Module 3

Basics of Financial Management

for Real Estate
Financial Management

Introduction:

► Finance may be defined as an art and science of managing [Link]

includes financial services and financial instruments.
► Finance is also referred as a provision of money at the time when it
is needed.
► Finance function is the procurement of funds and their effective
utilization in business concerns.
Business Finance:

► According to Wheeler, “Business finance is that business activity

which concerns with the acquisition and conversation of capital
funds in meeting financial needs and overall objectives of business
enterprise”.

► According to Guthumann and Dougall, “Business finance can

broadly be defined as the activity concerned with planning, raising,
controlling, administering of funds used in the business”
Financial Management:

▶ Introduction: it is an integral part of

overall management. It is concerned with
the duties of the financial manager in the
business firm. The term financial
management has been defined by
Solomon, “It is concerned with the
efficient use of an important economic
resource namely, capital funds”.
Approaches to Financial
Management:
Traditional approach:

Under this approach the role of financial management was

limited to the procurement of funds on suitable terms. The
utilisation of funds was considered out of the scope of financial
management
Limitations of Traditional Approach
Modern Approach:

The modern approach considers the term financial

management in broad sense. According to this approach,
the finance function covers both acquisition of funds as
well as there efficient utilisation.

This approach presents analytical way of looking into the

financial problems of the business.

According to this approach the financial management is

concerned with the solution to 3 major problems to finance:
3 Problems:
3 major Decisions:
Characteristics of Modern Approach:

• Financial Management is an Essential Part of Top management

• Continuous Function
• Wide Scope
• Centralised nature
• Applicable to all types of organisations
• Inseparable relationship between finance and other types of
activities
Functions of Financial Management:

• Determining the financial needs

• Financing Decision
• Investment Decision
• Working Capital decision
• Dividend policy decision
• Finance control
• Routine Function
Objectives or Goals Of Financial
Management:

Wealth
Maximization

Profit
maximization
Profit maximization:

According to this approach , all activities which increase profits should

be undertaken and which decreases profits should be avoided.

Profit maximization implies that the financial decision should be

guided by only one test, which is, select those assets , projects and
decisions which are profitable and reject those which are not.
 Criticism of Profit maximization
approach:

• Ambiguous
• Ignores the time value of Money
• Ignores Risk Factor
• Ignores Future Profits
• Ignores social obligation of Business
 Wealth Maximization:

This approach is now universally accepted as an appropriate criterion for

making financial decision as it removes all the limitations of profit
maximization approach.

It is also known as Net Present value (NPV) maximization approach.

According to this approach the worth of an asset is measured in terms
benefit received from its use less the cost of its acquisition.
Profit Maximization v/s Wealth
Maximization

• It uses cash flow instead of accounting profits

• It gives due importance to the time value of money

• It gives due importance to payments of Regular dividends

• It gives due importance to risk factor and analyses risk and

uncertainty
Functions of Financial manager:

• Financial planning
• Procurement of funds
• Coordination
• Control
• Business forecasting
• Other functions: cash management, credit
management , accounting etc.
Importance of Financial management:

• Helpful in acquiring Sufficient funds

• Proper utilisation of funds
• Proper cash management
• Proper use of profits
• Maximization of wealth
• Useful for shareholders
• Useful for Investors
• Useful for banks, financial
institutions etc
Financial Management

Todays agenda
► Time value of money
concept
► Concept of Compounding
► Concept of discounting
► Illustrations for practice
Financial Management

Concept:

► Time value of money means that the value of money is

different in different time periods.
► The value of money received today is more than the
value of the same
amount receivable at some other time in future.
► In other words, the money receivable in future is less
valuable then the same amount received today
Financial Management

Reasons:

► Risk
► Preference for present
consumptions
► Inflation
► Re Investment Opportunities
Financial Management

Techniques of time value of money:

► The cash flow arising at different periods of time can be made

comparable by using any of the following 2 techniques:
A. Compounding technique
B. Discounting or Present value technique
Financial Management

Compounding technique:

► This technique is used to calculate the future value (FV) of

present money.
► In this technique interest earned on the initial deposit
(initial principal)
becomes part of the principal at the end of first
compounding period.
► Thus the principal plus interest at the end of the period
becomes the principal amount for calculating interest for
the next period.
Financial Management

Compounding technique to find future value can be discussed with reference to:

► Future value of single present cash flow

► Future value of a series of equal cash flows
Financial Management

Future value of single present cash flow

n
► FV = PV (1+r)
► Where:
► FV= Future value
► PV = Present value
► r = Rate of interest
► n = number of payment
periods
Financial Management

Qus:
► Mr. x deposits 50,000 at 6% p.a for five years compounded
annually. How much will he get at the end of 5 years?
► Mr. Y deposits 10,000 for a period of 3 years at 8% p.a interest
compounded half yearly. What will be the total amount after 3
years?
Financial Management

Future value of a series of equal cash flows:

► In many instances a firm may be interested in the future value

of a series of equal payment or receipts made every year for a
number of years consecutively.
► For example: a firm deposits 10,000 each year at the end of
each year for
next 5 years. It is known as annuity of deposit of 10,000 for 5
years
► Note: when the cash flow occurs at the end of each period the
annuity is called regular annuity or deferred annuity .
► If the cash flow occurs at the beginning of each period the
annuity is
called annuity due.
Example
Financial Management

Qus for practice:

► A 5 year annuity of 6,000 per year is deposited in bank that

pays 8 % p.a interest compounded yearly. Find out total amount
available to the depositor at the end.
► Suppose you invest Rs 2000 per year in a stock index fund,
which earns 9% per year, for the next ten years, what would be
the closest value of the accumulated value of the investment
upon payment of the last instalment?
Financial Management

Discounting or Present value technique:

► After ascertaining the FV of present money, the process of

ascertaining the PV of a future sum can be discussed.
► This process is exactly opposite of compounding technique
and is known
as Discounting technique.
Financial Management

The discounting technique to find out

pv can be discussed in reference to:

► PV of a single future cash flow

► PV of a series of equal future cash
flows or annuity
► PV of a series of unequal future
cash flows
► PV of perpetuity
Financial Management

Qus for practice:

► Mr Arun is likely to receive 40,000 after 3 years. If the rate of

interest is 10% p.a. compounded annually , what is its
present value.
Capital Budgeting: Introduction

Capital Budgeting: Introduction

► The most important function of financial management is

not only the procurement of external funds for the
business but also to make the efficient and wise allocation
of these funds.
► The allocation of funds means the investment of funds in
various assets
and other activities. It is also known as “Investment
decision”
► The investment can be in short term or current assets and
long term or fixed assets.
► Investment decision related to long term assets are called long
term investment decision, they are widely known as capital
budgeting or capital expenditure decision.
Meaning of Capital Budgeting:

► Capital budgeting is a technique of making decisions for

investment in long term assets. It is a process of deciding
whether or not to invest the funds in a particular assets, the
benefits of which will be available over a period of time longer
than one year.
 Features:

• Funds are invested in long term assets.

• Funds are invested in present times in anticipation of future
profits.
• The future profit will occur to the firm over a series of year.
• Capital budgeting decisions involve a high degree of risk
because future
benefits are not certain.
Significance of Capital
Budgeting:

• Such decisions effect the

profitability of the firm.
• Long term period
• Irreversible decision
• Involvement of large amount of
funds
• Risk
• Most difficult to make.
Objectives:

• To ensure efficient control over capital

expenditures.
• To provide for cash needs for fulfilment of capital
projects.
• To ensure maximisation of profits.
• To determine the priorities of capital expenditure.
Problems:

• Risk and future

uncertainty
• Time element
• Difficult to measure
• Capital rationing
Kinds of capital Budgeting decision:

• Accept – reject decision

• Mutually competitive
decision
• Priority order decision
Financial Management

Capital Budgeting- Techniques

There are two criteria for Capital expenditure

Decision:

[Link] Profit criteria

2. Cash flow criteria

Methods:

1. Average rate of Return Method – Accounting profit criteria

2. Pay Back Method – Cash flow criteria

3. Net Present Value Method

4. Profitability Index

5. Internal rate of Return Method

Discounted cash flow criteria
 Which is Better?

Cash Flow Criteria is preferred as compared to Accounting profit criteria

because of following reasons:

1. In case of cash flow criteria , it is possible to consider time value

of money.

2. Cash flow criteria is based on cash flows rather than accounting

profits,
therefore it avoids accounting uncertainties.
Traditional Methods:

Average rate of
return method

Pay back method

1. ARR Method

ARR = Average annual profit after Tax * 100

Average Investment

Average annual profit after tax= Total of after tax profit of all years
Number of years

Average Investment= Original Investment + salvage value

2

Profit after tax means, profit after Dep. And taxes

 Advantages:

1. Simple

2. Entire life time of the project is considered

Disadvantages:

• It uses accounting income rather than Cash flows

• Time value of money not considered

• Difficult to fix a pre determined rate

• Size of investment not taken into consideration

 Payback Method:

• This method is the simplest and perhaps the most widely

employed
traditional method for appraising capital investment decision.

• This method calculates the number of years required to

payback the original investment in the project.

• In other words, PBP is the period which is required to recover

the original investment in the project.
 Methods to calculate PBP:

First Method: In case of equal Cash inflows each year:

PB= Investment
Constant annual cash inflow

Second Method: This method is adopted when the project

generates unequal cash inflow each year. Under this method,
PBP is calculated by adding up the cash inflows till the time
they become equal to the original investment.
 Advantages:

1. Simple

[Link] for firms suffering from

liquidity

[Link] in case of uncertain

conditions

4. Importance of short term earnings

5. Superior to ARR method

 Disadvantages:

1. It ignores the cash flow after PBP.

2. It Ignores the time value of money

3. It does not give the accept- reject decision in case of

single project

4. It ignores the cost of capital

5. It ignores the profitability of project.

Methods based on discounted Cash
Flow:

• One of the serious limitation of the ARR and pay back

period methods is that they do not take into
consideration time value of money. Existence of interest
provides money with its time value.

• As per the time value of money concept, rupee one of

today is more valuable than rupee one a year later.

• Therefore, while deciding on investment proposals, we

generally have to find present value of future cash
flows.
Net Present Value Method (NPV):

NPV method is one of the method of Discounted Cash flow (DCF)

technique.

Under this method, Present value of cash outflow and cash

inflow is calculated and the present value of cash outflow is
subtracted from present value of cash inflow.

The difference is called NPV.

NPV= PV of inflow- PV of outflow

Evaluating a project on Basis of NPV:

• If NPV is Positive- The project may be accepted

• If NPV is negative – The project may not be accepted

• If NPV is Zero – The project may be accepted only if non

financial benefits are there.

• If one has to choose, one project out of many then the

project with
highest NPV may be selected.
Advantages:

1. Time value of money is taken into consideration

2. Full life of the project is taken into consideration

3. Wealth Maximisation
 Limitations:

1. Difficult to understand and implement

2. Difficulty in fixing required rate of return

[Link] case of two projects with unequal initial investments,

this method may not give satisfactory result.

4. In case of two projects with different lives, this method may

not
give satisfactory result.
 Profitability Index (PI):

• This is the second method of evaluating the project through

DCF (Discounted cash flow) method. This method is also called
“Cost Benefit Ratio”.

• This method is similar to NPV approach. It measures the PV of

the returns per rupee invested. A major drawback of NPV method
is that it does not give satisfactory results while evaluating the
projects requiring different initial investment.

• NPV method is considered good when initial investment in various

projects is same, whereas PI method is adopted when initial cost of
different projects is different.
Calculations:

PI can be calculated as under:

Present value of cash inflows

Present value of cash outlay(or outflow)
 Accept/Reject Criteria:

• If PI is more than 1, project will be accepted

• If PI is less than 1, project will be rejected

• If PI is 1, project may be accepted only on the basis of non

financial considerations.

• If we have to select, one project out of several projects on the

basis of PI, the project having highest PI will be selected.
Advantages:

• This method takes into consideration, time value of money.

• It considers all cash flows during the life time of the project.

• This method is more reliable in comparison to NPV, when

initial investment is different.
Dis advantages:

• This method is difficult to understand and implement.

• Calculations are complex.

 Internal rate of Return(IRR) Method:

• Another method of evaluating a capital investment decision

through DCF is IRR method.

• IRR is also known as Time adjusted Rate of return, Marginal

efficiency of Capital, Marginal Productivity of capital and yield
on investment.

• Like NPV method, IRR also takes into consideration Time value
of money
by discounting the cash flows.

• IRR is the discount rate at which present value of cash inflows is

equal to present value of cash outflows. In other words, it is a rate at
which NPV of project is zero.
Evaluation of Project:

• To evaluate the project through IRR, IRR of the project is

compared with the pre determined required rate of return. If
IRR exceeds the required rate of return, the project will be
accepted.

• On the other hand if the IRR is lower than the required rate of
return then the project will be rejected.

• It is to be noted that at IRR discount rate, NPV of the project is zero.

• Hence at positive NPV, IRR will is higher and vice versa.

Calculations of IRR:

• Step 1: Calculate the fake PBP(Pay back period) on basis of

average
cash flows.

• Step 2: Locate the closest figure to fake payback period in the

annuity table (A-4) against the row of number of years of the
project. The closest figure located in any column, the rate of
that column will be first discount rate.

• Step 3: Find NPV of the project at first discount rate located

above, find 2 discount rates one at which NPV is positive and
one at which NPV is negative.
Contd….

Step 4: Now apply the following formula to find IRR:

Lower discount rate + NPV at lower discount rate *

Diff. in [Link] NPV at lower discount rate –
NPV at higher dis. Rate
 Advantages:

• This method also takes into consideration, time value of

money.

• It takes into account all cash inflows and outflows occurring

over the
entire life time of the project.

• Its calculation is difficult, but explanation is easy.

• IRR method, does not use any rate but it determines the
rate itself.

• It is consistent with the overall objective of

maximising the shareholders worth.
Dis advantages:

• Calculation of IRR requires tedious

calculations

• Sometimes, this method

produces more than one IRR, in
such a case it becomes difficult
to accept or reject the proposal.

• It is assumed under IRR that all

cash inflows of the project are
reinvested at IRR rate. This
assumption is not valid since the
cash inflows may be utilised for
any other purposes such as
distribution of dividend.