend themselves: 1. Provision of appropriate incentives and 2. Monitoring of agents/managers 1. Incentives to management: the incentive given to management is of various types. Some of them are as follows i) Stock options: confer on management the right to acquire shares of the enterprise at a special/concessional price ii) Performance shares are given based on the performance of the management as reflected in rates of return. iii) Cash bonus- linked to specified performance targets iv) Perquisites- such as company car, expensive offices and fringe benefits These incentives are closely related to the stake of management in the ownership of the company. They promote congruence between the personal goals of management and the interests of the owners. 2. Monitoring of managers: Since management accounts for a small portion of the ownership of the enterprise, they would not be oriented to the maximisation of the value of the shareholders. Monitoring of the activities of management can be done by: i) Bonding the agent ii) Auditing financial statements and limiting decision making by the management In case of bonding, the enterprise obtains a fidelity bond from a bonding company to the effect that the latter will compensate the former up to a certain specified amount of losses caused by dishonest acts of managers. The audit and control procedures and limiting managerial decisions are intended to ensure that the actions of management sub serve the interests of shareholders | ||
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Profit Maximisation V/s Wealth Maximisation | o Profit maximisation measures the firm’s performance by looking at it’s total profit. o It does not consider the risk which the firm may undertake in maximisation of profits. o It does not consider the effect of earning per share, dividend paid or any other return to shareholders on their wealth. o On the other hand, the wealth maximisation objective considers all future cash flows, dividends, EPS, risk of a decision, etc. o The firm that wishes to maximise profits may opt to pay no dividends and to reinvest the retained earnings. o Whereas a firm wishes to maximise the shareholders wealth may pay regular dividends. o Moreover the market price of a share reflects the shareholders expected returns, considering the long term prospects of the firm, reflects the differences in timing of the return, consider the risk and recognise the importance of distribution of returns. o There for the shareholders wealth as reflected in the market price of share is viewed as a proper goal of financial management. o The profit maximisation can be considered as a part of the wealth maximisation strategy. | ||
ROI | The two complementary approaches to return on investment are: · Return on total assets (ROTA) · Return on equity (ROE) The two separate measures are necessary because they throw light on different aspects of the business, both of which are important. Return on total assets looks at the operating efficiency of the total enterprise, while return on equity considers how that operating efficiency is translated into benefit to the owners. RETURN ON EQUITY (ROE) This ratio is arguably the most important in business finance. It measures the absolute return delivered to the shareholders. A good figure brings success to the business – it results in a high share price and makes it easy to attract new funds. These will enable the company to grow, given suitable market conditions, and this in turn leads to greater profits and so on. All this leads to high value and continued growth in the wealth of its owners. ROE = PAT x 100 Owner’s funds At the level of individual business, a good return on equity will keep in lace the financial framework for a thriving, growing enterprise. At the level of the total economy, return on equity drives industrial investment, growth in gross national product, employment, government tax receipts and so on. It is, therefore, a critical feature of the overall modern market economy as well as of individual companies. RETURN ON TOTAL ASSETS (ROTA) Return on total assets provides the foundation necessary for a company to deliver a good return on equity. A company without a good ROTA finds it almost impossible to generate a satisfactory ROE. ROTA = PBIT x 100 Total Assets PBIT is the amount remaining when total operating cost is deducted from total revenue, but before either interest or tax have been paid. Total operating cost direct factory cost, plus administration, selling and distribution overheads. This operating profit figure is set against the total assets figure in the balance sheet. The percentage relationship between the two values gives the rate of return being earned by the total assets. Therefore this ratio measures how well management uses all the assets in the business to generate an operating surplus. Return on total assets uses the three main operating variables of the business. · Total revenue · Total cost · Assets employed It is therefore the most comprehensive measure of total management performance. It must be noted that return on investment is a ratio. The term ratio refers to the numerical or quantitative relationship between two items / variables. The rationale of ratio analysis is that it makes related information comparable. However ratios by themselves mean nothing. Thus, the return on investment must be compared with: § A norm or a target § Previous ROI achieved in order to assess trends, and § The ROI achieved in other comparable companies ROI cannot be considered as the end of financial objectives because of the following reasons. § ROI is calculated from financial statements which are affected by the financial bases and policies adopted on such matters as depreciation and the valuation of stocks. § Financial statements do not represent a complete picture of the business, but merely a collection of facts, which can be expressed in monetary terms. These may not refer to other factors, which affect performance. § Over use of ROI as control on managers could be dangerous, in that management might concentrate more on simply improving the ratio than on dealing with the significant issues. E.g. the return on total assets can be improved by reducing assets rather than increasing sales. § ROI is a comparison of two figures, a numerator and a denominator. In comparing ROI, it may be difficult to determine whether differences are due to change in the numerator, or in the denominator or in both. Thus, ROI should be considered only as a tool for analysis rather than as the end of financial objectives. | ||
ROI and Du Pont analysis | o Du Pont is system or tool of financial analysis which enables in visualising the financial data such as Returns on Investment. o It is developed in 1919 by a finance executive at E.I. Du Pont de Nemours and Co. Of Wilmington, Delaware. o The system considers Return on Asset as a major measures of performance along with other factors such as Cost of Goods sold, Selling and Adm. Exp., inventories, Accounts Receivable and Cash. o The limitation of the model is that it could not present predictions and conduct monitoring of costs. o When the investment turnover (Total Asset turnover) is multiplied by the Net Profit Margin, the Product is known as ROI. It is also known as Du Pont Analysis. o This analysis shows that profitability depends not only on the NP Margin but also on how efficiently the firm has used its assets to generate sales. o The above analysis can be further extended to identify the Return on shareholders funds. o The Return on shareholder funds depends upon the use of debt in financing of total assets. | ||
Ways of Improving ROI | 1. Can be improved by increasing the net profit for the same amount of sale i.e. Increase the profit margin. 2. Can be improved by increasing the sales volume for the amount of investment. 3. By reducing the costs, it adds to the total earnings of the profit. 4. By increasing profits through investment in those avenues which are expected to bring an additional revenue by raising the size of firms total revenue. 5. Productivity improvement, expansion, diversification, replacement of wear and tear of old equipments, etc. | ||
Use of ROI in profit planning and control | o The left hand side of the Du Pont chart shows the details underlying the net profit margin ratio. 1. Indicates the areas where cost reduction may be affected to improve the net profit margin. 2. In planning of increasing sales volume or sales price of our products to maximise return on asset. 3. The above will increase the net profit margin, which will in turn increase the return on assets. o The right hand side shows the determinants of total asset turnover ratio. 1. It shows the efficient and effective use of fixed as well as current assets, which affects the total asset turnover ratio. 2. To increase the ratio measures should be taken for optimum utilisation of resources. 3. The above will increase the productivity and result in better sales performance. Return on Investment Earnings as % of sales multiplied Turnover Earnings divided by Sales Sales divided by Total Investment Sales minus Cost of sales Permanent plus Working investment capital Cost of sales plus Selling plus expenses Administrative expenses Inventories plus Accounts plus Cash receivables | ||
Capital Budgeting | n “ The term capital budgeting generally refers to acquiring inputs wih long run returns” By: Richard & Greenlaw. n “It is an long term planning for making & financing proposed capital outlay” By: Charles T Horn green. n Capital Budgeting means a decision relating to planning for capital assets as to whether money should be invested in the long term projects or not. n This Technique is used / employed to evaluate expenditure decisions which involves current outlays but are likely to produce benefits over a period of time. n The term Capital budgeting is used interchangeably with capital expenditure decisions & long term investment decisions. n Capital budgeting is a decision making process for making investment decisions in capital expenditure or fixed assets. n It is also known as “ Freezing of Capital ” in Fixed Assets. n It includes all those expenditure which are expected to produce benefits to the firm over more than one year & includes both tangible & intangible assets. Capital budgeting is the process of generating, evaluating, selecting and following-up on capital expenditure projects. The term Capital budgeting is used interchangeably with capital expenditure decision, capital expenditure management & long-term investment decision. The methods employed to evaluate the worth of capital expenditure proposals are known as capital budgeting techniques .The popular methods are- (a) Average rate of return (b) Pay back period (c) Net present value (d) Internal rate of return (e) Profitability index The following are the basic features of capital budgeting- · Potentially large anticipated benefits · A relatively high degree of risk · A relatively long time period between the initial outlay & the anticipated return n The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. n The firm’s investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision. n Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firm’s expenditures and benefits, and therefore, they should also be evaluated as investment decisions. Features of Investment Decisions n The exchange of current funds for future benefits. n The funds are invested in long-term assets. n The future benefits will occur to the firm over a series of years. Importance of Investment Decisions n Growth n Risk n Funding n Irreversibility n Complexity Types of Investment Decisions n One classification is as follows: n Expansion of existing business n Expansion of new business n Replacement and modernisation n Yet another useful way to classify investments is as follows: n Mutually exclusive investments n Independent investments n Contingent investments Investment Evaluation Criteria n Three steps are involved in the evaluation of an investment: n Estimation of cash flows n Estimation of the required rate of return (the opportunity cost of capital) n Application of a decision rule for making the choice Investment Decision Rule n It should maximise the shareholders’ wealth. n It should consider all cash flows to determine the true profitability of the project. n It should provide for an objective and unambiguous way of separating good projects from bad projects. n It should help ranking of projects according to their true profitability. n It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones. n It should help to choose among mutually exclusive projects that project which maximises the shareholders’ wealth. n It should be a criterion which is applicable to any conceivable investment project independent of others. Evaluation Criteria n 1. Discounted Cash Flow (DCF) Criteria n Net Present Value (NPV) n Internal Rate of Return (IRR) n Profitability Index (PI) n Discounted Payback Period (DPB) n 2. Non-discounted Cash Flow Criteria n Payback Period (PB) n Accounting Rate of Return (ARR) | ||
Methods of capital budgeting | INTERNAL RATE OF RETURN The discount rate which equates the present values of an investment’s cash inflows and outflows is its internal rate of return Acceptance rule: Accept if IRR > k ; Reject if IRR < k Project may be accepted if IRR = k
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PROFITABILITY INDEX The ratio of the present value of the cash flows to the initial outlay is profitability index or benefit cost ratio .It is also referred to as Benefit cost ratio Acceptance rule: Accept if PI > 1.0 ; Reject if PI < 1.0; Project may be accepted if PI = 1.0
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NET PRESENT VALUE The difference between PV of cash flows and PV of cash outflows is equal to NPV, the firm’s opportunity cost of capital being the discount rate. Acceptance rule : Accept if NPV > 0 (i e. NPV is positive) ; Reject if NPV < 0 (i.e. .NPV is negative); Project may be accepted if NPV= 0
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ACCOUNTING RATE OF RETURN An average rate of return is found by dividing the average profit by the average investment. Acceptance rule: Accept if ARR > minimum rate ; Reject if ARR < minimum rate
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PAY BACK PERIOD The number of years required to recover the initial outlay of the investment is called payback Acceptance rule: Accept if PB < Standard pay back; Reject if PB > Standard pay back
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NPV V/S IRR The following are the various dissimilarities between NPV and IRR – § Size disparity problem NPV and IRR method give different ranking to projects when the initial investment in projects under consideration i.e., mutually exclusive projects is different .The cash outlay of some projects is larger than that of others. § Timing of cash flows The most commonly found condition for the conflict between the NPV and IRR methods is the difference in the timing of cash flow § Projects with unequal lives Another situation in which the IRR and NPV methods would give a conflict ranking to mutually exclusive projects is when the projects have different expected lives. | |||
DISCOUNTED CASH FLOW METHODS | The methods of appraising capital expenditure proposals can be classified into two broad categories 1. Unsophisticated or traditional 2. Sophisticated or time adjusted The latter are more popularly known as discounted cash flow techniques as they take the time factor into account .In this method all cash flows are expressed in terms of their present values .It recognises that cash flow streams at different time periods differ in value & can be compared only when they are expressed in terms of a common denominator i.e., present values. The following are the various discounted cash flow techniques – · Net present value · Internal rate of return · Profitability index | ||
CAPITAL RATIONING | The capital rationing refers to the situation in which the firm has more acceptable investments requiring a greater amount of finance than is available with the firm .It is concerned with the selection of a group of investment proposals acceptable under the accept-reject decision .Ranking of the investments project is employed in capital rationing .Projects can be ranked on the basis of some pre determined criterion such as the rate of return .The project with the highest return is ranked first and the project with the lowest acceptable return last .The projects are ranked in the descending order of the rate of return | ||
Main Features of Capital Expenditure Decisions | 1. Purchase of capital equipments are non-repetitive, purchases occurring once in ten year. 2. It involves large investment over a long duration entailing careful budgeting. 3. Capital expenditure involves committing major outlays to get uncertain return in the future. 4. The Top most level in he organisation is involved in capital expenditure decision making. 5. Commitment of Large amount of funds. | ||
Assumption for Capital Proposals. | 1. Al the alternative investment proposals are risk less or carry an equal amount of risk. 2. Cash flow are net of corporate income taxes. 3. Investment outlays are made at the beginning of he year & cash inflows are received at the end of the year. | ||
THE PHASES OF CAPITAL BUDGETING | Capital budgeting is a complex process is which may be divided in to following phases: · Identification of potential investment opportunities · Assembling of proposed investments · Decision making · Preparation of capital budgeting and appropriations · Implementation · Performance review Identification of potential investment opportunities The capital budgeting process begins with the identification of potential investment opportunities. Typically the planning body develops the estimates of future sales, which serves as the basis for setting production target. This information in turn is helpful in identifying required investments in plant and equipment. For imaginative identification of investment ideas it is helpful to i) Monitor external environment regularly to scout investment opportunities, ii) Formulate a well defined corporate strategy based on a through analysis of strengths, weaknesses, opportunities and threats, iii) Share corporate strategy and prospective with person who are involved in the process of capital budgeting and, iv) Motivate employees to make suggestions. Assembling of investment proposals Investment proposal identified by the production department and other department is usually submitted in a standardized capital investment proposal firm. Generally, most of the proposals before they reach the capital budgeting committee or somebody who is assembles them are routed through several persons. The propose of routing a proposal through several persons is a primarily to ensure that the proposal is viewed from different angels. It also helps in creating a climate for bringing about co-ordination of interrelated activities. Investment proposals are usually classified into various categories for a facilitating decision – making budgeting and control. Decision-making A system of rupee gateway usually categorizes capital investment decision-making. Under this system, executives are vested with the power to O.K. investment proposals to certain limits. For ex, in one company the plant superintendent can O.K investment outlays upto Rs. 200000 the works manager upto. Rs. 500000 and the managing director upto Rs. 2000000. Investment requiring higher outlays needs the approval of the board directors. Preparation of capital budget and appropriation Project involving smaller outlays and which executives at lower levels can decide are often covered by a blanket appropriation for expeditious action. Project involving larger outlays are included in capital budget after necessary approvals. Before undertaking such project appropriation order is usually required. The purpose of this check is mainly to ensure that the funds position of the firm is satisfactory at the time of implementation. Further, provided an opportunity to review the project at the time of implementation. Implementation. Translating an investment proposal into a concrete project is a complex, time consuming and risk-fraught task. Delays in implementation, which are common, can lead to substantial cost – overruns. For expeditious implementation at reasonable cost, the following are helpful. Adequate formulation of project the major reason for delay is inadequate formulation of projects. Put differently, in necessary homework in terms of preliminary studies and comprehensive and detail formulation of the projects is not done. Many surprises and shocks are likely to spring on the way. Hence the need for adequate formulation of the project cannot be overemphasized. Use of the principal of responsibilities accounting Assigning specific responsibility to project managers for a completing a project within a define time frame and cost limit is helpful for expeditious execution and cost control. Use of network techniques for project planning and control several network techniques like PERT (program Evaluation Review Technique) and CPM (Critical path Method) are available. With the help of these techniques monitoring becomes easier. Performance Review Performance review, post completion audit, is a feedback device it is a menace for comparing actual performance with project performance. It may be conducted, most appropriately, when the operations of the project have established. It is useful in several ways: 1. It throws the light on how realistic were the assumptions underlying the project. 2. It provides a documented log of experience that is highly valuable for decision making; 3. It helps in uncovering judgmental biases; It includes a desired caution among project sponsors. | ||
KINDS OF CAPITAL BUDGETING DECISIONS | Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals. Basically the firm may be confronted with tress types of capital decisions: (i) the accept- reject decision; (ii) the mutually exclusive choice decision; and (iii) the capital rationing decision. (i) The Accept- Reject Decision: This is a fundamental decision in capital budgeting. If the project is accepted, the firm invests in it; if the proposal is rejected, the firm does not invest in it. In general, all those proposals, which yield a rate of return greater than a certain required rate of return or cost of capital is accepted and the rest, are rejected. Under the accept- reject decision, all the independent projects that satisfy the minimum investment criterion should be implemented. (ii) Mutually Excusive Project Decisions: Mutually exclusive projects are projects, which compete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually exclusive and only one may be chosen. Suppose, a company is intending to buy a new folding machine. There are three competing brands, each with different initial investment and operating costs. The three machines represent mutually exclusive alternatives, as only one of the three machines can be selected. Mutually excusive investment decisions acquire significance when more than one proposal is acceptable under the accept- reject decision. Then some techniques have to be used to determine the “best” one. The acceptance of this “best” alternative automatically eliminates the other alternatives. (iii) Capital Rationing Decision: In a situation where the firm has unlimited funds, capital budgeting becomes a very simple process in that all independent investment proposals yielding return greater than some predetermined level are accepted. However, this is not the situation prevailing in most of the business firms in the real world. They have a fix capital budget. A large number of investment proposals compete for these limited funds. The firm must, therefore, ration them. The firm allocates funds to projects in a manner that it maximizes long- run returns. Thus, capital rationing refers to the situation in which the firm has more acceptable investments, requiring a greater amount of finance than is available with the firm. Ranking of the investment projects is employed in capital rationing. Projects can be ranked on the basis of some pre-determined criterion such as the rate of return. The project with the highest return is ranked first and the project with the lowest acceptable return last. The projects are ranked in the descending order of the rate of return. It may be noted that only acceptable projects should be ranked. | ||
Term Loans | Meaning: Term loans, also referred to as term finance, represents a source of debt finance, which is generally repayable in more than one year and less than ten years. • They are employed to finance acquisition of fixed assets and WC margins. • They typically carry fixed interest rates, monthly or quarterly repayment schedules and a set maturity date. Classification: Bankers tend to classify term loans into three categories based on payback period: 1. Short term loans: Generally repayable within a period of 3 years including moratorium period. 2. Medium term loans: Repayable in more than 3 years and less than 6 years. 3. Long term loans: Repayable in more than 6 years. Basic Features: 1. Generally the maturity period is 6 to 10 years. In some cases grace period of 2 year granted. 2. It avoids underwriting commission and other flotation costs. 3. They provided on the basis of general agreement containing terms and conditions. 4. Granted after detailed appraisal of the project. 5. They are always secured, specifically by the assets acquired using the term loan funds. This is called primary security. 6. They are generally also secured by company’s fixed and current assets. This is called secondary or collateral security. 7. The lender may also create fixed or floating charge against the firm’s asset. 8. Restrictive Covenants: These are for financially weak borrowers. They are categorized as: a. Asset-related covenants: • Borrowing co. Should maintain minimum asset base. • Minimum current ration to be maintained. • Not to sell the FA without the lender’s permission B. Liability related covenants: • Restrained from incurring additional debt. • Repay existing loan. • Reduce debt-equity ratio by issuing additional equity and/or preference capital. • Limit the freedom of promoters to dispose of their shareholding. C. Cash-outflow related covenants: • Restricting cash dividends. • Restricting capital expenditures. • Restricting salaries and perks of managerial staff, etc. 9. Positive covenants: Included in a loan agreement in addition to negative covenants, which the firm should do. • Furnishing of periodical reports/ financial statements to the lender. • Maintenance of a minimum level of working capital. • Creation to sinking fund for redemption of debt, and • Maintenance of certain net worth. 10. Option to convert a part of the rupee loan into equity. 11.Repayment Schedule: a. Repayment of principal in equal installments or/and pay interest on the unpaid loan. Due to this interest payment will decrease over the years. Also called as Baloon payments. b. Other way is to pay equal loan installments including both interest and principal payments. c. Semi annual in case of Financial Institution and Quarterly in case of banks. 12.Interest: • Interest charges are tax deductible for the borrowing firm. • General rates in India are 12-15% • Loans at concessional interest rates are given for the projects undertaken in specified backward areas. • Financial institutions charge interest rate on the basis of credit risk of the proposal subject to minimum floor rate (PLR). • In case of default @2% p.a. Additional interest to be paid on principal amount and/or interest. Advantages & Disadvantages of Term Loan Advantages: 1. The cost is lower than the cost of equity and preference capital. 2. TL do not result in dilution of control. 3. TL are preferred since they are backed by security, which the lender prefers. Disadvantages: 1. TL do not carry voting rights. 2. Generally do not represent negotiable securities. 3. Failure in case of repayment may cause the existence of firm. Purposes of Term Loans • To install a new machinery or plant. • To purchase a permanent asset or to make certain additions to the existing. • To finance the funded debts or to pay off bonds or debentures bearing a high rate of interest, to reduce the interest burden on profits of the company. • For rearranging maturities, elimination of restrictive provisions of bonds issues, in redeeming the redeemable preference shares, etc. The Term (period) of Term Loan: • Primarily it depends upon the life of the asset. • It also depends upon the repayment capacity of borrower. In case of consumer loans this aspect is given higher weightage. • In some cases like educational loans additional facet of ‘Social Obligation’ is given. Interest Rates • Interest rate charged on the amount borrowed is calculated by adding minimum lending rate (MLR) and risk involved. I.e Interest rate = MLR + Risk involved • Interest rates are not related to the period or amount of the loan given but to the credit rating of the borrower as decided by the bank. • Penal interest: charged over and above the interest rate in case of failure of borrower in fulfilling the terms and conditions with out the approval of the appropriate authority. • Concessional rate: it is offered to the people in backward areas. • Liquidation: when account becomes obsolete, 60 days notice is given to the borrower after which the bank takes acquisition of assets. After acquisition 30 days recovery notice is given after which bank can liquidate the asset. • Margin: means the own contribution of the owner for purchase of machinery as no bank generally finances 100% of total cost of machinery. It depends upon the borrower and his credit rating. Securities • Primary security: it is taken for the asset for which term loan is given. • Collateral: It is not needed upto certain amount of term loan. For more than that amount minimum 30% to 35% security is needed. It depends on the credit rating of the borrower. Re-Schedulement of Loan • It is done in case of any genuine difficulties faced by the borrower. The bank calls it as Rehabilitation of loan. • In case of major default, interest charged is transferred to other account of the borrower so that no further interest is charged on it. Pre-Sanction inspection • Submitted along with the proposal. It should contain: 1. Particulars regarding industrial license and registration with the relevant authorities. 2. Arrangements made for import of machinery. 3. Government/RBI clearance in respect of FERA/MRTP companies and NRI investments. 4. Particulars of land and terms of purchase. 5. Permission for use of land for industrial purpose. • Checking Feasibility of the project: The sees to it that whatever the person applying for the loan is new in the field or experienced, and accordingly the procedure ahead is decided. • Checking the credit worthiness of the borrower: The bank in many ways checks the credit worthiness of the borrower accordingly the borrower is given some marks that decide the grade given to the borrower. Charge • Defined as the transfer on an interest or right in the assets of a person in favour of lender for the purpose of securing the repayment of loan. First Charge: In case borrower using same asset for which the loans are granted for raising finance from two lenders, the lender who has first lent to the borrower against the asset will have right on the asset before the second it is called first charge. Second Charge: After clearing the dues of first lender by selling the assets the second lender can claim his dues. It is called second charge. • Fixed Charge: In case of Fixed charge the lender can recover his dues from certain pre-decided assets only. • Floating Charge: The lender can recover his dues from a gamut of fixed assets. There for he has to bear less risk than fixed charge. • Lein: Refer to the right of a party to retain goods belonging to another party until a debt due to him is paid. • Mortgage: involves transfer of immovable property for securing payment. • Hypothecation: means securing payment against movable property. • Pledge: means securing repayment by transferring possession of goods in favour of lender. • Paari Passu: On equal Footing or Proportionately. Paari Passu is equal rights over the assets by two lending institutions. • Disbursement of Loan: The loan is never given in lump sum; it is always given in installment to prevent the misuse by the borrower. • Insurance: The bank should ensure that the assets or the machinery against which it has lent money is adequately insured, so that unforeseen losses or calamities are averted and all risks are insured. Steps involved in Term Loans 1. Conceiving the project and preparation of the projection regarding the projet report. 2. Submission of loan appraisal. 3. Initial processing of loan application and preparation of Flash Report. 4. Detailed appraisal of the project report. 5. Issue of letter of sanction. 6. Acceptance of terms and conditions. 7. Execution of loan agreement. 8. Disbursement of loans. 9. Creation and registration of security. 10. Monitoring/ Post Disbursement check. TERM LOAN PROCEDURE The procedure associated with a term loan involves the following principal steps: Submission of loan application – the borrower submits an application form that seeks comprehensive information about the project. The application form covers the following aspects: F Promoter’s background F Particulars of the industrial concern F Particulars of the project (capacity, process, technical arrangements, management, location, land and buildings, plant and machinery, raw materials, effluents, labour, housing, and schedule of implementation) F Cost of the project F Means of financing F Marketing and selling arrangements F Profitability and cash flow F Economic considerations F Government consents Initial processing of loan Application – when the application is received, an officer of the financial institution reviews it to ascertain whether it is complete for processing. If it is incomplete the borrower is asked to provide the required additional information. When the application is considered complete, the financial institution prepares a ‘flash report’ which is essentially a summarization of the loan application. On the basis of the ‘Flash Report’, it is decided whether the project justifies a detailed appraisal or not. Appraisal of the proposed project - the detailed appraisal of the project covers the marketing, technical, financial, managerial, and economic aspects. The appraisal memorandum is normally prepared within two months after site inspetion. Based on that a decision is taken whether the project will be accepted or not. Issue of the letter of sanction – if the project is accepted, a financial letter of sanction is issued to the borrower. This communicates to the borrower the assistance sanctioned and the terms and conditions relating thereto. Acceptance of the terms and conditions by the borrowing unit - On receiving the letter of sanction from the financial institution, the borrowing unit convenes its board meeting at which the terms and conditions associated with the letter of sanction are accepted and an appropriate resolution is passed to that effect. The acceptance of the terms and conditions has to be conveyed to the financial institution within stipulated period. Execution of loan agreement – the financial institution, after receiving the letter of acceptance from the borrower, sends the draft of the agreement to the borrower to be executed by the authorized persons and properly stamped as per the Indian Stamp Act, 1899. the agreement, properly executed and stamped, alongwith other documents as required by the financial institution must be returned to it. Once the financial institution also signs the agreement, it becomes effective. Disbursement of loans - Periodically, the borrower is required to submit information on the physical progress of the projects, financial status of the project, arrangements made for financing the project, contributions made by the promoters, projected funds flow statement, compliance with various statutory requirements, and fulfillment of the pre-disbursement conditions. Based on the information provided by the borrower, the financial institution will determine the amount of term loan to be disbursed from time to time. Before the entire term loan is disbursed, the borrower must fully comply with all the terms and conditions of the loan agreement. Creation of Security the term loans(both rupee and foreign currency) and the deferredpayment guarantee assistance provided by the financial institutions are secured through the first mortgage, by way of deposit of title deeds, of immovable properties and hypothecation of movable properties. As the creation of mortgage, particularly in the case of land, tends to be a time consuming process, the institutions permit interim disbursements against alternate security (in the form of guarantees by the promoters). The mortgage, however, has to be created within a year from the date of the first disbursement. Otherwise, the borrower has to pay an additional charge of 1 per interest. Monitoring - Monitoring of the project is done at the implementation stage as well as at the operational stage. During the implementation stage, the project is monitored through: 1. Regular reports, furnished by the promoters, which provide information about placement of orders, construction of buildings, procurement of plant, installation of plant and machinery, trial production, etc. 2. Periodic site visits 3. Discussion with promoters, bankers, suppliers, creditors, and other connected with the project 4. Progress reports submitted by the nominee directors, and 5. Audited accounts of the company. During the operational stage, the project is monitored with the help of - (i) quarterly progress report on the project, (ii) site inspection, (iii) reports of nominee directors, and (iv) comparison of performance with promise. The most important aspect of monitoring, of course, is the recovery of dues represented by interest and principal repayment. MODES OF SECURITY Term loans are provided on the basis of the following modes of security: Hypothecation: Under this mode of security, loans are provided against the security of movable property, usually inventory of goods. The goods hypothecated, however, continue to be in the possession of the owner of these goods (i.e., the borrower). The rights of the lending institution (hypothecatee) Depend upon the terms of contract between the borrower and the lender. Although the lender does not have physical possessions of the goods, it has legal right to sell the goods to realize the outstanding loan. Hypothecation facility is normally not available to new borrowers. Pledge: Pledge as a mode of security, is different from hypothecation in that in the former, unlike in the latter, the goods which are offered as security are transferred to the physical possession of the lender. An essential prerequisite of pledge is that the goods are in the custody of the lender. The borrower who offers security is called a “pawnor” (pledgor), while the lender is called the “pawnee” (pledgee). The lodging of the goods by the pledgor to the pledgee is a kind of bailment. Therefore, the pledge creates some liabilities for the lender. It must take reasonable care of goods pledged with it. The term “reasonable care” means care which a prudent person would take to protect its property. He would be responsible for any loss or damage if he uses the pledged goods for his own purposes. In case of non-repayment of the loans, the lender enjoys the right to sell the goods. Lien: The term lien refers to the right of a party to retain goods belonging to another party until a debt due to him is paid. The lien can be of two types: particular lien, and general lien. Particular lien is a right to retain goods until a claim pertaining to these goods is fully paid. On the other hand, general lien can be applied till all dues of the claimant are paid. Mortgage: It is the transfer of a legal/ equitable interest in specific immovable property for securing the payment of debt. The person who parts with the interest in the property is called ‘mortgagor’ and the person in whose favour the transfer takes place is called ‘mortgagee’. The instrument of transfer is called the ‘mortgage deed’. Mortgage is thus conveyance of interest in the mortgaged property. The mortgage interest in the property is terminated as soon as th debt is paid. Mortgages are taken as an additional security for working capital credit by banks. CHARGE – where immovable property of one person is, by the act of parties or by the operation of law, made security for the payment of money to another and the transaction does not amount to mortgage, the latter person is said to have a charge on the property and all the provisions of simple mortgage will apply such a charge. The provisions are as follows: u A charge is not the transfer of interest in the property though it is security for payment. But mortgage is a transfer of interest in the property. u A charge may be created by the act of parties or by the operation of law. But a mortgage can be created only by the act of parties. u A charge need not be made in writing but a mortgage deed must be attested. u Generally, a charge cannot be enforced against the transferee for consideration without notice. In a mortgage, the transferee of the mortgaged property can acquire the remaining interest in the property, if any is left. First charge and second charge. Loans are granted to borrowers against securities. Sometimes a borrower might use the same asset for raising finance from 2 or more lenders. In this case the lender who has first lent to the borrower against the asset will have a right on the asset, before the second lender, in case of default. This is known as the first charge. Only after the dues of the first lender are cleared, after selling off the asset, the second lender can claim his dues. This is known as the second charge. Generally the lender who has a second charge will price his loan higher, considering the fact that he has to bear a greater risk. Fixed and floating charge. Lenders lend money to borrowers against securities. A lender can have either a fixed or a floating charge on the securities. In case of a fixed charge, the lender can recover his dues from a certain predecided asset only, in case of a default by the borrower. On the other hand, a lender who has a floating charge can recover his dues from a gamut of fixed assets. The lender who lends on a fixed charge therefore has to bear higher risk than the one lending on a floating charge. FIXED AND FLOATING RATES: Floating rate as opposed to floating rates vary over the tenor of the loan. These variations are linked to changes in an underlying benchmark rate. Thus a borrower with a floating rate loan for three years could end up paying 3 percent in the first year, 4 in the second and six in the third. In most floating rate arrangements, the effective rate is not revised on a daily or a weekly basis but over longer intervals. Thus rates are revised every quarter, half yearly or yearly. The benchmarks for most contracts are either the yield on government securities or an interbank rate like the LIBOR. In the Indian case, the yield on government / treasury rate will be the benchmark. A formula then decides how the interest on a specific loan relates to this. For instance, a 10 ten year floating rate loan could have its return defined as the prevailing yield on 10 year government securities plus say one percentage point. MORATORIUM – Financial institutions may allow for a delay in the payment of the first principal installment to the borrowers. The period between the sanction of the loan and the first principal installment repayment is known as moratorium. RE-SCHEDULEMENT –in the event of a borrower not being able to pay their installments as per the repayment schedule, financial institutions may restructure the repayment schedule of the borrowers so as to prevent the asset from turning bad. INTEREST – Penal – financial institutions levy a penal interest on the borrowers who default on interest payment in spite of having the ability to pay. Rebate – financial institutions may grant a rebate in the interest payment to borrowers who are willing to pay but do not have the ability to pay. Waiver – financial institutions may also waiver off some part of the interest payment to borrowers who are not in a sound financial position. SENSITIVITY ANALYSIS – one measure which expresses risk in more precise terms is sensitivity analysis. It provides information as to how sensitive the estimated project parameters, namely, the expected cash flow, the discount rate and the project life are to estimation errors. The analysis on these lines is important as the future is always uncertain and there will always be estimation errors. Sensitivity analysis takes care of estimation errors by using a number of possible outcomes in evaluating a project. The method adopted under sensitivity analysis is to evaluate a project using a number of estimated cash flows to provide to the decision maker an insight into the variability of the outcomes. Sensitivity analysis provides different cash flow estimates under three assumptions (i) the worst (i.e. the most pessimistic), (ii) the expected (i.e. the most likely), and (iii) the best (i.e. the most optimistic) outcomes associated with the project | ||
Project Appraisal | Project appraisal is the process by which a financial institution makes an independent and objective assessment of the various aspects of the investment proposition for arriving at a financing decision. Broad aspects of appraisal There are four broad aspects of appraisal 1. Financial feasibility 2. Technical feasibility 3. Economic feasibility 4. Management competence 5. Market appraisal • Market Appraisal: 1. Examine the reasonableness of the demand projection. 2. Assess the adequacy of the marketing infrastructure. 3. Judge the knowledge, experience and competence of the key marketing personnel. • Technical Appraisal: Focuses mainly on the following aspects – 1. Product Mix. 2. Capacity. 3. Raw material & consumables. 4. Site & Location. 5. Building. 6. Plant & Equipments. 7. Break-even point. 8. Man power requirement etc. • Financial appraisals: 1. Reasonableness of the estimate of capital cost. 2. Reasonableness of the estimate based on working results. 3. Adequacy of Rate of Return. 4. Appropriateness of the Financing pattern. • Economic appraisals (“Social Cost Benefit Analysis”) • Managerial appraisal: 1. How resourceful the promoters are ? 2. How sound is the understanding of the project by the promoters ? 3. How committed the promoters are ? • Viability study is done on the following aspects. A. Technical Feasibility. B. Commercial & Economic Viability. C. Financial Feasibility. D. Managerial Competence They are 5 C’s of credit: Ø Character (Good Citizen) Ø Capacity (Cash Flow) Ø Capital (Wealth) Ø Collateral (Security) Ø Conditions (Economic Conditions) | ||
Internal funds – A source of find | Internal Financing is also Known as: ü Ploughing Back of Profits ü Self-Financing ü Accumulation of earnings over a period of time Determinants of internal financing F Total Earnings of the Enterprise. F Taxation Policy of the Government. F Dividend Policy. F Government Attitudes and Control. ADVANTAGE FOR COMPANIES F Best and Cheapest Source of Finance. F Stable Dividend Policy. F Increase in Efficiency. F Increase in Morale of Management. F Safety from Trade Cycles. F Increase in the Credithworthiness of the firm. ADVANTAGE TO SHAREHOLDERS • Increase in the Value of Share • Increase in the Equity • Increase in the Collateral Value of Shares ADVANTAGE TO THE SOCIETY • Capital Formation • Increase in the social welfare DEMERITS OF INTERNAL FUNDS • Danger of Monopoly • Fear of Over – Capitalization • Loss of Shareholders • Mis – allocation of Capital SOURCES OF INTERNATIONAL FINANCE The integration and associated globalisation of capital markets has opened up a vast of array of new sources and forms of financing. The corporate treasurers in the present day can access foreign capital markets as easily as the domestic ones. EQUITY FINANCING – Equity refers to a share in the ownership of the company. The firm might issue equity shares simultaneously in two or more countries. Such issues are known as euroequity shares. Equity can be raised in the form of ADR’S and GDR’s. ADR’s – A significant portion of public offerings by non-US companies in the US is in the form of ADR’s or American Depositary Receipts. ADR’s are negotiable instruments issued to investors by an authorised depositary, normally a US bank or depositary, in lieu of the shares of the foreign company, which are actually held by the depositary. ADR’s can be listed and traded in a US –based stock exchange. Equity can be raised from the non US market by way of GDR’s. GDR’s or Global depositary receipts are listed in a stock exchange other than American Stock exchange. BOND FINANCING – A corporate bond is a debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms. Foreign bond – A foreign bond is a bond sold in a foreign country in the currency of the country of issue.For example, A canadian company selling a foreign bond in New York, denominated in dollars. Eurobond – A eurobond is a bond issued that is denominated in a currency that is not that of the country in which it is issued. For example, a US denominated band sold outside US. BANK FINANCING AND DIRECT LOANS A major part of financing of foreign subsidiaries is also done by its parent company. When a subsidiary borrows from its parent, there is transfer of funds within the MNC and thus there is no increase in the cost of bankruptcy. The subsidiary is able to deduct its interest payments from income (debt being tax-deductible), while the parent treats the interest as income. GOVERNMENT AND DEVELOPMENT BANK LENDING Financing is also done by government or development banks. Because Government and development bank financing is generally at favourable terms many corporations consider these official sources of capital before considering the issue of stocks, bonds, etc. Host Government of foreign investments provide financing when the projects are likely to generate jobs, earn foreign exchange or provide training to their workers. STATE REASONS FOR USING INTERNAL FUNDS AS A SOURCE OF FINANCE. Many companies use retained profit as a source of finance. Instead of paying dividends to shareholders & borrowing funds from outside, Profit After Tax can be used as capital or a source of finance OR a part of Profit After Tax can be used for payment of dividends & remaining can be used as internal funding. Terms like, retained profits, retained earnings & internal funding indicate same thing. Following are the reasons for using internal funds as a source of finance: · Non-expensive – Retained earnings are self-evidently the cheapest form of finance. No interest is charged on retained earnings & at the same time, no shares are issued. As a result, there are no professional fees to be paid. · No change of ownership – Normally, existing owners of the business are reluctant to transfer the ownership in the new hands. Due to internal funding, ownership remains with existing managers. · Time – Reputed companies can get loans quite easily. But it takes several months to attract a suitable equity partner. A detail study of capabilities of equity partner is required. It should also be kept in the mind that chosen equity partner has to show interest in the company. · Exit strategies – Normally, private equity investors require an exist within three to five years. This means after every three to five years, company is bound to choose a new equity partner. · History – History shows that companies which are looking to build a substantial size over a 10 to 15 years period & want to retain control & ownership of the original shareholders & management team, retained earnings is the best source of finance. EVALUATE INTERNAL FUNDS AS A SOURCE OF FINANCE. Instead of paying dividends to shareholders & borrowing funds from outside, Profit After Tax can be used as capital or a source of finance OR a part of Profit After Tax can be used for payment of dividends & remaining can be used as internal funding. Terms like, retained profits, retained earnings & internal funding indicate same thing. According to history, internal funding is used for a steady growth over a period over 10 to 15 years. On internal funding, no professional fees have to be paid. Company need not go for the search of the private equity partner & at the same time, control & ownership are retained by existing partners & shareholders. On opposite side, as outsiders are not allowed to interfere in the business of the company due to fear of losing control, company does get talented & experienced people on the board. Companies, which are growth oriented, have to depend on private equity partner for working capital requirements. One more aspect to be considered while evaluating internal funds as a source of finance is that the banks, while giving loans or overdraft facilities, follow ‘one to one’ gearing rule which means that bank may be reluctant to lend more than the sum of the share capital plus retained profits. If the share capital is to remain unchanged, the only way a company can increase the amount a bank will be prepared to lend is through increasing retained profit. Now, it must be clear that it is up to individual company to decide whether to go for internal funding or private equity. As long as the management team understands the urgency of maximizing retained profits, company can be made fully self-sufficient in funding, with help from the bank. It can also be said that internal equity is not just about providing the comfort of full control to owner managers who might otherwise have to seek external equity investors, it is also about necessity of survival & success. DISCUSS RETAINED EARNINGS AS A PRUDENT INVESTMENT POLICY. Depreciation charges and retained earnings represent the internal sources of finance available to the company. If depreciation charges are used for replacing worn-out equipment, retained earnings represent the only internal source for financing expansion and growth. Companies normally retain 30 % to 80 % of profit after tax for financing growth. Hence, these are an important source of long-term financing. Retained earnings can be reviewed for their advantages and disadvantages from – 1. Firm’s Point of View: Advantages – 1. They are readily available internally. They do not require talking to outsiders. 2. They effectively represent infusion of additional equity in the firm. Use of retained earnings, in lieu of external equity, eliminates issue costs and losses on account of underpricing. 3. There is no dilution of control when a firm relies on retained earnings. Disadvantages – 1. The amount that can be raised by way of retained earnings may be limited. Further, the quantum of retained earnings tends to be highly variable. 2. The opportunity cost of retained earnings is quite high, since it is nothing but the dividends foregone by the equity shareholders. 2. Shareholder’s Point of View: Advantages – 1. Compared to dividend income, the capital appreciation that arises as a sequel to retained earnings is subject to a lower rate of tax. 2. Reinvestment of profits may be convenient for many shareholders as it relieves them to some extent of the problem of investing on their own. Disadvantages – 1. Shareholders who want a current income higher than the dividend income may be highly averse to converting a portion of capital appreciation into current income, as it calls for selling some shares. Many firms do not fully appreciate the opportunity cost of retained earnings. | ||
SOURCES OF FINANCE | The business requires two types of finance namely: 1. Short term finance 2. Long term finance Short term finance is concerned with decisions relating to current assets and current liabilities and is also called as working capital finance. Short term financial decisions typically involve cash flows within a year or within the operating cycle of the firm. Normally short term finance is for a period up to 3 years. The main sources of short term finance are: 1. Cash credit 2. Short term loans from financial institutions 3. Bill Discounting 4. Letter of credit 5. Inter-corporate deposits 6. Commercial papers 7. Factoring 8. Working capital advance by commercial banks 1. Cash Credit: Cash Credit facility is taken basically for financing the working capital requirements of the organization. Interest is charged the moment cash credit is credited to the Bank A/C irrespective of the usage of the Cash Credit. 2. Short term loans from financial institutions: Bank overdraft 3. Bill Discounting: Bill Discounting is a short term source of finance, whereby Bills Receivable received from debtors is in cashed from the bank at a discounted rate. 4. Letter of credit Letter of credit is an indirect form of working capital financing and banks assume only the risk, the credit being provided by the supplier himself. A letter of credit is issued by a bank on behalf of its customer to the seller. As per this document, the bank agrees to honor drafts drawn on it for the supplies made to the customer. I f the seller fulfills the condition laid down in the letter of credit. 5.Inter- corporate Deposits A deposit made by one company with another, normally for a period of six months is referred to as an ICD ie. Short-term deposits with other companies are a fairly attractive form of investment of short term funds in terms of rate of return. These deposits are usually of three types: a. Call deposits: A call deposit is withdraw able by the lender on a given days notice. b. Three-months Deposits: These deposits are taken by the borrowers to tied over a short term cash inadequacy c. Six-month Deposits: Normally lending companies do not extend deposits beyond this time frame. Such deposits are usually made with first-class borrowers. 6. Commercial papers A company can use commercial papers to raise funds. It is a promissory note carrying the undertaking to repay the amount or/ on after a particular date. 7. Factoring A factor is a financial institution which offers services relating to management and financing of debts arising form credit sales. Factoring provides resources to finance receivables as well as facilitates the collection of receivables. There are 2 banks, sponsored organizations which provide such services: a. SBI factors and commercial services LTD b. Canbank factors LTD, started operations since the beginning of 1997. 8. Working capital advance by commercial banks Since the above sources do not permit the use of funds, for a longer period of time, the business has to seek further sources, if the need is for a longer period of time, i.e. This extends up to 3 years and above. When a firm wants to invest in long term assets, it must find the needs to finance them. The firm can rely to some extent on funds generated internally. However, in most cases internal resources are not enough to support investment plans. When that happens the firm may have to curtail investment plan or seek external funding. Most firms choose to take external funding. They supplement internal funding with external funding raise from a variety of sources. The main sources of long term finance can broadly divided into: Internal sources include: a. Share capital (Equity shares and preference shares) b. Reserves and Surplus c. Personal loans and advances from owners called as ‘Quasi Capital’ External sources include: a. Term loan from banks, financial institutions and international bodies like International Monetary Funds, World Bank, Asian Development Bank. b. Debentures c. Loans and advances from friends and relatives d. Inter- Corporate Deposits e. Asian Depository Receipts / Global Depository Receipts f. Commercial Papers. The short term or long term finance is a function of financial management. The good and efficient management is that which can raise the funds whenever required and at the most competitive terms and conditions. Raising of funds either internally or externally requires a professional approach and also complying with so many legal, technical and statutory requirements prescribed by the Companies Act, Securities Exchange Board Of India, Stock Exchanges Authorities and also allied laws like Income Tax, Foreign Exchange Management Act, Banking Regulations Act, etc. | ||
CONTENTS OF THE CAPITAL STRUCTURE | The capital structure includes Funds received from the owners of the business i.e. the Shareholders and therefore called as: · Share holders fund · Proprietor fund · Owners fund The share holders fund are further classified into Ø Share Capital: Equity and Preference Ø Reserves and Surplus: General reserve, etc Ø Fictitious assets: Preliminary expenses etc The capital structure also includes Borrowed Funds which are further divided into: Ø Secured Loans (Bank loans, debentures, etc) Ø Unsecured loans ( loans from friends and relatives) | ||
Trading on Equity | Trading on Equity refers to the practice of using borrowed funds, carrying a fixed charge, to obtain a higher return to the Equity Shareholders. With a larger proportion of the debt in the financial structure, the earnings, available to the owners would increase more than the proportionately with an increase in the operating profits of the firm. This is because the debt carries a fixed rate of return and if the firm is able to earn, on the borrowed funds, a rate higher than the fixed charges on loans, the benefit will go the shareholders. This is referred to as “Trading on Equity” The concept of trading on equity is the financial process of using debt to produce gain for the residual owners or the equity shareholders. The term owes its name also to the fact that the equity supplied by the owners, when the amount of borrowing is relatively large in relation to capital stock, a company is said to be trading on equity, but where borrowing is comparatively small in relation to capital stock, the company is said to be trading on thick equity. Capital gearing ration can be used to judge as to whether the company is trading on thin or thick equity. | ||
RECEIVABLES MANAGEMENT | The management of accounts receivables management deals with viable credit and collection policies. A very liberal credit policy will increase sales and also bad debt losses. On the other hand a conservative credit policy will reduce bad debt losses but also reduce sales. A good credit policy should seek to strike a reasonable balance between sales and bad debt losses. The objective of receivables management is to promote sales and profits until that point is reached where the returns that the firm gels from funding of receivables is less than the cost that the firm has to incur in order to fund these receivables. This, the purpose of receivables is directly connected with the firms objective of making credit sales. The following aspects of receivables management are important: (A) Credit Policy: Credit policy means the decisions with regard to the credit standards, i.e. who gets credit and up to what amount and on what specific terms. The firms credit policy influences the sales level, the investment .level, in cash, inventories, accounts receivables and physical equipments, bad debt losses and collection costs. The various factors associated with credit policy are: (i) Credit Standards (ii) Credit Period (iii) Cash Discount (iv) Collection Programme. Credit Standard means classification of customers to whom credit can not be expended or can be extended. A firm can take the help of credit rating agencies for this purpose. Credit Period means the length of time customers are allowed to pay for their purchases. It may vary from 15 days to 60 days. Cash Discount is generally offered to induce prompt payment by the customers, credit terms provide the percentage of discount and the period during which it may be available, for example, credit terms of 2/10 net 30 means that a discount of 2 percent is offered if the payment is made by the 10th day otherwise the full payment is due by the 30th day. The Collection Programme means the collection effort of a firm as decided by the credit policy. The objective of the collection policy is to collect the receivables in time. The collection programme consists of the following details: (1) Monitoring the state of receivables, (2) Dispatch the letters to customers, whose due date is approaching, (3) communicate the customers by telephone at about the due date, (4) Threat of legal action to overdue accounts, (5) Actual legal action against overdue accounts. (B) Credit Evaluation: Credit evaluation means a review of a prospective customer by obtaining the information to judge the customers willingness and ability to pay his debt. In judging the credit worthiness of an applicant the three basic factors which should be considered are, character, capacity and collateral. The character refers to the willingness of the customer to honour his obligations. The capacity ' refers to the ability of a customers to pay on time and the collateral represents the security offered by him in the form of mortgages. A firm can use different ways to judge the creditworthiness of an applicant. Some of the ways are as follows: - Analysis of financial statements - obtaining of bank certificate - Analysis of past experience - Numerical credit scoring. (C) Credit Granting Decision: Credit evaluation helps to judge the credit worthiness of a prospective customer. Credit granting decision is a procedure of final decision whether to grant credit to the prospective customer or not. The decision to grant credit or not depends upon the (cost benefit analysis. The manager can form a subjective opinion based on credit evaluation about the chance of getting payment and the chance of not getting payment. The relative chances of getting the payment or not getting the payment are at the back of his mind while taking such a decision. Optimum Credit Policy n Estimation of incremental profit n Estimation of incremental investment in receivable n Estimation of incremental rate of return (IRR) n Comparison of incre-mental rate of return with required rate of return (RRR) n Optimum credit policy: IRR = RRR Credit policy variables n Credit standards n Credit analysis n collection period n default rate n character n capacity n condition n capital n collateral n customer categories n good accounts n bad accounts n marginal accounts n numerical credit scoring n ad hoc approach n simple discriminant approach n multiple discriminant approach n Credit terms n credit period n cash discount n Collection policy and procedures n regularity of collections n clarity of collection procedures n responsibility for collection and follow-up n case-by-case approach n cash discount for prompt payment n Credit information n financial statements n bank references n trade references n Credit investigation and analysis n analysis of credit file n financial analysis n analysis of business and management n Credit limit n Collection efforts Monitoring Receivable n Collection period n Aging schedule n Collection experience matrix | ||
Cash Management | • Cash management is concerned with the managing of: – cash flows into and out of the firm, – cash flows within the firm, and – cash balances held by the firm at a point of time by financing deficit or investing surplus cash Four Facets of Cash Management • Cash planning • Managing the cash flows • Optimum cash level • Investing surplus cash Motives for Holding Cash • The transactions motive • The precautionary motive • The speculative motive Optimum Cash Balance • Optimum Cash Balance under Certainty: Baumol’s Model • Optimum Cash Balance under Uncertainty: The Miller–Orr Model Factors Determining Cash Needs: The working capital needs of a firm are influenced by numerous factors. The important ones are: · Nature of business. · Seasonality of operations. · Production policy. · Market conditions. · Conditions of supply. Nature of business: The working capital requirement of a firm is closely related to the nature of its business. A service firm, like an electricity undertaking or a transport corporation which has a short operating cycle and which sells predominantly on cash basis, has a modest working capital requirement. On the other hand, a manufacturing concern likes a machine tools unit, which has a long operating cycle and which sells largely on credit, has a very substantial working capital requirement. Seasonality of operations: Firms which have marked seasonality in their operations usually have highly fluctuating working capital requirements. To illustrate, consider a firm manufacturing ceiling fans. The sale of ceiling fans reaches a peak during the summer months and drops sharply during the winter period. The working capital need of such firm is likely to increase considerably in summer months and decrease significantly during the winter period. On the other hand, a firm manufacturing product like lamps, which have even sales round the year, tends to have stable working capital needs. Production policy: A firm marked by pronounced seasonal fluctuation in its sales may pursue a production policy which may reduce the sharp variations in working capital requirements. For example, a manufacturer of ceiling fans may maintain a steady production throughout the year rather than intensify the production activity during the peak business season. Such a production policy may dampen the fluctuations in working capital requirements. Market conditions: The degree of competition prevailing in the market has an important bearing on working capital needs. When competition is keen, a larger inventory of finished is required to promptly serve customers who may not be inclined to wait because other manufacturers are ready to meet their needs. Further, generous credit terms may have to be offered to attract customers in a highly competitive market. Thus, working capital needs tend to be high because of greater investment in finished goods inventory and accounts receivable. If the market is strong and competition weak, a firm can manage with a smaller inventory of finished goods because customers can be served with some delay. Further, in such a situation the firm can insist on cash payment and avoid lock-ups of funds in accounts receivable –it can even ask for advance payment, partial or total. Conditions of supply: The inventory of raw materials, spares, and stores on the conditions of supply. If the supply is prompt and adequate, the firm can manage with small inventory. However, if the supply is unpredictable and scant, then the firm, to ensure continuity of production, would have to acquire stocks as and when they are available and carry large inventory on an average. A similar policy may have to be followed when the raw material is available only seasonally and production operations are carried out round the year n Investment in receivable n volume of credit sales n collection period n Credit policy n credit standards n credit terms n collection efforts | ||
Leverages: | Leverages: · Business Risk is risk due to fixed operating costs (operating leverage) · Financial Risk is risk due to fixed financial costs (interest, preference dividend) i.e. due to financial leverage. · Financial Leverage is also called as ‘Trading on Equity’ · Direct Costs usually would mean variable costs n Leverage is the employment of an asset or funds for which the firm pays a fixed cost or fixed return. n Operating Leverage is the use of fixed operating costs to magnify a change in profits relative to a given change in sales. n Financial Leverage is the tendency of residual income to vary disproportionately with operating profit. n Combined Leverage expresses the relationship between revenue on account of sales and the taxable income. n ROI Leverage is the ratio of EBIT and total assets. n Trading on Equity – Financial leverage is also sometimes called on trading on equity. n EPS – Earnings per share is calculated by dividing earnings available to equity share holders with number of equity shares. Essential characteristics of leverage n (a) Leverage is applied to the employment of an asset or funds. n (b) Profits tend to change at a faster rate than sales. n (c) There is risk return relationship which is basically found in the same direction. n (d) If higher is the leverage, higher will be the risk and higher will be the expected returns. Meaning of Financial Leverage n The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners’ equity in the capital structure, is described as financial leverage or gearing or trading on equity. n The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners’ equity. The rate of return on the owners’ equity is levered above or below the rate of return on total assets. A brief review of various types of leverage is as follows : n Return on Investment Leverage is an index of operational efficiency. It is calculated as follows : n EBIT n --------------- n Total Assets n Asset Leverage is the part of ROI leverage. It is like assets turnover. It is calculated as follows : n Sales n --------------- n Total Assets n A firm with a relatively high tur nover is said to have a high degree of asset leverage. n Operating Leverage is related to fixed cost. It indicates the impact of changes in sales on operating income. Say, n Contribution n --------------- n EBIT n Financial Leverage depends upon the ratio of debt and preferred stock together to common shares. It is calculated with the help of EBIT and EBT as below : n EBIT n --------------- n EBT n Combined Leverage is the multiplication of operating leverage and financial leverage. n Measures of Financial Leverage n Debt ratio n Debt–equity ratio n Interest coverage n The first two measures of financial leverage can be expressed either in terms of book values or market values. These two measures are also known as measures of capital gearing. n The third measure of financial leverage, commonly known as coverage ratio. The reciprocal of interest coverage is a measure of the firm’s income gearing. n The following are the essentials of financial leverage : n (1) It relates to liabilities side of balance sheet n (2) It is related to capital structure n (3) It is related to financial risk n (4) It affects earning after tax and earnings per share n (5) It may be favourable or unfavourable. Unfavourable leverage occurs when the firm does not earn as much as the funds cost. n Financial leverage is useful in n (i) Capital structure planning n (ii) Profit Planning n Financial leverage helps the finance managers while devising the capital structure of the company. A high financial leverage means high fixed financial costs and high financial risk. Increase in fixed financial costs may force the company into liquidation. n The primary motive of a company in using financial leverage is to magnify the shareholders’ return under favourable economic conditions. The role of financial leverage in magnifying the return of the shareholders’ is based on the assumptions that the fixed-charges funds (such as the loan from financial institutions and banks or debentures) can be obtained at a cost lower than the firm’s rate of return on net assets (RONA or ROI). n EPS, ROE and ROI are the important figures for analysing the impact of financial leverage. Effect of Leverage on ROE and EPS Operating Leverage n Operating leverage affects a firm’s operating profit (EBIT). n The degree of operating leverage (DOL) is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales. n It is a function of three factors : Fixed costs, Contribution, Volume of Sales n A few specific characteristics of operating leverage are as follows : n It affects assets side of Balance sheet n It is related to composition of fixed assets n It is related in fluctuations in business risk n It affects capital structure and return on total assets. n The operating leverage can be calculated by the following formula n Contribution C n OL = ------------------ or --------- n EBIT EBIT n where contribution means sales minus variables costs n EBIT means contribution minus fixed costs . n The operating leverage indicates the impact of change in sales on operating income. If a firm has a high degree of operating leverage, small change in sales will have large effect on operating income. A few areas of application are as follows : n (1) Operating leverage has an important role in capital budgeting decisions. Infact, this concept was originally developed for use in capital budgeting. n (2) Long term profit planning is also possible by looking at quantam of fixed cost investment and its possible effects. n (3) Generally, a high degree of operating leverage increases the risk of a firm. For deciding capital structure in favour of debt, the impact of further increase in risk will influence capital structure decision. Combining Financial and Operating Leverages n Operating leverage affects a firm’s operating profit (EBIT), while financial leverage affects profit after tax or the earnings per share. n The degrees of operating and financial leverages is combined to see the effect of total leverage on EPS associated with a given change in sales. n The degree of combined leverage (DCL) is given by the following equation: n another way of expressing the degree of combined leverage is as follows: n The variability of EBIT and EPS distinguish between two types of risk—operating risk and financial risk. n Operating risk can be defined as the variability of EBIT (or return on total assets). The environment—internal and external—in which a firm operates determines the variability of EBIT n The variability of EBIT has two components: n variability of sales n variability of expenses n The variability of EPS caused by the use of financial leverage is called financial risk. CALCULATION OF LEVERAGES n Sales ______________ n Less Variable Cost ______________ n Contribution ______________ n Less Fixed cost ______________ n Operating Profit/EBIT ______________ n Less Interest ______________ n Profit Before tax(PBT) ______________ n Less tax ______________ n Earnings after tax(EAT) ______________ n Less preference dividend ______________ n Earnings available ______________ to shareholders(EAS) IMPORTANCE OF LEVERAGES Leverages have the magnifying effect. Operating leverage magnifies EBIT with respect to contribution while financial leverage magnifies EPS with respect to EBIT. Financial leverage enhances the EPS without an additional investment. By having judicious assets mix and financing mix, EPS may be increased. A few areas identified in this regard are as follows : Investment in fixed assets (Operating leverage) Capital structure planning (Financial leverage) Profit planning (Combined leverage) Monitoring business and financial risk Maximising the value of share Improving EPS Judicious mixture of operating leverage and financial leverage. A firm with high operating leverage should not have a high financial leverage. Similarly, a firm having low operating leverage will stand to gain by having a high financial leverage. If both leverages are increased, the possibility of bearing more risk will increase. Conclusion: Leverage refers to the use of an asset or source of funds which involves fixed costs or fixed returns. Leverages can be operating, financial and combined. Operating leverage uses fixed operating costs to magnify the effects of changes in sales on the operating profits. Operating leverage may be favourable or unfavourable. High operating leverage is good when sales increase. Financial leverage affects financial risk of the firm. In financial leverage, the source of fund which wants fixed refund so that more than proportionate change in EPS may be reflected. Combined leverage is the multiplication of financial and operating leverage. In order to keep the risk under control, low financial leverage be kept alongwith high degree of operating leverage. EBIT – EPS analysis may help the financial managers to choose the optimum capital structure. | ||
Capital Structure | n The term capital structure is used to represent the proportionate relationship between debt and equity. n The various means of financing represent the financial structure of an enterprise. The left-hand side of the balance sheet (liabilities plus equity) represents the financial structure of a company. Traditionally, short-term borrowings are excluded from the list of methods of financing the firm’s capital expenditure. Questions while Making the Financing Decision n How should the investment project be financed? n Does the way in which the investment projects are financed matter? n How does financing affect the shareholders’ risk, return and value? n Does there exist an optimum financing mix in terms of the maximum value to the firm’s shareholders? n Can the optimum financing mix be determined in practice for a company? n What factors in practice should a company consider in designing its financing policy? Operating Leverage vs. Financial Leverage n OL is related to investment activities, FL is more concerned with financial matters n OL Useful to take capital expenditure decision, FL is Useful for mixing debt and equity in capital structure n With help of OL, fluctuation in EBIT can be predicted ; With help of FL, changes in EPS due to debt-equity can be predicted n OL is used to predict business risk ; FL is used to predict financial risk n | ||
Working capital management | n Gross working capital (GWC) GWC refers to the firm’s total investment in current assets. Current assets are the assets which can be converted into cash within an accounting year (or operating cycle) and include cash, short-term securities, debtors, (accounts receivable or book debts) bills receivable and stock (inventory). n Net working capital (NWC). n NWC refers to the difference between current assets and current liabilities. n Current liabilities (CL) are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses. n NWC can be positive or negative. n Positive NWC = CA > CL n Negative NWC = CA < CL n GWC focuses on n Optimisation of investment in current n Financing of current assets n NWC focuses on n Liquidity position of the firm n Judicious mix of short-term and long-tern financing Operating Cycle n Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. The operating cycle of a manufacturing company involves three phases: n Acquisition of resources such as raw material, labour, power and fuel etc. n Manufacture of the product which includes conversion of raw material into work-in-progress into finished goods. n Sale of the product either for cash or on credit. Credit sales create account receivable for collection. n The length of the operating cycle of a manufacturing firm is the sum of: n inventory conversion period (ICP). n Debtors (receivable) conversion period (DCP). n Inventory conversion period is the total time needed for producing and selling the product. Typically, it includes: n raw material conversion period (RMCP) n work-in-process conversion period (WIPCP) n finished goods conversion period (FGCP) n The debtors conversion period is the time required to collect the outstanding amount from the customers. n Creditors or payables deferral period (CDP) is the length of time the firm is able to defer payments on various resource purchases. n Gross operating cycle (GOC) The total of inventory conversion period and debtors conversion period is referred to as gross operating cycle (GOC). n Net operating cycle (NOC) NOC is the difference between GOC and CDP. n Cash conversion cycle (CCC) CCC is the difference between NOP and non-cash items like depreciation. n Permanent or fixed working capital A minimum level of current assets, which is continuously required by a firm to carry on its business operations, is referred to as permanent or fixed working capital. n Fluctuating or variable working capital The extra working capital needed to support the changing production and sales activities of the firm is referred to as fluctuating or variable working capital. Determinants of Working Capital n Nature of business n Market and demand n Technology and manufacturing policy n Credit policy n Supplies’ credit n Operating efficiency n Inflation Issues in Working Capital Management n Levels of current assets n Current assets to fixed assets n Liquidity Vs. profitability n Cost trade-off Estimating Working capital n Current assets holding period n To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the company’s experience in the previous years. This method is essentially based on the operating cycle concept. n Ratio of sales n To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales. n Ratio of fixed investment n To estimate working capital requirements as a percentage of fixed investment. Working Capital Finance Policies n Long-term n Short-term n Spontaneous n Matching n Conservative n Aggressive Short-term Sources of Finance n Trade Credit n Accrued Expenses and Deferred Income n Bank Borrowings n Factoring of receivables n Commercial Paper Trade Credit n Customer gets from supplier of goods in normal course of business. n An informal arrangement, granted on an open account basis, not formally acknowledge as a debt. n Trade credit may also take the form of bills payable. n Credit Terms refers to the conditions of due date and cash discount. n Advantages 1. Easy Availability. 2. Flexibility. 3. Informality. n Disadvantages 1. Implicit Cost. 2. Stretching A/P can prove to be very costly. n Accrued Expenses 1. Accrued Wages and Salaries. 2. Accrued taxes and Interest. n Deferred Income 1. Advance Payments. Bank Finance for Working Capital n Overdraft n Cash Credit n Purchase or Discounting of Bills n Letter of Credit n Working Capital Loan Security for Bank Finance n Hypothecation n Pledge n Mortgage n Lien Regulation of Bank Finance n Dehejia Committee (1968) n Tandon Committee (1974) n Chore Committee (1979) In the deregulated economic environment in India recently, banks have considerably relaxed their criteria of lending. In fact, each bank can develop its own criteria for the working capital finance. | ||
Cost of capital | n The project’s cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. n The firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects. Significance of the Cost of Capital n Evaluating investment decisions, n Designing a firm’s debt policy, and n Appraising the financial performance of top management. The Concept of the Opportunity Cost of Capital n The opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk. n Opportunity cost of capital is given by the following formula: where Io is the capital supplied by investors in period 0 (it represents a net cash inflow to the firm), Ct are returns expected by investors (they represent cash outflows to the firm) and k is the required rate of return or the cost of capital. n The opportunity cost of retained earnings is the rate of return, which the ordinary shareholders would have earned on these funds if they had been distributed as dividends to them. Weighted Average Cost of Capital Vs. Specific Costs of Capital n The cost of capital of each source of capital is known as component, or specific, cost of capital. n The overall cost is also called the weighted average cost of capital (WACC). n Relevant cost in the investment decisions is the future cost or the marginal cost. n Marginal cost is the new or the incremental cost that the firm incurs if it were to raise capital now, or in the near future. n The historical cost that was incurred in the past in raising capital is not relevant in financial decision-making. n The following steps are involved for calculating the firm’s WACC: n Calculate the cost of specific sources of funds n Multiply the cost of each source by its proportion in the capital structure. n Add the weighted component costs to get the WACC. n WACC is in fact the weighted marginal cost of capital (WMCC); that is, the weighted average cost of new capital given the firm’s target capital structure. Book Value Versus Market Value Weights n Managers prefer the book value weights for calculating WACC: n Firms in practice set their target capital structure in terms of book values. n The book value information can be easily derived from the published sources. n The book value debt—equity ratios are analysed by investors to evaluate the risk of the firms in practice. n The use of the book-value weights can be seriously questioned on theoretical grounds: n First, the component costs are opportunity rates and are determined in the capital markets. The weights should also be market-determined. n Second, the book-value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus, they do not reflect economic values. n Market-value weights are theoretically superior to book-value weights: n They reflect economic values and are not influenced by accounting policies. n They are also consistent with the market-determined component costs. n The difficulty in using market-value weights: n The market prices of securities fluctuate widely and frequently. n A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm changes. Flotation Costs, Cost of Capital and Investment Analysis n A new issue of debt or shares will invariably involve flotation costs in the form of legal fees, administrative expenses, brokerage or underwriting commission. n One approach is to adjust the flotation costs in the calculation of the cost of capital. This is not a correct procedure. Flotation costs are not annual costs; they are one-time costs incurred when the investment project is undertaken and financed. If the cost of capital is adjusted for the flotation costs and used as the discount rate, the effect of the flotation costs will be compounded over the life of the project. n The correct procedure is to adjust the investment project’s cash flows for the flotation costs and use the weighted average cost of capital, unadjusted for the flotation costs, as the discount rate. n A most commonly suggested method for calculating the required rate of return for a division (or project) is the pure-play technique. n The basic idea is to use the beta of the comparable firms, called pure-play firms, in the same industry or line of business as a proxy for the beta of the division or the project. n The pure-play approach for calculating the divisional cost of capital involves the following steps: n Identify comparable firms. n Estimate equity betas for comparable firms. n Estimate asset betas for comparable firms. n Calculate the division’s beta. n Calculate the division’s all-equity cost of capital. n Calculate the division’s equity cost of capital. n Calculate the division’s cost of capital. The Cost of Capital for Projects n A simple practical approach to incorporate risk differences in projects is to adjust the firm’s WACC (upwards or downwards), and use the adjusted WACC to evaluate the investment project. n Companies in practice may develop policy guidelines for incorporating the project risk differences. One approach is to divide projects into broad risk classes, and use different discount rates based on the decision-maker’s experience. n For example, projects may be classified as: n Low risk projects discount rate < the firm’s WACC n Medium risk projects discount rate = the firm’s WACC n High risk projects discount rate > the firm’s WACC | ||
Basic Terms | Net worth: Net worth means total equity including reserves and surplus less intangible assets like goodwill. (FA+CA) – (CL & Borrowed funds). Capital employed: Capital employed is total shareholders fund and borrowed fund. In other words, it means total sources. The formula for capital employed is: Capital employed=Share capital + reserves & surplus + P&L a/c (cr) + loans (borrowed funds). Return on capital employed: Return on capital employed is the return on total resources or profitability on the overall investment viz total resources utilized by the business. Total resources employed or total capital employed means the total funds at the disposal of the business. Common size statement: The determination of trends and comparisons of amounts are facilitated by use of percentage of figures instead of rupee amount. The amounts and accounts in financial statements are reduced to % and these % are presented for comparison purpose. Such statements are called common size statements. Ratio analysis: Ratio analysis is the process of computing, determining and presenting the relationships between items or group of items in the financial statements through accounting ratios. An analysis is normally undertaken for the purpose of projecting financial position or profitability, knowledge of trends is usually more significant than knowledge of present status only. An analysis of trends through ratio analysis helps in appraisal of financial conditions, efficiency and profitability of a business. Ratio analysis helps to relate information in the financial data in a meaningful manner. It facilitates comparison. | ||
One liners | 1. Accounts Payable (Payables): Money owed to suppliers. 2. Accounts Receivable (Receivables): Money owed by customers. 3. Asset Allocation: The process of determining the optimal division of an investor's portfolio among different assets. Most frequently this refers to allocations between debt, equity, and cash. 4. Asset Liability Management: A risk management technique for protecting an institution's capital. 5. Assets: Anything that the firm owns. 6. Authorised share capital: Maximum number of shares that a company can issue, as specified in the firm's articles of incorporation. 7. Average Tax Rate: The rate calculated by dividing the total tax liability by the entity's taxable income. Also referred to as “Effective Tax Rate” (ETR) 8. Balance Sheet: A basic accounting statement that represents the financial position of a firm on a given date. 9. Book Value: The depreciated value of a company's assets (original cost less accumulated depreciation) less the outstanding liabilities. This can be book value of equity shares, book value of fixed assets, book value of investments made by a business entity etc. 10. Break-even analysis: Analysis of the level of sales at which a project would just break even. 11. Broker: A person who facilitates transactions (buy and sell) in the secondary market. 12. Brokerage Commission: The amount of money your brokerage house would charge for a given transaction (buy/sell). This is how these firms make their living. 13. Buyback: When a firm repurchases its own stock from the public. 14. Capital Asset: All property used in conducting a business other than assets held primarily for sale in the ordinary course of business or depreciable, and real property used in conducting a business. 15. Capital Budgeting: The decision-making process with respect to investment in fixed-assets. It involves measuring the additional cash flows associated with investment proposals and evaluating the viability of those proposed investment. 16. Capital Gains or Loss: The profit or loss made when an asset is sold for more than the purchase price is a capital gain. If the sale price is less than the purchase price, this is a capital loss. 17. Capital Gearing: Short- and long-term debt as a percentage of net tangible assets. 18. Capital Markets: Markets for long-term financial securities. 19. Capital Structure: The equity and longer-term debt obligations that fund an enterprise. 20. Cash Budget: A detailed plan of future cash flows. This budget is composed of four elements: cash receipts, cash disbursements, net change in cash for the period, and new financing needed. 21. Collateral Assets: That is used as security for a loan. 22. Commission: The broker's fee for purchasing or selling assets. 23. Cost of Capital: The rate that must be earned by the company to satisfy all the firm's providers of capital. It is based on the opportunity cost of funds. 24. Credit Risk: The risk that the other party in a business deal or transaction may fail to perform on its obligations. 25. Credit: The promise to pay in the future in order to buy or borrow in the present. The right to defer payment of debt. 26. Current Asset: Asset that is expected to be turned into cash within a year. 27. Current Liability: Liability that is expected to be paid in less than a year. 28. Debentures: Secured medium-term debt and debenture certificates are issued to the holders by the debt raising company. 29. Depreciation: (1) Reduction in the book or market value of an asset. 30. Discount: An amount deducted from the regular price for those who purchase with cash instead of credit. Dont confuse this with the discount on a bond, which is different. See the bonds section. 31. Discounting: The inverse of compounding. This process is used to determine the present value of a cash flow. 32. Dividend Yield Dividends per share divided by the price of the security. 33. Dividend: Distribution of wealth by firm to shareholders based on number of shares owned. 34. Earnings Before Interest and Taxes (EBIT): A measure of enterprise cash flow, largely replaced in recent finance literature by Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). 35. Earnings Per Share (EPS): Company's earnings divided by the number of shares outstanding. 36. EBIT: A company's Earnings Before Interest and Taxes. 37. Economic Risk: Exposure to changes in exchange rates, local regulations, product preferences, etc., that favour the products or services provided by a competitor. See also Competitive Currency Risk. 38. Economic Value Added (EVA): A corporate performance measurement and analysis technique that stresses the importance of cash flow increments above the market-determined weighted average cost of capital. Often stated as: EVA = NOPAT - (Capital X WACC) where NOPAT = Net Operating Profit After Tax and WACC = Weighted Average Cost of Capital 39. Employee Stock Ownership Plan (ESOP): A trust organized under the provisions of the original ERISA legislation to permit a sponsoring company to transfer shares of its stock in tax-deductible contributions for the ultimate benefit of the company's employees upon their retirement. ESOPs are defined contribution pension plans with the maximum annual contribution limited to 25% of the company's payroll. For some companies the shares held by an ESOP have become a significant part of the corporate capitalisation 40. Expected return: The average possible return for an investment 41. External Financing: Financing projects through new issues of securities; debt and/or equity. 42. Extra Dividend: Dividend that is not expected to be repeated. 43. Face Value: Value of security shown on certificate. Also called par value, which is typically Re.1/- to Rs.100/- in the case of equity shares and Rs.100/- to Rs.1000/- in the case of bond or a debenture. 44. Financial Assets: Securities that have a claim on assets of a borrower. Term used to denote the assets of a lender. 45. Financial Intermediaries: Financial institutions, banks, NBFCs that assist the transfer of savings from economic agents with excess savings to those that need capital for investments. 46. Financial Investment: Investment in financial assets. 47. Financial Risk Management: The process whereby an organization optimizes the manner in which it takes risks. 48. Financial Risk: Additional risk borne by shareholders because of a firm's use of debt. 49. Fixed Costs (overhead): A cost that is fixed for a given period of time. It is not dependent on the amount of goods and services produced during the period. Fixed costs are to a large extent dependent upon fixed assets. 50. Forward: An agreement to execute a transaction at some time in the future. 51. Future: An agreement to execute a transaction at some time in the future. 52. Futures Market: Where futures contracts are traded. 53. Growth: Stocks of companies that have an opportunity to invest in projects that earn more that the required rate of return. 54. Hedge: To take offsetting risks. 55. Hedging: The purchase or sale of a derivative security (such as options or futures) in order to reduce or eliminate risk associated with undesirable price changes of another security. 56. Inflation: A general increase in prices of goods and services. 57. Intermediaries: See Financial Intermediaries. 58. Internal Financing: Financing projects through retained earnings. 59. IPO (Initial Public Offering): Securities are offered for the first time to the public. 60. Key factor: A risk factor that is used in estimating value at risk. 61. Legal Risk: Risk relating to legal uncertainties 62. Limited Liability: Limitation of a shareholder's losses to the amount invested. 63. Liquidity: Refers to an investor's ability to convert an asset into cash. The faster the conversion the more liquid the asset. Illiquidity is a risk in that an investor might not be able to convert the asset to cash when most needed. Moreover, having to wait for the sale of an asset can pose an additional risk if the price of the asset decreases while waiting to liquidate. 64. Listing: When a company's stock trades on an official exchange. 65. Long-term gain: A gain on the sale of a capital asset where the holding period was six months or more and the profit was subject to the long-term capital gains tax. 66. Market risk: Risk from changes in market prices. 67. Market value: The value at which an asset trades, or would trade in the market. 68. Marketable Securities: Security investments that the firm can quickly convert into cash balances. 69. Maturity Date: The date on which the last payment on a bond is due. 70. Net Present Value (NPV): A project's net contribution to shareholders wealth, which is determined by the present value of a project's cash flows less initial investment. 71. Net Working Capital (NWC): Current assets minus current liabilities. 72. Operating Leverage: Capitalizing on fixed operating costs in a business enterprise 73. Operational Risk: Risk from mistakes or failures in operations. 74. Opportunity Cost of Capital: The expected return that is foregone by investing in a project rather than a financial security with comparable risk. 75. Over-valued: An asset whose market value is greater than its intrinsic (formula or theoretical) value. 76. P/E Ratio: Price to earnings ratio. The price of a share of stock divided by earnings per share of stock for a twelve-month period. 77. Payment Date: Date on which dividends are paid to registered owners. 78. Payout Ratio: Percent of earnings that is paid out as dividends. 79. Portfolio: A combination of assets. 80. Premium :(1) This generally refers to extra money an investor is willing to pay to buy something. (2) For a bond, a premium is the amount for which the security sells above its par value. 81. Prepayment: The payment of a debt prior to its being due. 82. Quote: The highest bid to buy and the lowest offer to sell a security at a given time. (See: Ask, and Bid) 83. Real Assets: Tangible assets include: plant and equipment; intangible include: technical expertise, trademarks & patents. 84. Regular Dividend: Dividend that is expected to be maintained at regular time intervals. 85. Retained Earnings: Earnings not paid out as dividends. 86. Return on Equity: The return on the equity shareholders’ funds = Paid up capital and reserves and surplus. Formula = {PAT (-) Preference share dividend}/Paid up capital + reserves and surplus. 87. Risk Factor: A random variable whose uncertainty represents a source of risk. 88. Risk Limit: A procedural tool for managing risk. 89. Risk: Exposure to uncertainty. 90. Short Term Gain (Loss): The gain (loss) realized from the sale of securities or other capital assets held six months or less. 91. Transaction Costs: The costs of transacting trades. 92. Turnover: The total money value of currency contracts traded is calculated by multiplying size by the number of contracts traded. 93. Under-valued: An asset that is selling at a price below its intrinsic (theoretical or formula) value. 94. Venture Capital: Capital supplied to particularly high-risk projects, such as start-ups or to companies denied conventional financing. 95. Weighted Average Cost of Capital (WACC): The sum of the implied or required market returns of each component of a corporate capitalization, weighted by that component's share of the total capitalization. See also Economic Value Added (EVA). 96. Window-dressing: Where financial institutions or companies raise funds for specific reporting dates such as year ends to give the appearance of high liquidity. 97. Working Capital. Current assets minus current liabilities. | ||
Sunday 11 September 2011
Fm-SSF concepts & short notes
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