Tag: Financial Management Osmania University B.com Notes

Cost of Irredeemable Debt or Perpetual Debt:

Irredeemable debt is that debt which is not required to be repaid during the lifetime of the company. Such debt carries a coupon rate of interest. This coupon rate of interest represents the before tax cost of debt. After tax cost of perpetual debt can be calculated by adjusting the corporate tax with the before tax cost of capital. The debt may be issued at par, at discount or at premium. The cost of debt is the yield on debt adjusted by tax rate.

Symbolically, cost of perpetual debt (Kd) can be calculated using the following formula:

Cost of irredeemable debt (Kd) = I/NP (1 – t)

Where:

I = Annual interest payment,

NP = Net proceeds from issue of debenture or bond, and

t = Tax rate.

Cost of Irredeemable Preference Share:

Irredeemable preference share is not required to be repaid during the lifetime of the company. Such preference shares carry a rate of dividend, which is the cost of irredeemable preference shares. Since the shares may be issued at par, at premium or at a discount, the cost of preference shares is the yield on preference shares. Cost of irredeemable preference shares is calculated by using the following formula:

KP = DP/NP

Where:

DP = Preference dividend and

NP = Net proceeds from issue of preference shares.

Cost of Redeemable Preference Shares:

Redeemable preference shares are those that are repaid after a specific period of time. Hence while calculating the cost of redeemable preference shares, the period of preference shares and redeemable value of the preference shares must be given due consid­eration.

Like irredeemable preference shares, redeemable preference shares may also be issued at par, discount or at a premium. Moreover, there may be floatation costs. So, to calculate net proceeds, adjust­ment for floatation cost is necessary. Since it is redeemable the redeemable value may differ from its face value depending on whether the preference shares are redeemed at par, discount or at premium.

The cost of redeemable preference share can be calculated by using the following formula:

Kp = {Dp + 1/n (RV-NP)}/ {1/n (RV+NP)}

Where:

Dp = Preference dividend,

n = Period of preference share,

RV = Redeemable value of preference share, and

NP = Net proceeds from issue of preference shares.

Problem of weights

The assignment of weights to each type of funds is a complex issue. The finance manager has to make a choice between the risk value of each source of funds and the market value of each source of funds. The results would be different in each case. It is clear from the above discussion that it is difficult to calculate the cost of capital with precision. It can never be a single given figure. At the most it can be estimated with a reasonable range of accuracy. Since the cost of capital is an important factor affecting managerial decisions, it is imperative for the finance manager to identify the range within which his cost of capital lies.

Computation of cost of retained earnings and depreciation funds

The cost of capital raised through retained earnings and depreciation funds  will depend upon the approach adopted for computing the cost of equity capital. Since there are different views, therefore, a finance manager has to face difficult task in subscribing and selecting an appropriate approach.

Controversy regarding the dependence of cost of capital upon the method and level of financing

There is a, major controversy whether or not the cost of capital dependent upon the method and level of financing by the company. According to the traditional theorists, the cost of capital of a firm depends upon the method and level of financing. In other words, according to them, a firm can change its overall cost of capital by changing its debt-equity mix. On the other hand, the modern theorists such as Modigliani and Millerthe firm’s total cost of capital argue that is independent of the method and level of financing. In other words, the change in the debt-equity ratio does not affect the total cost of capital. An important assumption underlying MM approach is that there is perfect capital market. Since perfect capital market does not exist in practice, hence the approach is not of much practical utility.

Future costs versus historical costs

It is argued that for decision-making purposes, the historical cost is not relevant. The future costs should be considered. It, therefore, creates another problem whether to consider marginal cost of capital, i.e., cost of additional funds or the average cost of capital, i.e., the cost of total funds.

Computation of cost of equity

The determination of the cost of equity capital is another problem. In theory, the cost of equity capital may be defined as the minimum rate of return that accompany must earn on that portion of its capital employed, which is financed by equity capital so that the market price of the shares of the company remains unchanged. In other words, it is the rate of return which the equity shareholders expect from the shares of the company which will maintain the present market price of the equity shares of the company. This means that determination of the cost of equity capital will require quantification of the expectations of the equity shareholders. This is a difficult task because the equity shareholders value the equity shares on the basis of a large number of factors, financial as well as psychological. Different authorities have tried in different ways to quantify the expectations of the equity shareholders. Their methods and calculations differ.

In the wake of fierce global competitiveness, path-breaking technological advancement, increasing regulatory requirements following spate of reporting scandals, changes in business models, growing internationalization of business and sensitivity to financial markets, Indian Corporate to survive and thrive and compete globally will have to redefine tectonically the role of their finance managers so that their focus is less on traditional finance jobs like transaction processing, budgeting and capital raising and instead more on strategy making and managing risks and ensuring greater transparency in corporate reporting.

Todays and tomorrow’s finance managers are expected not only to confine themselves to financial planning, capital raising, managing assets and monitoring with new perspectives, new approaches and new skills but also to assume the role of strategic partner and participate actively in the front-end of strategic thinking, building and reviewing business portfolio, managing risks, and act as an agent among various constituencies within and outside the organization.

Managing money is a tricky business, managing other people’s money is not just tricky; It’s a lot challenging and difficult Considering most people need guidance on where to invest, how to save taxes, the best insurance scheme, which fund to invest in, which stock to hold, which one to sell, how to plan children education and their own retirement. Finance experts are most sought after with a fast-growing working population that earns well and needs expert handling of their finances.

In his endeavor to reduce cost of funding the firm’s requirements, finance managers of Indian Corporate shall have to evolve new financial instruments of the likes of zero-coupon bonds, deep discount bonds, floating rate bonds, secured premium notes, convertible warrants, futures and options incorporating attractive features that could entice finicky investors. Securitization can prove to be the most potent financial instrument for a finance manager in garnering funds at relatively cheaper rate.

Securitization, in fact, is a carefully structured process by which a pool of loans and other receivables are packaged and sold in the form of asset-backed securities to the investors to procure the required funds from them. Through this process relatively illiquid assets comprising loans and receivables are converted into securities. Securitization is cheaper source of financing in comparison to conventional fund raising instruments.

In highly discontinuous and uncertain environment business risks arising out of tumultuous fluctuations in commodity prices, share prices, interest rates and foreign exchange rates have increased considerably which, in turn, have not only enhanced cost of managing business but also increased vulnerability of the organization. A finance manager will have to play crucial role in hedging the unwanted business risks of the firm.

The three most important roles finance and accounting should serve within a company are:

• Identifying opportunities to improve the business
• Executing company strategy
• Budgeting and forecasting

The role of the finance manager

The first objective of the accounting activity is to deliver information necessary for the measurement of the company’s performance. Using some generally accepted and regulated standards and principles, the accountants prepare the financial statements that establish the profit based only on the registered sales and expenses. On the other hand, the financial manager focuses on the actual entries and issues of cash flow that are related to such income and expenses. He/she keeps the company solvent by analysing and planning the cash flows necessary for paying the obligations and purchasing the assets needed by the company to reach its financial objectives. If the individuals involved in the accounting activities focus on collecting information and presenting the financial statements, the financial manager evaluates the situations elaborated by the accounting activity, creates additional information and takes decisions based on subsequent analyses. The purpose of the financial activity is to provide correct and easily interpretable information about the company’s past, present and future operations. The financial manager uses this information, either in its basic form, or after certain processing and analyses, as important entries in the decision-making process.

Reporting

A good finance manager should produce financial reports that show the organization’s financial position, operating performance and cash flow over a period of time through the use of meaningful financial statements. He / She should create management reports on a regular basis that are relevant to decision making processes, measuring performance against measures and targets (output and outcomes) established during finance management planning, against budget objectives, and/or against financial management performance standards used within an industry.

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.

Financial Planning is the process of estimating the capital required and determining its competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise.

Nature of Financial Management

Management of Cash:

Financial management monitors all funds movement in an organization. Finance managers supervise all cash movements through proper accounting of all cash inflows and outflows. They ensure that there is no situation like deficiency or surplus of cash in an organization. Finance manager observes all cash movements (inflow and outflow) and ensures they should face any deficiency or surplus of cash. Financial Planning is the process of estimating the capital required and determining it’s competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise.

Selects Investment Pattern:

Once funds are procured it is important to allocate them among profitable investment avenues. The investment proposal should be properly analyzed regarding its safety, profitability, and liquidity. Before investing any amount in it all risk and return associated with it should be properly evaluated. Before investing the amount, the investment proposal should be analysed and properly evaluates its risk and returns.

Decides Capital Structure:

Deciding optimum capital structure for an organization is a must for attaining efficiency and earning better profits. It involves deciding the proper portion of different securities like common equity, preferred equity, and debt. The proper balance between debt and equity should be attained which minimizes the cost of capital. Proper balance between debt and equity should be attained, which minimizes the cost of capital.

Financial management decides proper portion of different securities (common equity, preferred equity and debt).

Apply Financial Controls:

Implying financial controls in business is a beneficial role played by financial management. It helps in keeping the company actual cost of operation within the limit and earning the expected profits. There are various processes involved in this like developing certain standards for business in advance, comparing the actual cost or performance with pre-established standards, and taking all required remedial measures.

Raises Shareholders Value:

Financial management works towards raising the overall value of shareholders. It aims at increasing the amount of return to shareholders by reducing the cost of operations and increasing the profits. The finance manager focuses on raising cheap funds from different sources and invest them in the most profitable avenues.

Select Sources of Fund:

Choosing the source of funds is one of the crucial decisions for every organization. There are various sources available for raising funds like shares, bonds, debentures, venture capital, financial institutions, retained earnings, owner investment, etc. Every business should properly analyze different sources of funds available and choose one which is cheapest and involves minimal risk.

Estimates Capital Requirements:

Financial management helps in anticipation of funds required for running the business. It estimates working and fixed capital requirements for carrying out all business activities. The finance manager prepares a budget of all expenses and revenues for a particular time period on the basis of which capital requirements are determined.

Importance of Financial Management

Manages Cash Movements:

Financial management monitors and manages all cash movements in business organizations. All cash inflows and outflows in an organization are properly recorded by financial managers. They ensure that there is no deficiency or surplus of cash.

Facilitates Cost Control:

Financial managers focus on controlling all costs associated with the business. They prepare a budget for all activities of the business and ensure that all expenses go in accordance with the pre-determined budget. Financial managers take all remedial measures if the cost is found to be more than pre allotted budget.

Determines Capital Structure:

Financial management decides the optimum capital structure of the organization. It decides the proportion of equity and debt to be included in the capital. The proper balance between debt and equity should be attained which minimizes the cost of capital.

Forecasts Cash Flows:

Financial management forecasts the fund required for carrying out the activities by the business. Estimation of fund requirement is the foremost and primary function played by financial management.

Better Disposal Of Surplus:

Decisions regarding using the surplus or profit earned by the business are taken by financial managers. They decide whether it should be distributed as dividends to shareholders or should be retained for plowing it back into the business. The finance manager decides an optimum dividend payout ratio out of available profit by considering all expansion and growth opportunities available to the organization.

Proper Use of Funds:

Financial management ensures that all financial resources are properly utilized in the organization. Financial managers supervise the use of all funds and checks whether they are invested in better assets. Before allocating any funds in any investment avenue they properly evaluate risk and return associated with it.

Raises the Funds:

Once the fund required by business are estimated, financial managers are responsible for the acquisition of such funds. Financial managers choose among different sources available for raising funds like shares, debentures, loans, etc. They choose the one which provides funds at low cost and has fewer conditions attached to them.

Financial planning has been defined as “the advance programming of all plans of financial management and the integration and coordination of these plans with the operating plans of the enterprise.” There is hardly any aspect of a business which does not have both financial requirements and financial consequences. Financial planning deals with both sources and uses of funds.

Factors affecting Financial Planning

Financial planning of a business is determined by the following factors:

(i) Objectives. Objectives of financial planning should be consistent with the overall objectives of the business. The main objectives of financial planning are to raise funds at reasonable cost and utilize them in the best possible manner.

(ii) Requirements of the Enterprise. A good financial plan should take care of the present and future requirements of the business. Provision of or various contingencies, replacement of assets, and growth and diversification of business enterprise must be made.

(iii) Economy. Case of raising capital should be reasonable. Capital structure should be such as to create an appropriate balance between the cost of funds and the company’s ability to pay.

(iv) Solvency and Liquidity. The funds should be invested in those ventures which are likely to give sufficient return on investment. Moreover, adequate cash should always to available to meet the requirements of the enterprise. The enterprise should be solvent and liquid not only in the short-term but also in the long-term.

(v) Flexibility. Financial planning should ensure flexibility allow the diversion of funds into more profitable channels. It should also make provision for raising of additional funds at a short notice.

(vi) Optimum Capital Structure. There should be proper capitallsation of the company. An optimum mix of equity shares, preference shares and debentures should be kept in mid while raising funds from different resources.

Limitations of Financial Planning

Rapid Changes:

The growing mechanisation of industry is bringing rapid changes in industrial process. The methods of production, marketing devices, consumer preferences create new demands every time. The incorporation of new changes requires a change in financial plan every time.

Once investments are made in fixed assets then these decisions cannot be reversed. It becomes very difficult to adjust a financial plan for incorporating fast changing situations. Unless a financial plan helps the adoption of new techniques, its utility becomes limited.

Difficulty in Change:

Once a financial plan is prepared then it becomes difficult to change it. A changed situation may demand change in financial plan but managerial personnel may not like it. Even otherwise, assets might have been purchased and raw material and labour costs might have been incurred. It becomes very difficult to change financial plan under such situations.

Problem of Co-ordination:

Financial function is the most important of all the functions. Other functions influence a decision about financial plan. While estimating financial needs, production policy, personnel requirements, marketing possibilities are all taken into account.

Unless there is a proper-co­ordination among all the functions, the preparation of a financial plan becomes difficult. Often there is a lack of co-ordination among different functions. Even indecision among personnel disturbs the process of financial planning.

Difficulty in Forecasting:

Financial plans are prepared by taking into account the expected situations in the future. Since, the future is always uncertain and things may not happen as these are expected, so the utility of financial planning is limited. The reliability of financial planning is uncertain and very much doubted.

Financial Planning is the process of estimating the capital required and determining their competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise.

Objectives of Financial Planning

• Determining capital structure: The capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in the business. This includes decisions of debt- equity ratio- both short-term and long- term.
• Determining capital requirements: This will depend upon factors like cost of current and fixed assets, promotional expenses and long- range planning. Capital requirements have to be looked with both aspects: short- term and long- term requirements.
• A finance manager ensures that the scarce financial resources are maximally utilized in the best possible mannerat least cost in order to get maximum returns on investment.
• Framing financial policies with regards to cash control, lending, borrowings, etc.

Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures, programmes and budgets regarding the financial activities of a concern. This ensures effective and adequate financial and investment policies. The importance can be outlined as:

• Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is maintained.
• Adequate funds have to be ensured.
• Financial Planning ensures that the suppliers of funds are easily investing in companies which exercise financial planning.
• Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily through enough funds.
• Financial Planning helps in making growth and expansion programmes which helps in long-run survival of the company.
• Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the company. This helps in ensuring stability an d profitability in concern.

Sources of finances:

Sources of finance for business are equity, debt, debentures, retained earnings, term loans, working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds are used in different situations. They are classified based on time period, ownership and control, and their source of generation. It is ideal to evaluate each source of capital before opting for it.

They are classified based on time period, ownership and control, and their source of generation.

On the basis of the period, the different sources of funds can be classified into three parts. Which are:

(i) Long Term Equity

Long-term sources fulfill the financial requirements of a business for a period more than 5 years. It includes various other sources such as shares and debentures, long-term borrowings and loans from financial institutions. Such financing is generally required for the procurement of fixed assets such as plant, equipment, machinery etc.

(ii) Medium Term

Medium-term sources are the sources where the funds are required for a period of more than one year but less than five years. The sources of the medium term include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions.

(iii) Short Term

Short-term sources Funds which are required for a period not exceeding one year are called short-term sources. Trade credit, loans from commercial banks and commercial papers are the examples of the sources that provide funds for short duration.

Short-term financing is very common for the financing of present assets such as inventories and account receivables. Seasonal businesses that must build inventories in terms of future prospects of selling requirements often need short-term financing for the interim period between seasons. Wholesalers and manufacturers with a major portion of their assets used in inventories or receivables also require a large number of funds for a short period.

On the basis of ownership, the sources can be classified into Owner’s funds and Borrowed funds.

(i) Owners Fund

Owner’s funds mean funds which are procured by the owners of a business, which may be a sole entrepreneur or partners or shareholders of a business. It also includes profits which are reinvested in the business. The owner’s capital remains invested in the business for a longer duration and is not required to be refunded during the life period of the business.

This capital forms the base on which owners gain their right of control of management in the business. Some entrepreneurs may not like to dilute their ownership rights in the business and others may believe in sharing the risk. Equity shares and retained earnings are the two important sources from where owner’s funds can be obtained.

(ii) Borrowed Funds

Borrowed funds refer to the funds raised with the help of loans or borrowings. This is the most common type of source of funds and is used the majority of the time. The sources for raising borrowed funds include loans from commercial banks, loans from financial institutions, issue of debentures, public deposits and trade credit.

These sources provide funds for a specific period, on certain terms and conditions and have to repay the loan after the expiry of that period with interest. A fixed rate of interest is paid by the borrowers on such loans. Often it does put a lot of burden on the business as payment of interest is to be made even when the earnings are low or when the loss is incurred. These institutions don’t take into consideration the activities of business after the loan is given. Generally, borrowed funds are provided on the security of some assets of the borrower.

The way of classifying the sources of funds is whether the funds are generated from within the organization or from external sources of the organization.

(i) Internal sources

Internal sources of funds are those that are generated inside the business. A business, for example, can generate funds internally by speeding collection of receivables, disposing of surplus inventories and increasing its profit. The internal sources of funds can fulfill only limited needs of the business.

(ii) External sources

External sources of funds are the sources that lie outside an organization, such as suppliers, lenders, and investors. When a large amount of money is needed to be raised, it is generally done through the external sources. External funds may be costly as compared to those raised through internal sources.

In some cases, business is required to mortgage its assets as security while obtaining funds from external sources. The issue of debentures, borrowing from commercial banks and financial institutions and accepting public deposits are some of the examples of external sources of funds commonly used by business organizations.