chapter Overview of Financial Management Learning Objectives After studying this chapter you are able to understand: = Financial Objectives of a Business Firm = Profit Maximization and Wealth Maximization Objectives = Importance of Value Maximization Objective «Traditional and Modem Approaches to Business Finance «Meaning of Investment, Finance and Dividend Decisions = Comparison of Financial Management with Financial Accounting and Economics ‘# Functions of a Financial Controller ‘= Organization Chart of Finance Function ‘= Reasons for centralizing Finance Function Impact of Corporate, Business and Personal Taxation on Financial Management = Meaning of Tax Shield = Impact of Inflation on Business Firm «Impact of Depreciation on Business Firm Business Objective Financial Objectives of a Business Firm For long-range planning and management controls, a company establishes its overall objectives, Such objectivesare ral developed by the top management and they usually consist of general statement or a series of statements in gene terms stating what the company expects to achieve. Sometimes, the objective set may be stated in such broad terms as it is goal of the company to be a leader in technology in the industry, to achieve profits with a high level of ‘manufacturing efficiency, a high degree of customer satisfaction. For the purpose of measuring performance and ogChapter 1 Overview ol Financial Mananement 5 to set objectives o ° inthe Y to set objectives or goals in more precise terms. Objective setting is thus an important phase business enterprise, ‘ness enterprise, since upon correct abjectives setting the ene structure of the strategies, policies and plans of acompany rests. The Ofphysica tanec ast heablectives are sally in quantitaivetermsandate set withina time fame, The setting So reeatahe ciered win a Line period provides thebasisof conversion ofthe targetsinto financial certain cases, both the physical targets and the finan abjctiveg sarees they sal agen he taal tet and nan. he peimary financial + return on capital employed or return on investment + value addition and profitability + growth in earnings per share nd price/earnings ratio + growth in the market value of the share + growth in dividends to shareholders + optimum level of leverage + survival and growth of the firm + minimization of finance charges * efficient utilization of short, medium and long-term finances. Profit Maximization Profit as an objective has emerged from over a century of economic theory. In this traditional economic theory, the typical firm was small, owner managed and competing with a large number of similar firms, Under these circumstances, profit is the rational objective because: + The profit of the firm became the income of the owner. Maximization of profit then ensured the self-interest of the owner/manager, who both decide the actions ofthe flrm and ensure that these are cartied out, + The force of competition imposed profit maximization upon the firm to survive in business. The true objective of the firm is something closely related to profit. Often the objective is tied to survival, security or the maintenance of liquid assets, Each of these objectives is complementary to profit, in that the maximization of profit may ensure the attainment of that objective. The behaviour of the firm can then be modelled as ifthe firm was maximizing profit. It has traditionally been argued that the objective of a company isto earn profit, hence the objective of Financial Management is also maximization of profits, The profit maximization objective ofa firm is criticized for the following reasons: «= The concept of profit maximization ig vague and narrow. , «It ignores the risk factor, as well as, timing of returns. «It may allow decisions to be taken at the ost pfJong-run stability and profitability ofthe concern. «It emphasizes the short-run profitability and short-term projects. «It may cause to decrease in share price. = «The profits only one ofthe many objectives ofa modern firm in which the different stakeholders participate, «It fails to consider the social responsibility of business Wealth Maximization Wealth maximidation means maximizing the net present value (or weal) of a course of action. The net present aan ane of ation isthe difference between the present valve ofits benefits and present vale ofits costs vale OF eh ch haa psiiv net present value cteates wealthand therefor isdesirable financial action a negative net presentaluesouldbereeted. Between amber of esalemutvalyexcusveprojsts rest pa igher net present value should be adopted. The maximization of wealth possible by making toe a into get benefits that exceeds cots. The wealth maximization goal isadvocated onthe allowing grounds:6 Div Division One Principles of Corporate Finance AA Wakes into consideration long-run survival and growth of the firm + Itis consistent with the object of owners economic welfare: + It suggests the regular and consistent dividend payments to the shar pital ‘cholders. appreciation of the share price The financial decisions are taken with a view to Improve the ¢ It considers the risk and time value of money. + share. It considers all future cash flows, dividends and earnings Pet Maximization of firm's value is reflected in the market price of share. ealth maximization. rather than maximization of i criticized as narrow and it ignores the concept of wealth riaximization of society, since society's resources are used to the advantage ofa parila aren Tice resources should be optimally allocated, it should result in capital formation and growth of the economy. which “tmataly leads to monimisation of economic welfare ofthe society. The welfare to the Peopie & uged throug optimum utilization of resources, reasonable prices of goods made available to society, supply 0 auality pro ucts, payment of taxes to the government, contentment of suppliers, meeting the financial obligations in time, repayment of principal and interest of loans to banks and financial institutions etc = Pre vartly enabjes firm rofit maximization partly enabjes the fir aflow of profits «= The sharcholders always prefel wealth maximization The wealth maximization objective of a firm Value Maximization ‘The goal offirm isto maximize the present wealth of the ownersi-e, equity shareholders in acompAhy: ‘company’s acquit tharos are actively nein the stock maton, the wealth ofthe Gqully charsholdes i eitesenie sn the inarket value of the equity shares The firm's cashflow and its impact on value maximization is shown in figure 1 | FIGURE 1.1 FIRM’S CASHFLOW AND VALUE MAXIMIZATION + | Acquire temporary fixed assets, working capital ‘and permanent eel working capital Generate net cash inflows from operation used to fd) Sence debt idend Retained ea obligations distribution pics ores re-investment Firm's wealth maximization7 Chapter 1 Overview of Financial Management The prime goal for company form of organization is ta maximize the market 1c of equity shares of the company. The market price of vy [Hakes into account present and firm, a share servesasan indes of the performance of the canny Prospective future carnings per share, risk assoc ited with the business, dividend and retention policies of th level of, ing ete, The shareholder's wealth is maimized only when the market value af the share is maximized Inthe [Link] wealth nayinrication of Vinancial Management [Link]'valie maximization Other Objectives Sales Maximization The interests of the company are best served by the maximization of sales revenue, which brings with it the benefits of growth, market share and status, The size of the firm, prestige, and aspirations are more closely identified with sales revenue than with profit Growth Maximization Managers will seck the objectives which give them satisfaction, such as salary, prestige status and job security, On the other hand, the owners of the firm (shareholders) are concerned with market values such as profit, sales and market share. These differing sets of objectives are reconciled by concentrating oon the growth of the size of the firm, which brings with it higher salaries and status for managers and larger Profits and market share for the owners of the firm. lar Maximization of ROI The strategic aim ofa business enterprise is to earn a return on capital. [fin any partic case, the return in the long-run is not satisfactory, then the deficiency should be corrected or the activity be abandoned fora more favourable one. Measuring the historical performance of an investment centee calls for a comparison of the profit that has been earned with capital employed. The rate of return on investment is. determined by dividing net profit orincome by the capital employed or investment made to achieve that profit. Return on investment analysis provides a strong incentive for optimal utilization of the assets of the company. This encourages managers to obtain assets that will provide a satisfactory return on investment and to dispose of assets that are not providing an acceptable return. In selecting amongst alternative long-term investment proposals, ROI provides a suitable measure for assessment of profitability of each proposal. Social Objectives The business enterprise isan integral part ofthe functioning of a country. As such, in return {or the privileges and rights granted to itby the state, the business firm shouldbe made increasingly responsible for social objectives. The profits are not merely an objective, they are the very reason for the existence of the business enterprise. The assumption of profit maximization has the enormous advantage of enabling decisions to be modelled. But at the same time nonprofit maximizing theories cannot be ignored. Approaches to Business Finance Traditional Approach Finance is the life blood of any business firm.’Financial Management study about the process of procuring and judicious use of financial resources with a view to maximizing the value of the firm thereby the value of the owners i.e,equity shareholdersin acompany is maximized, Financial Managementis primarily concerned with acquisition, financing and management of assets of business concern in order to maximize the wealth of the firm for its owners. , The basic responsibility of the Finance Manager is to acquire funds needed by the firm and investing those funds in profitable ventures that will maximize firm's wealth, as well as, yielding returns to the business concern, The success or failure of any firm is mainly linked with the quality of financial decisions. The focus of Financial Managements on efficient and judicious use of resources to attain the desired objective ofthe firm. The traditional view of Financial Management looks into the following functions, that a Finance Manager of a business Fim will perform: , _/® Arrangement of short-term and long-term funds from financial institutions. £ Mobilization of funds through financial instruments like equity shares, preference shares, debentures, ~ bonds etc. Orientation of Finance function with the Accounting function and compliance of legal provisions.8 wisn One Principe of Compenate Finance er is not just confined ance Manag we at funls available to thy efficient With the increase in complexity of modern business situation the role of Fl Procurement of funds, but his area of fet tended to juticions an aren of func tioning is extended to jie iou eae firm. keeping in view the objectives of the firm and expectations of the providers of 1 Me lodern Approach fanomy and it as created a ney Globalization has cause! to integrate the national econamy with the worl TT nese concerns. Thishas and challenges (0 tne ization. Financial Management financial environment which brings new opportuniti on and its respon sity in vi distress and are t" int has assumed lites in the organ over! ef rere toovercoe ime preacer significance. TiS now a Thpragmatic readjustment of Financia i imancial Management and Finance Officer (CFO) changes from rected to analyze the firm and Jed to total retormation of the Finance func ment policy changes. Today’ in India has changed substantially in scope and comple yy innovative means Finance Managers are seized with problems of financial In the current economic scenario, Financial Manageme ei question of survival of entities inthe total spectrum of economic acti, 1 Management The information ag has given afresh perspective O70 pinance Managers With the shift in paradigm itis imperative that the TOE OF i exp Controller toa Facilitator. In view of modern approach, the Finance to determine the following: + total funds requirement of the firm, + assets to be acquired, and + pattern of financing the assets. f Financial Decisions Classification o' ve in the following three types of decisions se Finance Manager of a modern business firm will generally involve in t The Fane Mao oto) nance ds and (c) Dividend decisions: (a) Investment decisions, (b) Finance decisions, ions 1s are those which determine how scarce resot be as small as purchase of an equipmen tment in working capital in the form of a sectncnt which enhance internal growth is termed as ‘infernal investment’ and acquisition of entities represents antennal mvestment’ The investment decisions should aim at investment in assets only when they are expected to an a minimum acceptable return, which is also called as ‘hurdle rate’. The firm should select ¢ rate of return on the projects urcesin terms of funds available are committed to t oras big as acquisition of an entity. Investment f inventory, receivables, cash et Investment Decis Investment decision: projects. The project may in fixed assets require supporting inves carn a return greater th only those capital investment proposals whose net present value is positive and th should exceed the marginal cost of capital. In situations of capital rationing, the investment proposals are selected based on maximization of net present value. The profitability of each individual project will contribute to the overall profitability ofthe firm and leads to creation of wealth, The investment decisions of a Finance Manager cover the following areas «+ Ascertainment of total volume of funds, a firm can commit «+ Appraisal and selection of capital investment proposals + Measurement of risk and uncertainty in the investment proposals + Prioritizing of investment decisions + Funds allocation and its rationing + Determination of fixed assets to be acquired + Determination of levels and management of investments in current assets + Buy or lease decisions + Asset replacement decisions + Restructuring, reorganization, mergers and acquisitions + Securities analysis and portfolio managementeee} awa ay c=t-¥ Working Capital Management Worxwnec: apital is defined as the excess of current assets over current liabilities. Working capital refers 's Pi toa firm's investment in short-term assets viz, cash, short-term securities, amounts teceivables and inventories of raw materials, work-i focess and finished goods. The management of working capital is no less important than the management of long-term financial investment. Lack of efficient Cand effective utilization of working capital leads to earn low rate of return on capital employed or even compels to sustain losses. Working capital toa company is like the blood to human body. Chapter nine discusses about classificatian of working capital, operating cycle concept, computation of operating cycle period, measures to reduce operating cycle, working capital policies, strategies in financing working capital, overtrading, over capitalization, under capitalization. Chapter ten discusses about determinants of working capital need, working capital estimation methods, cash cost approach to working capital estimation, ‘estimation of working capital need in case of seasonal industries, shift working and inflationary conditions and computation of working capital leverage. Chapter 11, 12and 13 discuss about the management of inventory, receivables and cash assets. Chapter 14 discusses the aspects of financing working capital and costo taking credit. The chapter also discuss the meaning and mechanism of factoring and forfating. Chapter fiteen discusses the different modes of financing international trade which needs special attention for export business. It includes aspects of credit risk and need for insurance of [Link] the aspects of preshipment and postshipment trade finance.Chapter Working Capital Planning Learning Objectives A ir rer studying this chapter you are able to understand: Meaning of Working Capital Objectives of Working Capital ‘Management Items included in Current Assets and. ‘Current Liabilities Meaning of Gross and Net Working Capital “Meaning of Permanent and Temporary Working Capital Meaning of Positive and Negative Working Capital Concept of Operating Cycle Computation of Operating Cycle Period Reasons for prolonged Operating Cycle Measures to Reduce Operating Cycle Working Capital Policies and Level of Current Assets Conservative and Aggressive Working Capital Management Strategies Hedging Strategy of Working Capital Management Zero Working Capital Strategy Impact of Overtrading on Working Capital Meaning of Overcapitalization and Under capitalization Symptoms of Poor Working Capital Management ‘Measures to overcome Working Capital Crunch Classification of Working Capital Meaning of Working Capital Working capital manager in keeping the wheels of a financial decisions. Shortage 166 = sment isa significant in Financial Management due to the fact that it plays a pivotal role business enterprise running, Working capital management is concerned with short;term) ‘cof funds for working capital has caused many businesses to fail and in many cases has agChapter 9 Working Capita Planning 167 retanted theit growth, Lack of offic 1 and eflective utilization of working capital leads to earn low rate of return esoenennane SLELEN compels to sustain losses. The need for skilled working capital management ieee working capital estore fim invests a part of is permanent capita in fixed assets and keeps part ofitfor amount of workingeapial fee 8819 day eequitements, We wll hardly find a firm which doesnot requite any Spending upon the ne tts normal operations. The requirement of working capital varies from firm to firm ot apply te Work’ of business production policy. marke conditions, seasonality of operations conditions ue BE capital to-a company is ike the blood to human body. Its the most vital ingredient of a Working capital man, “gement if carried out effectively, efficiently and consistently, will ensure the health of an : Spiked nt TYeMsits funds for long. term purposes and for short-term operations. That portion of acompany’scapital, invested in short. ‘erm or current assets to carry on its day to day operations smoothly, is called the working capital, Working capital refers to a firm's investment in short-term assets viz., cash, short-term Sete ara ounts receivables and inventories of raw materials, work-in-process and finished goods. It refers toall aspects of current assets and current liabilities, The management of working capital sno les important than the management of long-term financial investment. Sufficient liquidity is necessary and must be achieved and maintained to provide that fund's to payoff obligation as they arise or mature, The adequacy of cash and other content asses together with ther effcient handling virtually determine the survival ofthe company. The efficient working capital management is necessary to maintain a balance of liquidity and profitability If the funds ae tied- spisilecarent assels represent poor and inefficient working capital management which affects the firm's liquidity constant price + That replenishment ism FOQ Per unit, Le. there are no price discounts lade instantaneously, ie., the whole batch delivered at once. Sh otimum quantity of materials to he ordered after consideration of the following four categories of costs: Ordering Costs Thesearethe. production within the firm. Costsassociated with acquiring theinventory purchased from external sources or with. 6 of information processing on inventory + Costs of reviewing, locating so status eviewing re negotiating prices and delivery terms / + Preparation of purchase order + Costs of receiving goods / + Documentation processing costs v + Transport costs + Intermittent costs of chasing orders, rejecting faulty goods / Costs of receiving stocks against orders, checking, recording, inspection, billing ei. + Additional costs of frequent or small quantity orders + Where goods are manufactured internally, the setup and tooling costs associated with each production run, Carrying Costs These costs are sociated with the possession or holding of inventory. They will include: + Storage costs (rent, lighting, heating, refrigeration, air-conditioning etc.) «Costs of money tied up in inventory + Stores staffing, equipment maintenance and running costs + Handling costs , + Rates, taxes and insurance + Audit, stock taking or perpetual inventory costs + Required rate of return on investment in current assets + Obsolescence and deterioration costs + Insurance and security costs + Costs of money tied up in inventory + Pilferage and damage costs , Stock-out Costs The stock-out costs are associated with running out of stock. These costs are relatively difficult to assess, yet they are very pertinent to decisions on inventory, Twotypes of shortage costs arse: one cases oflost sales land the other case is back order - customers may wait for sometime for delivery. To expedite delivertextra costs by ‘way of overtime, high cost delivery, special concession etc. may be incurred. These costs include: «= Lost contribution through the lost sales caused by the stock-out «Loss of future sales because customers go elsewhere + Loss of customer goodwill Cost of production stoppages caused by stock-outs of WIP or ray material « Labour frustration = Over stoppages Extra costs associated with urgent replenishment purchases of small quantities208 Division One Principles of Corporate Finance The EOQ can be determined graphically as illustrated in figure 1-1 FIGURE 11.1. GRAPHICAL DETERMINATION OF £00. ‘ oe 7 ° £0Q (Units) Order quantity The following formula is used in calculation of EOQ; — 2AB Eoq = ,/2ZAB — — \cs Where, A = Annual consumption = Cost per unit B = Cost of placing an order S_ = Storage and other inventory carrying cost The above formula can be modified to fit into the circumstances in which some of these assumptions do not hold. ‘The rationale of EOQ ignores buffer stocks which are maintained to cater for variations in lead time and demand. ‘The EOQ isan operational research technique that includes riskand uncertainty asa part of the study and thusassists management decision-making and control, Illustration 11-3' The budgeted sales and cost of sales of Rahaman Brothers for coming year are 15 crore and? 10 crore respectively. The current level of inventory is 5 times. Considering that inventory is financed at an average cost of 10% p.a. Calculate the expected cost saving for budget period by doubling the inventory turnover. sa Current level of inventory held = €10crores/5 = @ 2 crores With stock turnover doubling, the average level of inventory will be @ 1 cr. .. Inventory carrying cost = @l crore x 10/100 = @ 10 lakhs IMlustration 11-4’A manufacturer used 400 units of a component every month and he buys them entirely from an outside supplier @ @ 40 per unit. The order placing and receiving cost is € 100 and storage and carrying cost is 15% of the value of stock. Calculate EOQ., is ge Annual consumption = 400 units x 12 months = 4,800 w | 24,800 units x ® 100 BOQ = | e40x15/100 = 400 units 5 ‘The annual demand of a certain component bought from the market ° is 1,000 units, - the carrying cost per unit is®3 p.a. Calculate the Economic OniecOegen te ott rder Quantity for the item. Mlustration 11~ placingan order ist 60and : 21,000 units x® 60 i Cn a = 200 unitsChapter 11 Inventory Management 209 Wlustration 11-6 ‘rh, annual dema per unit per annum is 259 Hemand for a product is 6,400 units, The unit cost is 26 and inventory carrying cost S25 of the average inventory cast the cost af procurement is? 75, what isthe time between two consecutive orders, == E0Q 25 6.400 units 75 800 units x \ tox asian lo. of orders p.a a Ad = 6,400 units/800 units Borders ‘ lween two orders 12 months/8 orders = 1.5 months £0Q with Discounts. A particularly unrealistic oo aa oe assumption with the basic EOQ calculation is that the price per item remains constant. ally some foi iscount can be obtained by orderin, ties, Such price discounts can be aiated i ained by ordering increasing quantities. Such pri incorrorate into te EOQ formula, but it becomes much more complicated. A similar approach isto consider the costs ass with the normal EOQ and compare these costs with the costs at each succeeding discount point and then ascertain the best quantity to order. + Beneficial Effects - Savings will come from: (a) Lower price per item, and (b) Thelarge order quantity means that fewer orders need tobe placed and hence, ordering costs are reduced. + Adverse Effects - Increased costs arise from the extra stockholding costs caused by the average stock level being higher due to the larger order quantity. Mlustration 11-7 From the following particulars with respect to a particular item of materials of a manufacturing company, calculate the best quantity to order: Ordering quantity (tons) Price per ton (@) Lessthan 2500 ~ 6.00 250 but less than 800 590 £800 but less than 2,000 ~ 5.80 2,000 but less than 4,000 5.70 4,000 and above 5.60 ‘The annual demand for the material is 4,000 tons, Stock holding costs are 20% of material cost per annum. The delivery cost per order is ® 6.00. Statement Showing the Optimum Ordering Quantity of Materials ‘Annual demand (Tones) 4000 4,000 4,000 4,000 4,000 Order size (Tones) 200 = 250-800 2,000 4,000 No. of orders (Annual demand/Order size) 20 16 5 2 1 Price per ton ® 600 5905.80 5.70 5.60 Value per order (Order size Price per ton) 120014754640 11,400 22,400 Average inventory _(Value per order x 1/2) _ 6007382320 5,700__11,200 Pee a oo ®@) Ordering cost. _-—_—(No. of orders x€6.00) 120 36 30 2 6 Carrying cost (20% of item 6) 120 148, 464 1,140 2,240 @ HO 48S 2.286 demand x Price) (b) 24,000 23,600 23,200 22,800, 22,400 rascal Com (a) +(b) 24240 23,844 23,694 23,952 24,646 21 800 tones order size is¥ 23.694, Therefore, the best quantity tobe ordered is 800 tones, 800 s. Total ordering and carrying cost ‘Annual cost of material (Annual +. The total minimum cost:a Inventory Levels Various levete tory are fi sar mn excese inventory iscarried and simuttaneousty there will nat be Bny Strack ete The ctock mowemente and the fixation of stock levels 18 explained in gure 11.2 falloweing invents level are fixed for each item of stock Reorder Level Ie leve! ot tock availability when new order shouldbe raised The stores departenent will initiate the purchase v/ratevial when the stock of material reac hee at this pit. This evel fixed between the minimum and maximum stock levels and the following formula is useful for this purpose: Maximum Ucage » Mavimum Lead Time Minimum Stock Level Irs the lower limit holon which th stock of any stckitem should not normally be allowed to fll. Theit levels also alle ster) stock or ufier stack level: The main object of establishing this level is to protect against stock-out of 2 povticvlay stk item and in fination of which average rate of consumption and the time required for replenish ment. ic. lead time are given prime consideration Reorder Level - (Average or Normal Usage x Average Lead Time) Maximum Stock Level Iv represents the upper limit beyond which the quantity of any item is not normally allowed to rise to ensure that unnecessary work ing capital is not blocked in stock items, Maximum stock level represents the total of safety stock leve! and economic order quantity. Maximum stock level can be expressed as below: Reorder Level + Economic Order Quantity - (Minimum Usage x Minimum Lead Time) Danger Level 11s fixed below the minimum stock level and if stock reaches below this level, urgent action for replenishment of ‘stock should be taken to prevent stock out position,“ - ‘average Consumption x Lead Time for Emergency Purchases, Average Stock Level In as the average of minimum and maximum stock levels. (Minimum Stock Level + Maximum Stock Levell/2 ‘or Minimum Stock Level + 1/2 Reorder Quantity FIGURE 11.2 FIXATION OF STOCK LEVELS Masson eve | ton | ta | fender Level |