Chapter-4

Financial Management

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.

Scope/Elements of Financial Management

1. Investment decisions includes investment in fixed assets (called as capital budgeting).
Investment in current assets are also a part of investment decisions called as working capital
decisions.
2. Financial decisions- They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the
returns thereby.
3. Dividend decision- The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning capacity,
market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital so
that a balance is maintained between debt and equity capital.
Functions of Financial Management
1. Estimation of capital requirements: A finance manager has to make estimation with
regards to capital requirements of the company. This will depend upon expected costs and
profits and future programmes and policies of a concern. Estimations have to be made in an
adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity analysis.
This will depend upon the proportion of equity capital a company is possessing and
additional funds which have to be raised from outside parties.
 3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period of
financing.
4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager. This
can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other benefits
like bonus.
b. Retained profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintainance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. This can be done through many techniques
like ratio analysis, financial forecasting, cost and profit control, etc.

Importance of Financial Management

A company may go awry and incur losses without sound financial management. The following
points highlight its importance:

 It helps a business to organize its finances and acquire the necessary capital.
 It is crucial for efficient and effective use of borrowed money.
 Businesses need financial management to make financial decisions.
 It is essential for executing plans in light of up-to-date financial reports and data on relevant key
performance Indicators.(KPIs).
 It ensures that the company is adhering to all the legal requirements on financial aspects.
 It ensures that each department operates within budget and in alignment with strategy.

Financial Goal - Profit vs Wealth

Every firm has a predefined goal or an objective. Therefore the most important goal of a
financial manager is to increase the owner’s economic welfare. Here economics welfare may
refer to maximization of profit or maximization of shareholders wealth. Therefore Shareholders
wealth maximization (SWM) plays a very crucial role as far as financial goals of a firm are
concerned.
Profit is the remuneration paid to the entrepreneur after deduction of all expenses.
Maximization of profit can be defined as maximizing the income of the firm and
minimizing the expenditure. The main responsibility of a firm is to carry out business by
manufacturing goods and services and selling them in the open market. The mechanism of
demand and supply in an open market determine the price of a commodity or a service. A firm
can only make profit if it produces a good or delivers a service at a lower cost than what is
prevailing in the market. The margin between these two prices would only increase if the firm
strives to produce these goods more efficiently and at a lower price without compromising on the
quality.

The demand and supply mechanism plays a very important role in determining the price of a
commodity. A commodity which has a greater demand commands a higher price and hence may
result in greater profits. Competition among other suppliers also effect profits. Manufacturers
tend to move towards production of those goods which guarantee higher profits. Hence there
comes a time when equilibrium is reached and profits are saturated.

According to Adam Smith - business man in order to fulfill their profit motive in turn
benefits the society as well. It is seen that when a firm tends to increase profit it eventually
makes use of its resources in a more effective manner. Profit is regarded as a parameter to
measure firm’s productivity and efficiency. Firms which tend to earn continuous profit
eventually improvise their products according to the demand of the consumers. Bulk production
due to massive demand leads to economies of scale which eventually reduces the cost of
production. Lower cost of production directly impacts the profit margins. There are two ways to
increase the profit margin due to lower cost. Firstly a firm can produce at lower sot but continue
to sell at the original price, thereby increasing the revenue. Secondly a firm can reduce the final
price offered to the consumer and increase its market thereby superseding its competitors.

Both ways the firm will benefit. The second way would increase its sale and market share while
the first way only tend to increase its revenue. Profit is an important component of any business.
Without profit earning capability it is very difficult to survive in the market. If a firm continues
to earn large amount of profits then only it can manage to serve the society in the long run.
Therefore profit earning capacity by a firm and public motive in some way goes hand in hand.
This eventually also leads to the growth of an economy and increase in National Income due to
increasing purchasing power of the consumer.

Risk and Return

Risk and return in financial management is the risk associated with a certain investment and its
returns. Usually, high-risk investments yield better financial returns, and low-risk investments
yield lower returns. That is, the risk of a particular investment is directly related to the returns
earned from it.

The risk and return analysis aim to help investors find the best investments. Hence, investors use
many methods to analyze and evaluate the market, industry, and company. Diversification of the
portfolio, i.e., choosing an optimal mix of different investment options, can reduce the risk and
amplify returns.
Risk and Return in Financial Management Explained

Risk and return in investing are perhaps the most crucial parameters considered by investors
while choosing an investment option. Individuals who invest on a large scale analyze the risks
involved in a particular investment and the returns it can yield. Let’s take a step-by-step
approach to understand the concept.

First, let’s begin with risk. A risk can be defined as the uncertainty related to the investment,
market, or company. Investors want profits, and the risks can potentially reduce the profits,
sometimes even making a loss for them.

Many types of risk are involved in investments – market-specific, speculative, industrial,

volatility, inflation, etc. However, studying the market thoroughly can help investors make the
right decisions. They can analyze the trends and forecast the situation.

Now, let’s understand return on investment, or ROI. It can be explained as the financial gains
from investing in a certain investment. Ideally, individuals prefer investments that give them
higher returns, like stocks of Google, Amazon, etc.

Relationship between Risk and Return

The correlation between financial risk and return is fairly simple to comprehend. The risk in
choosing a certain investment is directly proportional to the returns. Therefore, selecting a high-
risk investment can give higher profits, while a low-risk investment will minimize the returns.

So, plotting a graph between the risk of investment and returns will give a straight line passing
through the center.
Risk & Return Analysis Methods:
Payback Period Method

Capital Budgeting is one of the important responsibilities of a finance manager of a company.

The capital budgeting process involves identifying and evaluating capital projects, that is, the
projects in which a business entity would receive cash flows over a period of more than one year.

Since the capital projects involve investment decisions in long term assets, sound capital
budgeting decisions become all the more important.

This is because such decisions cannot be reversed at a low cost given the large amount that
makes up the long term assets of the business entity.

Various capital budgeting techniques are used to help management evaluate various investment
projects. Payback Period is one of the techniques used to analyze whether a particular investment
project should be accepted or rejected.

What is Payback Period?

Payback Period is the number of years it takes to recover the initial investment or the original
investment made in a project. It is based on the incremental cash flows from a particular
investment project.

Thus, various investment proposals are evaluated based on the number of years it takes for a
business entity to recover the initial cost of the investment proposal. Typically, the investment
project with a shorter payback period is preferred over alternate investment projects.

Characteristics of Payback Period Method

 Payback Period method is one of the traditional methods of capital budgeting. It helps a
business entity decide upon the desirability of an investment proposal based on the useful
life and the expected returns of a project.
 This method does not take into account time value of money which is an important factor
in determining the desirability of an investment project used in other capital budgeting
methods.
 Payback Period is one of the oldest and simplest methods to evaluate investment
proposals and is widely used in the small scale sector.
 Payback period is calculated based on the information available from the books of
accounts of a business entity.
Advantages of Payback Method

The main advantages of payback period are as follows:

1. A longer payback period indicates capital is tied up.

2. Focus on early payback can enhance liquidity
3. Investment risk can be assessed through payback method
4. Shorter term forecasts
5. This is more reliable technique
6. The calculation process is quicker than and simple than any other appraisal techniques
7. This is a very easily understood concept

Disadvantages of Payback Period Method

There are numbers of serious drawbacks to the payback Period Method:

1. It ignores the timing of cash inflows within the payback period

2. It ignores the cash flow produced after the end of the payback period and therefore the
total return of the project.
3. It ignores the time value of money
4. It influences for excessive investment in short term projects.
Example:A Machine costing $ 240,000 is to be depreciated over ten years to a nil residual
value. The profits after depreciation for the first 5 years are as follows:

Year Profits after Depreciation

1 22,000
2 27,000
3 39,000
4 49,000
5 18,000

Solution:

Profit after Cumulative Cash

Year Depreciation Cash flow ($)
depreciation Flow ($)
1 22,000 24,000 46,000 46,000
2 27,000 24,000 51,000 97,000
3 39,000 24,000 63,000 160,000
4 49,000 24,000 73,000 233,000
5 18,000 24,000 42,000 275,000

Payback Period = 4 years + (275,000 – 233,000)/73,000 * 12 months = 4.7 years.

Net Present Value Method:
The basic financial concept of time value money states that the money you have known is more
valuable than the money you collect later on. This is because you can use it now to earn more
money by running a business or buying something now and selling it later for more, or simply
putting it in the bank and earning more interest. The money received in the future is also less
valuable because inflation erodes its purchasing power. But how do you compare the value of
money now with the value of money in the future? This is where net present value plays an
important role. Net Present Value or NPV is the sum of the present value of cash inflows and
outflows. In other words, it is the difference between the present values of cash inflows and the
present value of cash outflows over some time.
Net Present Value Formula
NPV is a strong approach to determine if the project is profitable or not. It considers the interest
rate, which is generally equivalent to the inflation rate, Hence, the real value of money now at
each year of operation is considered.
Following are the formulas used to calculate NPV.

Present Value = (Future Value cash flow)/(1 + r)n

Here,
 r is the interest rate.
 n is the number of years.

NPV Decision Rule

The following NPV signs explain whether the investment is good or bad.

NPV > 0 - The present value of cash inflows is more than the present value of cash outflows.
The money earned on the investment is more than the money invested. Hence, it is a good
investment.

NPV = 0 - The present value of cash flows is more than the present value of cash outflows. The
money earned on the investment is equal to the money invested. Therefore, there is no difference
between cash inflows and cash outflows.

NPV < 0 - The present value of cash inflows is less than the present value of cash outflows. The
money earned on the investment is less than the money invested. Hence, it is not a fruitful
investment.
 Advantages of Net Present Value (NPV) –

The net present value of a project in business guides the finance team for making wise decisions.
Let us now go through the numerous benefits it has for the company, in the long run:

 Simple to Use: The net present value method is easy to apply to a real business project if the
cash flows and discount rate are known.
 Provides Time Value of Money: This method takes into consideration the effect of inflation
on the future profitability of the project, thus estimating the time value of money.
 Customization: In NPV, the discount rate can be adjusted according to the risk prevailing in
the industry, along with various other factors, to obtain an appropriate output.
 Determines Investment Value: The earnings throughout the project’s life span can be
acquired by using the NPV method, which facilitates the company to know the future value of
a specific investment.
 Comparable: It facilitates the comparison of values generated in the future, by two or more
similar projects to find out the most feasible option.
 Comprehensive Method: It finds the present value of a project by examining the effect of
various factors like risk, cash outflows, and inflows.
 Measures Profitability: It is one of the most proficient methods of determining the actual
profitability of a project in its lifetime.
 Identifies Risk: In the absence of NPV, the managers would fail to estimate the risk of loss or
meagre profitability in case of a long-lived project. It is otherwise possible by identifying the
project with negative or zero NPV.
 Reinvestment Assumption: The net present value is quite logical since, here the cash flows
are not expected to be reinvested in the financial market, as done in the internal rate of return.

The obvious advantage of the net present value method is that it takes into account the basic idea
that a future dollar is worth less than a dollar today. In every period, the cash flows are
discounted by another period of capital cost. Actually, the NPV method takes into consideration
the cost of capital and the risk inherent in making projections about the future.

In general, a projection of cash flows 10 years into the future is inherently less certain than cash
flows projected next year. Cash flows that are projected further in the future have less impact on
the net present value than more predictable cash flows that happen in earlier periods.

Disadvantages of Net Present Value (NPV) –

The biggest disadvantage to the net present value (NPV) method is that it requires some
guesswork about the firm’s cost of capital. Assuming a cost of capital that is too low will result
in making suboptimal investments. Assuming a cost of capital that is too high will result in
forgoing too many good investments.

The net present value (NPV) is an effective means of evaluating a project’s profitability;
however, it has certain drawbacks. These are as follows:
 Forecasting Errors: While assessing the viability of a long-lived project, the estimation of
cash flows may not be that accurate for the later years.
 Minimum Contribution to Shareholder’s Value: The shareholder’s value maximization is
the result of the overall growth of a company, whereas a high NPV contributes little towards it.
 Depends Upon Discount Rates: Since this method is based on discount rates, even a slight
change may result in an entirely different NPV.
 Neglects Sunk Cost: The sunk cost like research and development, trial, etc. incurred before
the project starts, is mostly high. This cost is wholly ignored under the computation of NPV.
 No Effect on EPS and ROE: Often, the projects with high NPV but the short duration may
not enhance the earning per share and return on equity.
 Incomparable for Differing Project Size: The concept of capital rationing is applied in NPV;
therefore, the projects which do not lie under the capital budget limit cannot be compared
under this method.

Example: 1. Assume that ABC Inc is considering two projects namely Project X and
Project Y and wants to calculate the NPV for each project. Both project X and project Y is
four-year project and cash flows of both the projects for four years are given below:
Year Project A Project B
1 5000 1000
2 4000 3000
3 3000 4000
4 1000 6750

The firm's cost of capital is 10% for each project and the initial investment amount is ＄10,000.
Calculate the NPV of each project and determine in which project the firm should invest.

Solution:

Year Project A Present Value Project B Present value

1 5000 4545.45 1000 909.09
2 4000 3305.78 3000 2479.33
3 3000 2253.94 4000 3053.43
4 1000 683.01 6750 4610.34
Total 10788.18 11004.01
Investment 10000 10000
NPV 788.18 1004.01

Answer: We can see, the NPV of project Y is greater than the NPV of project X. Hence, the firm
should invest in project Y.
Internal Rate of Return Method

The internal rate of return or IRR is the return at which the company determines the project
break even. As per the Knight's, IRR is commonly used by financial analysts along with the Net
Present Value or NPV. Both the methods are quite similar but use different variables. With NPV,
the analyst assumes the discount rate and then calculates the present value of the investment.
However, with IRR, the analyst calculates the actual return provided by project cash flows, then
compares the rate of return with the company's hurdle rate (expected rate of return). If the IRR
return is higher, it is worthwhile to invest in the project.

What is the Internal Rate of Return?

The internal rate of return is a method used to estimate the profitability of the potential
investment. It is the discount rate that makes the net present value of an investment equals zero.
The Internal rate of return method is widely used in discounting cash flow analysis, and also
used for analyzing capital budgeting method.

While calculating the IRR, the present value of future cash flows equals the initial investment of
the project, and thus makes the NPV = 0.

After calculating the IRR, it should be compared with the minimum required rate of return or
cost of capital of the project. For example, If the calculated IRR is found greater than the
minimum required rate of return, then the project should be accepted whereas If the calculated
IRR is found lesser than the minimum required rate of return, then the project should be rejected.

Internal Rate of Return Definition

The internal rate of return or IRR is a discounting cash flow method to determine the rate of
return earned by the project excluding the external factor. By IRR definition, it is the discounting
rate at which the present value of all future cash flows is equal to the initial investment, that is
the rate at which the company investments break even.

Internal Rate of Return Formula

IIRR is the interest rate that makes the net present value (NPV) of all cash flows equal to zero.
The NPV is the difference between the present value of cash inflows (estimated profit) and the
present value of cash outflow (estimated expenditure) over a period of time. When NPV sets to
zero, then it equates the present value of inflows and outflows, and this makes the IRR
calculation more simple. When NPV sets to zero, then it equates the present value of inflows
and outflows, and this makes the IRR calculation more simple.

Internal Rate of Return (IRR) is a popular investment evaluation method, as it offers the
profitability of a project in percentage terms. The IRR criterion is also popular because it can be
easily compared with the opportunity cost of capital. However, like all other investment
evaluation methods, it also has some merits and demerits.
Merits of IRR Method
Following are the merits of using IRR as an investment evaluation method −
 Time value of money − IRR considers the time value of money. It states that a rupee
today will be worth more than a rupee tomorrow. By considering the time value of
money, IRR makes a correct assumption about profitability. In fact, IRR saves enough
wealth by considering the time value of money.
 Measurement of profitability − IRR considers all cash flows to correctly measure the
profitability of an investment proposal. This provides a comprehensive measurement of
profitability as future cash inflow and outflow estimates are considered. By including cash
flow features, IRR takes the view of the entire life of a project to measure profitability in
the long-term future.
 Increase in Shareholders’ value − IRR aims to maximize the shareholders’ wealth by
considering all aspects related to shareholders’ wealth maximization rules. It is by large
one of the most promising features of IRR because every investment needs to prioritize
shareholders’ wealth creation and maximization.

Demerits of IRR Method

Following are some of the demerits of using IRR as an investment evaluation method −
 Multiple Rates of Return − According to IRR, an investment project may have different
and multiple rates of return. Having more than one rate not only increases the complexity
of the calculation, but it also creates a dilemma where choosing the best project becomes
critical. Therefore, having multiple rates of returns is one of the prominent demerits of
IRR.
 Failing to identify the best project in case of mutually exclusive ones − IRR may fail
to identify the best project if there are mutually exclusive projects on the horizon. Not
being able to identify the better project means there may be large losses in the future for
which IRR estimation becomes flawed and non-competitive in nature.
 Value additivity does not hold good − Unlike NPV, value additivity doesn’t hold good
for IRR. This means that the IRR for a larger project need not be equal to the sum of all
smaller subsidiary projects. In addition of smaller projects’ IIRs are incapable to produce
the IRR of the larger project, it is not possible to calculate the value of IRR of the larger
projects even if we know the smaller IRRs. This creates a big issue in applying and
calculating IRRs in both theory and practice.