CHAPTER – I

AN OVERVIEW OF FINANCIAL MANAGEMENT

1.1. Introduction
Finance is a field that deals with the study of investments. It includes the dynamics of assets and
liabilities over time under conditions of different degrees of uncertainties and risks. Finance can
also be defined as the science of money management. Market participants aim to price assets
based on their risk level, fundamental value, and their expected rate of return. Finance can be
broken into three sub-categories: public finance, corporate finance and personal finance.
1.1.1. Meaning of Financial Management
Financial management refers to the efficient and effective management of money (funds) in such
a manner as to accomplish the objectives of the organization. It is the specialized function
directly associated with the top management. The significance of this function is not seen in the
'Line' but also in the capacity of the 'Staff' in overall of a company. It has been defined
differently by different experts in the field.
Definition of Financial Management
"Financial management is that activity of management which is concerned with the planning,
procuring and controlling of the firm's financial resources. " By Deepika &Maya Rani
1.1.2. Classification of Finance
Finance is broadly defined into two parts:-
1. Private finance:-
The private finance can be further divided into personal finance and business finance. the
personal finance is concerned with the acquisition and the proper utilization of economic
resource by the individuals and households for meeting their different needs The business
finance is also a part of private finance. the business finance is concerned with the acquisition,
management and utilization of fund by the private business organizations. the business
organizations may also be in the form of public enterprises. but the public enterprises fall under
the category of public finance.
2. Public Finance

Public finance is the study of the financial aspect of the government. here we study about the
government expenditure, public revenue, public borrowing and financial administration. The
economic activities of the public enterprises also fall under public finance. The objective of
private of business finance is to earn maximum return or profit. On the contrary the objective of
public finance is to maximize social welfare
1.1.3. Sources of Finance

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Sources of finance 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 it.
On the basis of a time period, sources are classified as long-term, medium term, and short
term. Ownership and control classify sources of finance into owned capital and borrowed
capital. Internal sources and external sources are the two sources of generation of capital. All
the sources of capital have different characteristics to suit different types of requirements.
According to the sources of Generation
Based on the source of generation, the following are the internal and external sources of finance:
I. Internal Sources
The internal source of capital is the capital which is generated internally by the business. These
are as follows:
1. Retained profits
2. Reduction or controlling of working capital
3. Sale of assets etc.
The internal source of funds has the same characteristics of owned capital. The best part of the
internal sourcing of capital is that the business grows by itself and does not depend on outside
parties. Disadvantages of both equity capital and debt capital are not present in this form of
financing. Neither ownership dilutes nor does fixed obligation or bankruptcy risk arise.
II. External Sources

An external source of finance is the capital generated from outside the business. Apart from the
internal sources of funds, all the sources are external sources of capital.

Deciding the right source of funds is a crucial business decision taken by top-level finance
managers. The wrong source of capital increases the cost of funds which in turn would have a
direct impact on the feasibility of project under concern. Improper match of the type of capital
with business requirements may go against the smooth functioning of the business. For instance,
if fixed assets, which derive benefits after 2 years, are financed through short-term finances will
create cash flow mismatch after one year and the manager will again have to look for finances
and pay the fee for raising capital again.
1.2. Scope of Financial Management

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Imagine that you were to start your own business. No matter what type you started, you would
have to answer the following three questions in some form or another:
1. What long-term investments should you take on? That is, what lines of business will
you be in and what sorts of buildings, machinery, and equipment will you need?
2. Where will you get the long-term financing to pay for your investment? Will you bring
in other owners or will you borrow the money?
3. How will you manage your everyday financial activities such as collecting from
customers and paying suppliers?
These are not the only questions by any means, but they are among the most important.
Corporate finance, broadly speaking, is the study of ways to answer these three questions.
Accordingly, we’ll be looking at each of them in the chapters ahead.
The Financial Manager
A striking feature of large corporations is that the owners (the stockholders) are usually not
directly involved in making business decisions, particularly on a day-to-day basis. Instead, the
corporation employs managers to represent the owners’ interests and make decisions on their
behalf. In a large corporation, the financial manager would be in charge of answering the three
questions we raised in the preceding section.
The financial management function is usually associated with a top officer of the firm, such as a
vice president of finance or some other chief financial officer (CFO). The vice president of
finance coordinates the activities of the treasurer and the controller. The controller’s office
handles cost and financial accounting, tax payments, and management information systems. The
treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning,
and its capital expenditures. These treasury activities are all related to the three general questions
raised earlier, and the chapters ahead deal primarily with these issues. Our study thus bears
mostly on activities usually associated with the treasurer’s office.
Scope of Financial Management
As the preceding discussion suggests, the financial manager must be concerned with three basic
types of questions. We consider these in greater detail next.
Investment Decision/Capital Budgeting Decision

Capital Budgeting The first question concerns the firm’s long-term investments. The process of
planning and managing a firm’s long-term investments is called capital budgeting. In capital
budgeting, the financial manager tries to identify investment opportunities that are worth more to

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the firm than they cost to acquire. Loosely speaking, this means that the value of the cash flow
generated by an asset exceeds the cost of that asset.

The types of investment opportunities that would typically be considered depend in part on the
nature of the firm’s business. For example, for a large retailer such as Wal-Mart, deciding
whether or not to open another store would be an important capital budgeting decision.
Similarly, for a software company such as Oracle or Microsoft, the decision to develop and
market a new spread sheet would be a major capital budgeting decision. Some decisions, such as
what type of computer system to purchase, might not depend so much on a particular line of
business.

Regardless of the specific nature of an opportunity under consideration, financial managers must
be concerned not only with how much cash they expect to receive, but also with when they
expect to receive it and how likely they are to receive it. Evaluating the size, timing, and risk of
future cash flows is the essence of capital budgeting. In fact, as we will see in the chapters
ahead, whenever we evaluate a business decision, the size, timing, and risk of the cash flows will
be, by far, the most important things we will consider.
Financing Decision/Capital Structure Decision
Capital Structure The second question for the financial manager concerns ways in which the
firm obtains and manages the long-term financing it needs to support its long term investments.
A firm’s capital structure (or financial structure) is the specific mixture of long-term debt and
equity the firm uses to finance its operations. The financial manager has two concerns in this
area. First, how much should the firm borrow? That is, what mixture of debt and equity is best?
The mixture chosen will affect both the risk and the value of the firm. Second, what are the least
expensive sources of funds for the firm?

If we picture the firm as a pie, then the firm’s capital structure determines how that pie is
sliced—in other words, what percentage of the firm’s cash flow goes to creditors and what
percentage goes to shareholders. Firms have a great deal of flexibility in choosing a financial
structure. The question of whether one structure is better than any other for a particular firm is
the heart of the capital structure issue.

In addition to deciding on the financing mix, the financial manager has to decide exactly how
and where to raise the money. The expenses associated with raising long-term financing can be
considerable, so different possibilities must be carefully evaluated. Also, corporations borrow

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money from a variety of lenders in a number of different, and sometimes exotic, ways. Choosing
among lenders and among loan types is another job handled by the financial manager.
Working Capital Decision
Working Capital Management The third question concerns working capital management. The
term working capital refers to a firm’s short-term assets, such as inventory, and its short-term
liabilities, such as money owed to suppliers. Managing the firm’s working capital is a day-to-day
activity that ensures that the firm has sufficient resources to continue its operations and avoid
costly interruptions. This involves a number of activities related to the firm’s receipt and
disbursement of cash. Some questions about working capital that must be answered are the
following: (1) How much cash and inventory should we keep on hand? (2) Should we sell on
credit? If so, what terms will we offer, and to whom will we extend them? (3) How will we
obtain any needed short-term financing? Will we purchase on credit or will we borrow in the
short term and pay cash? If we borrow in the short term, how and where should we do it? These
are just a small sample of the issues that arise in managing a firm’s working capital.
The three areas of corporate financial management we have described— capital budgeting,
capital structure, and working capital management—are very broad categories. Each includes a
rich variety of topics, and we have indicated only a few of the questions that arise in the different
areas.
1.3. The Goal of a firm in Financial Management
The goal of a firm in financial management can be either the profit maximisation or wealth
maximisation, let us discuss it in the following paragraphs
Profit Maximization simply means that The maximization of the firm’s net income or EPS.
Earnings Per Share (EPS) Net income divided by the number of shares of common stock
outstanding.
In arguing that managers should take steps to maximize the firm’s stock price, we have said
nothing about the traditional objective, profit maximization, or the maximization of earnings
per share (EPS). However, while a growing number of analysts rely on cash flow projections to
assess performance, at least as much attention is still paid to accounting measures, especially
EPS. The traditional accounting performance measures are appealing because (1) they are easy
to use and understand; (2) they are calculated on the basis of more or less standardized
accounting practices, which reflect the accounting profession’s best efforts to measure financial
performance on a consistent basis both across firms and over time; and (3) net income is
supposed to be reflective of the firm’s potential to produce cash flows over time.

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Generally, there is a high correlation between EPS, cash flow, and stock price, and all of them
generally rise if a firm’s sales rise. Nevertheless, as we will see in subsequent chapters, stock
prices depend not just on today’s earnings and cash flows—future cash flows and the riskiness
of the future earnings stream also affect stock prices. Some actions may increase earnings and
yet reduce stock price, while other actions may boost stock price but reduce earnings. For
example, consider a company that undertakes large expenditures today that are designed to
improve future performance. These expenditures will likely reduce earnings per share, yet the
stock market may respond positively if it believes that these expenditures will significantly
enhance future earnings. By contrast, a company that undertakes actions today to enhance its
earnings may see a drop in its stock price, if the market believes that these actions compromise
future earnings and/or dramatically increase the firm’s risk. Even though the level and riskiness
of current and future cash flows ultimately determine stockholder value, financial managers
cannot ignore the effects of their decisions on reported EPS, because earnings announcements
send messages to investors. Say, for example, a manager makes a decision that will ultimately
enhance cash flows and stock price, yet the short-run effect is to lower this year’s profitability
and EPS. Such a decision might be a change in inventory accounting policy that increases
reported expenses but also increases cash flow because it reduces current taxes. In this case, it
makes sense for the manager to adopt the policy because it generates additional cash, even
though it reduces reported profits. Note, though, that management must communicate the reason
for the earnings decline, for otherwise the company’s stock price will probably decline after the
lower earnings are reported.
Stockholder Wealth Maximization
Meaning
The primary goal for management decisions; considers the risk and timing associated with
expected earnings per share in order to maximize the price of the firm’s common stock.
Shareholders are the owners of a corporation, and they purchase stocks because they are looking
for a financial return. In most cases, shareholders elect directors, who then hire managers to run
the corporation on a day-to-day basis. Since managers are working on behalf of shareholders, it
follows that they should pursue policies that enhance shareholder value. Consequently,
throughout this book we operate on the assumption that management’s primary goal is
stockholder wealth maximization, which translates into maximizing the price of the firm’s
common stock. Firms do, of course, have other objectives—in particular, the managers who
make the actual decisions are interested in their own personal satisfaction, in their employees’

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welfare, and in the good of the community and of society at large. Still, for the reasons set forth
in the following sections, stock price maximization is the most important goal for most
corporations.

What types of actions can managers take to maximize the price of a firm’s stock? To answer this
question, we first need to ask, ―What factors determine the price of a company’s stock?‖ While
we will address this issue in detail in we can lay out three basic facts here. (1) Any financial
asset, including a company’s stock, is valuable only to the extent that the asset generates cash
flows. (2) The timing of the cash flows matters—cash received sooner is better, because it can
be reinvested to produce additional income. (3) Investors are generally averse to risk, so all
else equal, they will pay more for a stock whose cash flows are relatively certain than for one
with relatively risky cash flows. Because of these three factors, managers can enhance their
firms’ value (and the stock price) by increasing expected cash flows, speeding them up, and
reducing their riskiness.

Within the firm, managers make investment decisions regarding the types of products or services
produced, as well as the way goods and services are produced and delivered. Also, managers
must decide how to finance the firm—what mix of debt and equity should be used, and what
specific types of debt and equity securities should be issued? In addition, the financial manager
must decide what percentage of current earnings to pay out as dividends rather than retain and
reinvest; this is called the dividend policy decision. Each of these investment and financing
decisions is likely to affect the level, timing, and riskiness of the firm’s cash flows, and therefore
the price of its stock. Naturally, managers should make investment and financing decisions
designed to maximize the firm’s stock price.

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 Chapter – 2

Financial Analysis and Planning

2.1. Meaning Financial Analysis

Financial analysis (also referred to as financial statement analysis or accounting analysis

or Analysis of finance) refers to an assessment of the viability, stability and profitability of a
business, sub-business or project. It is performed by professionals who prepare reports using
ratios that make use of information taken from financial statements and other reports. These
reports are usually presented to top management as one of their bases in making business
decisions.

In the words of Myers, ―Financial statement analysis is largely a study of relationship

among various financial factors in a business as disclosed by a single set of statements and a
study of the trends of these factors as shown in a series of statements.‖ Analysis of financial
statements may be compared to x-raying the financial position to diagnose the financial strength
and weakness of the business.
Financial analysts often assess the following elements of a firm:
1. Profitability - its ability to earn income and sustain growth in both the short- and long-
term. A company's degree of profitability is usually based on the income statement,
which reports on the company's results of operations;
2. Solvency - its ability to pay its obligation to creditors and other third parties in the long-
term;
3. Liquidity - its ability to maintain positive cash flow, while satisfying immediate
obligations;
4. Stability - the firm's ability to remain in business in the long run, without having to
sustain significant losses in the conduct of its business. Assessing a company's stability
requires the use of the income statement and the balance sheet, as well as other financial
and non-financial indicators. etc.
2.1.1. Need of Analysis of Financial Statement

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The analysis of financial statement helps the analyst to know the financial information from the
financial data contained in the financial statements and to assess the financial health (i.e. strength
or weakness) of an enterprise. It also helps to make a forecast for the future which helps us to
prepare budgets and estimates. The following are the need for analysis of Financial Statements
1. It helps us to know the reasons for relative changes—either in profitability or in the
financial position as a whole.
2. It also helps to know both the short-term liquidity position vis-a-vis working capital
position; as also the long-term liquidity and solvency position of a firm.
3. It also highlights the operating efficiency and the present profit-earning capacity of the
firm as a whole.
4. High Courts, Supreme Court, Arbitrators also require financial statements to settle
various disputed matters.
5. Various financial journal (viz. Bank Bulletins), newspapers etc. also require financial
statements for analyzing and scrutinizing the financial position of a firm for the readers.
6. To assess the risk (both financial as well as business) involved with firm.
7. To assess the present earning capacity of the firm for the purpose of inter-firm
comparison and thereby to assess the progress or otherwise of the firm
2.1.2. Sources of Financial Data
The sources of financial data includes the mainly the a. Balance Sheet, b. Income Statement, c.
Cash Flow Statement
a. Balance Sheet

The balance sheet provides an overview of assets, liabilities and stockholders' equity as a
snapshot in time. The date at the top of the balance sheet tells you when the snapshot was taken,
which is generally the end of the fiscal year. The balance sheet equation is assets equals
liabilities plus stockholders' equity, because assets are paid for with either liabilities, such as
debt, or stockholders' equity, such as retained earnings and additional paid-in capital. Assets are
listed on the balance sheet in order of liquidity. Liabilities are listed in the order in which they
will be paid. Short-term or current liabilities are expected to be paid within the year, while long-
term or noncurrent liabilities are debts expected to be paid after one year.
b. Income Statement
Unlike the balance sheet, the income statement covers a range of time, which is a year for annual
financial statements and a quarter for quarterly financial statements. The income statement

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provides an overview of revenues, expenses, net income and earnings per share. It usually
provides two to three years of data for comparison.
c. The Statement of Cash flows

The cash flow statement merges the balance sheet and the income statement. Due to accounting
convention, net income can fall out of alignment with cash flow. The cash flow statement
reconciles the income statement with the balance sheet in three major business activities. These
activities include operating, investing and financing activities. Operating activities include
cash flows made from regular business operations. Investing activities include cash flows due to
the buying and selling of assets such as real estate and equipment. Financing activities include
cash flows from debt and equity. This is where analysts can also find the amount of dividends
paid and/or dollar value of shares repurchased.

2.1.3. Approaches of Financial Analysis and Interpretations

Financial analysis is classified on the basis of materials used and modus operandi of the
analysis. This is shown below

Types of Analysis

On the basis of On the basis of

Modus Operandi
Materials used
Operandi

External Internal Horizontal Vertical

analysis Analysis Analysis Analysis

External analysis
Such type of analysis is made by outsiders who have no access to the books of accounts. They
constitute investors, creditors, credit agencies and government agencies. As they don’t have
access to the books of accounts they have to depend on the published accounts for the purpose of
analysis. However, government regulation requiring auditing of accounts has made published
accounts more reliable and dependable. As compared to internal analysis, external analysis is not
done in detail and hence it serves limited purpose.
Internal Analysis
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It is done by those parties in the business who have access to books of account.
Such parties can be designated as accountant or financial analyst. Sometimes it can also be done
by employees to know the performance of the business. Internal analysis is done in more detail
when compared to external analysis.
Horizontal Analysis
When financial analysis is done for number of years, it is known as horizontal
analysis. Such analysis sets a trend wherein the figures of various years are compared with one
standard year known as base year. Based on the trend prevailing it is possible to make decision
and form a rational judgment about the progress of the business. This type of analysis is also
known as dynamic analysis as it measures the change of position of the business over a number
of years.
Vertical Analysis
When analysis is made for data covering one year's period, it is known as vertical
analysis. This type is also known as static analysis as it measures the state of affairs of the
business as on given period of time. This type of analysis is useful in comparing the performance
of several firms belonging to the same industry or various departments belonging to the same
company.
Tools, or Techniques or Methods of Financial Analysis
For analyzing the financial data and interpreting them in a systematic manner and a number of
techniques or tools are available. These are as follows:
1. Comparative financial statements
2. Common-size statement analysis.
3. Trend analysis.
4. Average analysis
5. Ratio analysis
6. Fund flow analysis
7. Cash flow analysis
Trend Analysis or Trend Ratios
Trend ratios can be defined as the index numbers of the movements of the various financial
items on the financial statement for a number of periods. It is a statistical device applied in the
analysis of financial statements to reveal the trend of the items with the passage of time. They
are very useful in predicting the behavior of the various financial factors in future. Sometimes
trends are significantly affected by external causes over which the organization has no control.
Such factors are Government policies, economic conditions, change in income and its
distribution etc.

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Points to be considered in calculation of trend ratios:
(a) The accounting principles and practices followed should be constant throughout the
period for which analysis is made.
(b) Trend ratios should be calculated only for items having logical relationship with one
another.
(c) There should be financial statement for a number of years.
(d) Take one of the statements as the base with reference to which all other statements
are to be studied but the selected base statements should belong to a normal year.
(e) Every item in the base statement should be stated as 100.
(f) Trend Ratios of each item in other statement is calculated with reference to same
item in the base statement by using the following formula.
Absolute value of item in the state under study / absolute value of the same item in
the base statement x 100
From the following data, calculate trend percentage taking 2015 as base
2015 2016 2017
(Br) (Br) (Br)

Sales 5000 7500 10000

Purchases 4000 6000 7200

Expenses 500 800 1500

Profit 500 700 1300

Statement showing Trend Percentages

2015 2016 2017 Trend % (base yr 2015)
B B B 2015 2016 2017
r r r
. . .
Purchases 4000 6000 7200 100 150 180
Expenses 500 800 1500 100 160 300
Profit 500 700 1300 100 140 260
Sales 5000 7500 10000 100 150 200

Ratio Analyses
In order to understand the importance of ratio analysis in financial analysis, the following short
term solvency can be considered
o Current Ratio

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 o Liquid Ration
Current Ratio
The current ratio is a Liquidity ratio that measures a company's ability to pay short-term
and long-term obligations. To gauge this ability, the current ratio considers the current total
assets of a company (both liquid and illiquid) relative to that company’s current total liabilities.
The formula for calculating a company’s current ratio is: Current Ratio = Current Assets /
Current Liabilities

The current ratio is called ―current‖ because, unlike some other liquidity ratios, it
incorporates all current assets and liabilities. The current ratio is also known as the working
capital ratio

Quick Ratio or Liquid Ratio

The liquid ratio, on the other hand, is a liquidity indicator that filters the current ratio by
measuring the amount of the most liquid current assets there are to cover current liabilities (you
can think of the ―quick‖ part as meaning assets that can be liquidated fast). The quick ratio,
also called the “acid-test ratio,” is calculated by adding cash & equivalents, marketable
investments and accounts receivables, and dividing that sum by current liabilities.

For Example:
Your are given the following information: (Values in Birr)
Cash 18000
Debtors 142000
Closing stock 180000
Bills payable 27000
Creditors 50000
Outstanding expenses 15000
Tax Payable 75000
Calculate Current ratio and Liquidity ratio.

Solution

Current Assets : Cash 18000 Current Liabilities:

Bills payable 27000
Debtors 142000 Creditors 50000
Stock 180000 O/S Exp 15000
Total Current Assets 340000 Tax payable 75000
Total C/Liabilities 167000
Current Ration = Current Assets/Current Liabilities = 340000/167000 = 2.036
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Liquid Ratio = Liquid Assets/Current Liabilities
Liquid assets = Current Assets – Stock
340000-180000 = 160000
Liquid Ratio = 160000/167000 = 0.96

2.2 Financial Planning (Forecasting)

Definition of Financial Planning
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.
Objectives of Financial Planning
Financial Planning has got many objectives to look forward to:
a. 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.
b. 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.
c. Framing financial policies with regards to cash control, lending, borrowings, etc.
d. A finance manager ensures that the scarce financial resources are maximally utilized
in the best possible manner at least cost in order to get maximum returns on
investment.
2.3. The Financial Planning Process
The financial planning process can be broken down into six steps:
1. Project financial statements and use these projections to analyze the effects of the
operating plan on projected profits and various financial ratios. The projections can also
be used to monitor operations after the plan has been finalized and put into effect. Rapid
awareness of deviations from the plan is essential in a good control system, which, in
turn, is essential to corporate success in a changing world.
2. Determine the funds needed to support the five-year plan. This includes funds
for plant and equipment as well as for inventories and receivables, for R&D programs,
and for major advertising campaign

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 3. Forecast funds availability over the next five years. This involves estimating the
funds to be generated internally as well as those to be obtained from external sources.
Any constraints on operating plans imposed by financial restrictions must be
incorporated into the plan; constraints include restrictions on the debt ratio, the current
ratio, and the coverage ratios.
4. Establish and maintain a system of controls to govern the allocation and use of
funds within the firm. In essence, this involves making sure that the basic plan is
carried out properly.
5. Develop procedures for adjusting the basic plan if the economic forecasts
upon which the plan was based do not materialize. For example, if the economy turns out
to be stronger than was forecasted, then these new conditions must be recognized and
reflected in higher production schedules, larger marketing quotas, and the like, and as
rapidly as possible. Thus, Step 5 is really a ―feedback loop‖ that triggers modifications to
the financial plan.
6. Establish a performance-based management compensation system. It is
critically important that such a system rewards managers for doing what stockholders
want them to do—maximize share prices.
In the remainder of this planning process, we discuss how firms use computerized financial
planning models to implement the three key components of the financial plan: (1) the sales
forecast, (2) pro forma financial statements, and (3) the external financing plan.

2.4 Sales Forecast – Importance

Sales are the lifeblood of a business. ... Sales forecasting is a crucial part of the financial
planning of a business. It's a self-assessment tool that uses past and current sales statistics to
intelligently predict future performance. With an accurate sales forecast in hand, you can plan
for the future.

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Sales are the lifeblood of a business. It's what helps you pay employees, cover operating
expenses, buy more inventory, market new products and attract more investors. Sales forecasting
is a crucial part of the financial planning of a business. It's a self-assessment tool that uses past
and current sales statistics to intelligently predict future performance.
With an accurate sales forecast in hand, you can plan for the future. If your sales forecast says
that during December you make 30 percent of your yearly sales, then you need to ramp up
manufacturing in September to prepare for the rush. It might also be smart to invest in more
seasonal salespeople and start a targeted marketing campaign right after Thanksgiving. One
simple sales forecast can inform every other aspect of your business
Sales forecasts are also an important part of starting a new business. Almost all new
businesses need loans or start-up capital to purchase everything necessary to get off the ground:
office space, equipment, inventory, employee salaries and marketing. You can't just walk into a
bank with a bright idea and lots of enthusiasm. You need to show them numbers that prove your
business is viable. In other words, you need a business plan.
A central part of that business plan will be the sales forecast. Since you won't have any past
sales numbers to work with, you'll have to do research about related businesses that operate in
the same geographical market with a similar customer base. You'll have to make concessions for

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the difficulty of starting from scratch, meaning that the first few months will be lean. Then you'll
need to convince the bank that your business has fresh ideas that will eventually outsell the
competition. All of these ideas need to be expressed as numbers -- losses, profits and sales
forecasts that the bank can easily understand.
As your business grows, sales forecasts continue to be an important measurement of your
company's health. Wall Street measures the success of a company by how well it meets its
quarterly sales forecasts. If a company predicts robust sales in the fourth quarter but only earns
half that amount, it's a sign to stockholders that not only is the company performing poorly, but
management is clueless. When attracting new investors to a private company, sales forecasts can
be used to predict the potential return on investment

The overall effect of accurate sales forecasting is a business that runs more efficiently,
saving money on excess inventory, increasing profit and serving its customers better
Chapter – 3
THE TIME VALUE OF MONEY
3.1. Concept of Time value of Money
One of the most important tools in time value analysis is the cash flow time line, which is used
by analysts to help visualize what is happening in a particular problem and then to help set up
the problem for solution.
Meaning of cash flow Time Line
―An important tool used in time value of money analysis; it is a graphical representation used to
show the timing of cash flows.‖

To illustrate the time line concept, consider the following diagram:

Time
0 1 2 3 4 5

PV=100 FV = ?

Cash Flow

Time 0 is today; Time 1 is one period from today, or the end of Period 1; Time 2 is two
periods from today, or the end of Period 2; and so on. Thus, the numbers above the tick marks
represent end-of-period values. Often the periods are years, but other time intervals such as
semiannual periods, quarters, months, or even days can be used. If each period on the time line
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represents a year, the interval from the tick mark corresponding to 0 to the tick mark
corresponding to 1 would be Year 1, the interval from 1 to 2 would be Year 2, and so on. Note
that each tick mark corresponds to the end of one period as well as the beginning of the next
period. In other words, the tick mark at Time 1 represents the end of Year 1, and it also
represents the beginning of Year 2 because Year 1 has just passed.
Cash flows are placed directly below the tick marks, and interest rates are shown directly
above the time line. Unknown cash flows, which you are trying to find in the analysis, are
indicated by question marks. Here $ 100 is invested at Time 0, and we want to determine how
much this investment will be worth in 5 years if it earners 5 percent interest each year.

3.2. The Future Value (Compounding)

A dollar in hand today is worth more than a dollar to be received in the future because, if you
had it now, you could invest it, earn interest, and end up with more than one dollar in the future.
The process of going from today’s values, or present values (PVs), to future values (FVs) is
called compounding.
Meaning of Compounding
―The arithmetic process of determining the final value of a cash flow or series of cash flows
when compound interest is applied.‖
To illustrate,
Suppose you deposit $100 in a bank that pays 5 percent interest each year. How much would you
have at the end of one year? To begin, we define the following terms:
PV = present value, or beginning amount, in your account. Here PV = $100.
i= interest rate the bank pays on the account per year. The interest earned is based on the
balance at the beginning of each year, and we assume that it is paid at the end of the
year. Here i = 5%, or, expressed as a decimal, i = 0.05. Throughout this chapter, we
designate the interest rate as i (or I) because that symbol is used on most financial
calculators.
INT = dollars of interest you earn during the year = Beginning amount X i. Here INT =
$100(0.05) = $5.
FVn = future value, or ending amount, of your account at the end of n years. Whereas PV is
the value now, or the present value, FVn is the value nyears into the future, after the
interest earned has been added to the account.
N = number of periods involved in the analysis. Here n = 1.

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In our example, n = 1, so FVn can be calculated as follows:
FVn = FV1 = PV + INT
= PV + PV(i)
= PV(1+ i)
= $100(1 + 0.05) = $100(1.05) = $105.

Thus, the future value (FV) at the end of one year, FV1, equals the present value multiplied by
1 plus the interest rate, so you will have $105 after one year.
Meaning of Future Value (FV)
―The amount to which a cash flow or series of cash flows will grow over a given period of time
when compounded at a given interest‖
What would you end up with if you left your $100 in the account for five years? Here is a time
line set up to show the amount at the end of each year:
0 5% 1 2 3 4 5

Initial -100 FV1= ? FV2= ? FV3= ? FV4= ? FV5= ?

Deposit
Interest Earned: 5.00 5.25 5.51 5.79 6.08
Amount at the end of
Each period =FVn 105.00 110.25 115.76 121.55 127.63
Note the following points:
(1) You start by depositing $100 in the account— this is shown as an outflow at t = 0.
(2) You earn $100(0.05) = $5 of interest during the first year, so the amount at the end of Year 1
(or t = 1) is $100 + $5 = $105.
(3) You start the second year with $105, earn $5.25 on the now larger amount, and end the
second year with $110.25. Your interest during Year 2, $5.25, is higher than the first year’s
interest, $5, because you earned $5(0.05) = $0.25 interest on the first year’s interest.
(4) This process continues, and because the beginning balance is higher in each succeeding year,
the annual interest earned increases.
(5) The total interest earned, $27.63, is reflected in the final balance at t = 5, $127.63.
Note that the value at the end of Year 2, $110.25, is equal to
FV2 = FV1(1 + i)
= PV(1 + i)(1+ i)
= PV(1 + i)2
= $100(1.05)2 = $110.25.
Continuing, the balance at the end of Year 3 is

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 FV3 = FV2(1 + i)
= PV(1 + i)3
= $100(1.05)3 = $115.76,
And
FV5 = $100(1.05)5 = $127.63.
In general, the future value of an initial lump sum at the end of n years can be found by
applying the following Equation

FVn = PV(1 +i)n.

Graphic view of Compounding Principle

3.3 The present value (Discounting)

Suppose you have some extra cash, and you have a chance to buy a low-risk security that will
pay $127.63 at the end of five years. Your local bank is currently offering 5 percent interest on

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five-year certificates of deposit (CDs), and you regard the security as being exactly as safe as a
CD. The 5 percent rate is defined as your opportunity cost rate, or the rate of return you could
earn on an alternative investment of similar risk.
Meaning of Opportunity Cost Rate
―The rate of return on the best available alternative investment of equal risk‖
How much should you be willing to pay for the security?
From the future value example presented in the previous section, we saw that an initial amount
of $100 invested at 5 percent per year would be worth $127.63 at the end of five years. As we
will see in a moment, you should be indifferent between $100 today and $127.63 at the end of
five years. The $100 is defined as the present value, or PV, of $127.63 due in five years when
the opportunity cost rate is 5 percent.
Meaning of Present Value (PV)
―The value today of a future cash flow or series of cash flows.‖
If the price of the security were less than $100, you should buy it, because its price would then
be less than the $100 you would have to spend on a similar-risk alternative to end up with
$127.63 after five years. Conversely, if the security cost more than $100, you should not buy
it, because you would have to invest only $100 in a similar risk alternative to end up with
$127.63 after five years. If the price were exactly $100, then you should be indifferent—you
could either buy the security or turn it down. Therefore, $100 is defined as the security’s fair, or
equilibrium, value.
Meaning of Fair (Equilibrium) Value

―The price at which investors are indifferent between buying or selling a security.‖

In general, the present value of a cash flow due n years in the future is the amount which, if it
were on hand today, would grow to equal the future amount. Since $100 would grow to $127.63
in five years at a 5 percent interest rate, $100 is the present value of $127.63 due in five years
when the opportunity cost rate is 5 percent.
Meaning of Discounting
―The process of finding the present value of a cash flow or a series of cash flows; discounting is
the reverse of compounding.‖
Finding present values is called discounting, and it is simply the reverse of compounding—if
you know the PV, you can compound to find the FV, while if you know the FV, you can
discount to find the PV. When discounting, you would follow these steps:

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Time Line:

0 5% 1 2 3 4 5

PV = ? 127.63

Equation:
To develop the discounting equation, we begin with the future value equation,
FVn = PV(1 + i)n = PV(FVIFi,n).
Next, we solve it for PV in several equivalent forms:
PV = FVn / (1 + i)n = FVn [1/1+i]n = FVn (PVIF i,n,)
The last form of equation recognizes that the interest factor PVIF i, n, is equal to the term in
parentheses in the second version of the equation.
Numerical Solution

0 5% 1 2 3 4 5

-100 105 110.25 115.76 121.55 127.63

÷1.05 ÷1.05 ÷1.05 ÷1.05 ÷1.05

Divide $127.63 by 1.05 five times, or by (1.05)5, to find PV = $100.

Tabular Solution
The term in parentheses in Equation is called the Present Value Interest Factor for i and n, or
PVIFi,n.
Meaning Present Value Interest Factor for i and n (PVIFi,n)
―The present value of $1 due n periods in the future discounted at i percent per period‖.
The value of PVIFi,n for i = 5% and n = 5 is 0.7835, so the present value of $127.63 to be
received after five years when the appropriate interest rate is 5 percent is $100:
PV = $127.63(PVIF5%,5) = $127.63(0.7835) = $100.
Graphical view of Discounting Process

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Hyperbolic discounting refers to the tendency for people to increasingly choose a smaller-
sooner reward over a larger-later reward as the delay occurs sooner rather than later in time.

In economics exponential discounting is a specific form of the discount function, used in the
analysis of choice over time (with or without uncertainty). Formally, exponential
discounting occurs when total utility is given by.

CHAPTER – 5
CAPITAL BUDGETING DECISIONS

Introduction
The investment decisions of a firm are generally known as the capital budgeting, or capital
expenditure decisions. The firm’s investment decisions would generally include expansion,
acquisition, modernisation and replacement of the long-term assets. Sale of a division or
business (divestment) is also as an investment decision.
Meaning and Features

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A capital budgeting decision may be defined as the firm's decision to invest its current funds
most efficiently in the long-term assets in anticipation of an expected flow of benefits
over a series of years. It has the following features
1. The exchange of current funds for future benefits.
2. The funds are invested in long-term assets.
3. The future benefits will occur to the firm over a series of years.
Importance of Capital Budgeting
Investment decisions require special attention because of the following reasons.
1. They influence the firm's growth and profitability in the long run
2. They affect the risk of the firm
3. They involve commitment of large amount of funds
4. They are irreversible, or reversible at substantial loss
5. They are among the most difficult decisions to make.
Evaluation criteria in Capital Budgeting
Three steps are involved in the evaluation of an investment:
1. Estimation of cash flows
2. Estimation of the required rate of return (the opportunity cost of capital)
3. Application of a decision rule for making the choice
Investment Analysing Tools
Discounted Cash Flow (DCF) Criteria
a. Net Present Value (NPV)
b. Internal Rate of Return (IRR)
c. Profitability Index (PI)
. Non-discounted Cash Flow Criteria (Traditional Methods)

d. Payback Period (PB)

e. Discounted payback period (DPB)
f. Accounting Rate of Return (ARR)
Time value of Money and Capital Budgeting Tools

 The time value of money is based on the premise that the value of money changes
because of investment opportunities available to investors. Hence, Rs 100 today is not
same as Rs 100 after one year.
 The capital budgeting methods that are based on the time value of money are called

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 discounted cash flow (DCF) Criteria. They include two methods: (1) Net Present Value
(NPV) and (2) Internal Rate of Return (IRR). Profitability Index (PI), a variant of NPV
method, also a DCF technique.
 Non-DCF techniques are not able to differentiate between cash flows occurring in
different time periods. They not focus on value, and hence, they violate the principle
of the shareholder wealth maximisation.
Net Present Value Method
a) Cash flows of the investment project should be forecasted based on realistic assumptions.
b) Appropriate discount rate should be identified to discount the forecasted cash flows.
c) Present value of cash flows should be calculated using the opportunity cost of capital as the discount
rate.
d) Net present value should be found out by subtracting present value of cash outflows from present value
of cash inflows. The project should be accepted if NPV is positive (i.e., NPV > 0).
Computation of NPV

The formula for the net present value can be written as follows:
 C C2 C3 Cn 
NPV   1     C0
 (1  k ) (1  k ) (1  k )
2 3
(1  k ) n 
n
Ct
. NPV    C0
t 1 (1  k )
t

Exercise

Assume that Project X costs Br 2,500 now and is expected to generate year-end cash
inflows of Br. 900, Br 800, Br 700, Br 600 and Br 500 in years 1 through 5. The
opportunity cost of the capital may be assumed to be 10 per cent.

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Why NPV is Important?

o Positive net present value of an investment represents the maximum amount a firm would
be ready to pay for purchasing the opportunity of making investment, or the amount at
which the firm would be willing to sell the right to invest without being financially worse-
off.
o The net present value can also be interpreted to represent the amount the firm could raise at
the required rate of return, in addition to the initial cash outlay, to distribute immediately to
its shareholders and by the end of the projects’ life, to have paid off all the capital raised
and return on it.
Acceptance Rule

a) Accept the project when NPV is positive NPV > 0

b) Reject the project when NPV is negative NPV < 0
c) May accept the project when NPV is zero NPV = 0
The NPV method can be used to select between mutually exclusive projects; the one with
the higher NPV should be selected.

Evaluation of NPV Method

NPV is most acceptable investment rule for the following reasons:

 Time value
 Measure of true profitability
 Value-additivity
 Shareholder value
Limitations of NPV Method

 Involved cash flow estimation

 Discount rate difficult to determine
 Mutually exclusive projects
 Ranking of projects

Payback Period Method

Payback is the number of years required to recover the original cash outlay invested in a
project. If the project generates constant annual cash inflows, the payback period can be
computed by dividing cash outlay by the annual cash inflow. That is:

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 Initial Investment C
Payback =  0
Annual Cash Inflow C

For example:

Assume that a project requires an outlay of Br 50,000 and yields annual cash inflow of Br
12,500 for 7 years. The payback period for the project is:

Rs 50,000
PB   4 years
Unequal cash flows: Rs 12,000
In case of unequal cash inflows, the payback period can be found out by adding up the cash
inflows until the total is equal to the initial cash outlay.

For example:

Suppose that a project requires a cash outlay of Br 20,000, and generates cash inflows of Br
8,000; Br 7,000; Br 4,000; and Br 3,000 during the next 4 years. What is the project’s
payback?

3 years + 12 × (1,000/3,000) 12 months

3 years + 4 months
Accepting Rule
 The project would be accepted if its payback period is less than the maximum or
standard payback period set by management.
 As a ranking method, it gives highest ranking to the project, which has the shortest
payback period and lowest ranking to the project with highest payback period.

Importance of Payback Period Method

1. Simplicity. Payback is simple to understand and easy to calculate. The
business executives consider the simplicity of method as a virtue. This is
evident from their heavy reliance on it for appraising investment proposals in
practice.
2. Cost effective. Payback method costs less than most of the sophisticated
techniques that require a lot of the analysts' time and the use of computers.
3. Short-term effects. A company can have more favourable short-run effects on
earnings per share by setting up a shorter standard payback period. It should,
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 however, be remembered that this may not be a wise long-term policy as the
company may have to sacrifice its future growth for current earnings.
4. Risk shield. The risk of the project can be tackled by having a shorter standard
payback period as it may ensure guarantee against loss. A company has to
invest in many projects where the cash inflows and life expectancies are
highly uncertain. Under such circumstances, payback may become important,
not so much as a measure of profitability but as a means of establishing an
upper bound on the acceptable degree of risk.
5. Liquidity: The emphasis in payback is on the early recovery of the investment.
Thus, it gives an insight into the liquidity of the project. The funds so released can be
put to other uses.

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 Chapter – 6
Long Term of Financing

Introduction to Capital Market

A capital market is a Financial Market in which long-term Debt or Equity -
backed Securities are bought and sold. There are two types of market viz., primary market and
secondary market. In primary markets, new stock or bond issues are sold to investors, often via a
mechanism known as Underwriting. In the secondary markets, existing securities are sold and bought
among investors or traders, usually on stock exchange, over-the -counter, or elsewhere.
Meaning of Public issue
In a capital market, company can borrow funds from primary market by way of public issue of
shares and debentures. ...
Long term financing
The important sources of long term financing are presented in the diagram

Ordinary Shares

Ordinary shares (called common stocks in USA) are important securities used by the firms to
raise funds to finance their activities. Ordinary shares provide ownership rights to ordinary
shareholders. They are legal owners of the company. As a result, they have residual claims on
income and assets of the company. They have the right to elect directors and maintain their
proportionate ownership in the company, i.e., preemptive right.

Ordinary shares represent the ownership position in a company. The shareholders are legal
owners of the company. Ordinary shares are also known as variable income securities (the
rate of dividend is not fixed and not committed). It is a source of permanent capital.
Advantages of ordinary shares are as follows:

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 1. It is a permanent capital, as they do not have maturity date.
2. It increases the base of the firm, and thus increases its borrowing limits.
3. A company is not legally bound to pay dividend. When the profits are
insufficient or firm have need of funds for investment in profitable
opportunities, it can reduce or suspend payment of dividend.
Limitations of ordinary shares are as follows:

1. The control of the corporate is affected by the issuance of equity shares.

2. The exclusive use of ordinary shares as a medium of capital eliminates the
advantages likely to accrue from the policy of trading on equity.
3. Individual and institutional investor cannot purchase equity shares because of
choice or legal restrictions.
4. The excessive use of equity shares may result in over capitalization in future
when the earning capacity of the firm fails to raise up to the desired level of
equity providers.
5. Ordinary shares are riskier from investors' point of view as there is
uncertainty regarding dividend and capital gains.
Residual Claim on Ordinary Shares

The ordinary shareholders have a claim to the residual income; i.e., earnings available for
equity shareholders after satisfying all providers of funds. This income may be split into two
parts, i.e., dividends and retained earnings. Residual income is either directly distributed in the
form of dividend or indirectly in the form of capital gains (retained earnings reinvested,
enhance the earnings of the firm in future). Dividends are payable based on discretion of
company's board of directors. Thus, ordinary share is a risky security from the investors'
point of view.

Preference Shares
Preference shares and debentures are also important securities used by firm to raise funds to
finance their activities. Preference shareholders are also legal owners of the company, but they
have the claim over assets of the firm before the claim of equity shares settled. They also have the
right to have fixed dividend if company decides to pay, before on equity shares.
The advantages of preference shares to the company are as follows:

1) It provides financial leverage advantage since preference dividend is a

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 fixed and non-committed obligation. The non-payment of preference
dividend does not threaten the life of the company.
2) It provides some financial flexibility to the company since company can
postpone dividend payment.
3) The preference dividend payments are restricted to the stated amount. The
preference shareholders’ do not participate in excess profits of the
company.
4) Preference shareholders do not have any voting rights except in case
dividend arrears exist.
The following are the limitations of preference shares:

1) The preference dividend is no tax-admissible expenses as do interest on

debenture. So, it is costlier than debentures.
2) Although preference dividend can be omitted, they may have to be paid
because of their cumulative nature. Non-payments of preference dividend
adversely affect the image of the company. Thus, in future, it is quite
difficult for the company to raise funds.
Debentures
A debenture is a long term promissory note for raising loan capital. The purchaser of debenture
is called debenture holder. Debenture holder is the creditor of the firm.
The important features of debentures are enumerated as under:
a. It is a long term, fixed income financial security.
b. The contractual rate of interest is fixed and known. It indicates the
percentage of par value of the debentures that will be paid, non -
cumulatively - annually, semi-annually or quarterly; cumulatively - along
with principal on maturity.
c. Debentures are issued for a specific period of time, and on maturity date
redeemed by company.
d. Debenture issues may include buy-back provision. Buy-back provisions
enable the company to redeem debentures at specified pric e before
maturity date.
e. Debentures are either secured (by alien on company's specific assets) or
unsecured.

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 f. The yield on a debenture is related to its market price; therefore, it could
be different from the coupon rate of interest. Hence,

Annual Interest
Yield = --------------
Market Price
g. An indenture or debenture trust deed is a legal agreement between the
company issuing debentures and the debenture trustee who represents the
debenture holders.
Debenture has a number of advantages as long term sources of finance:

1) It involves less cost to the firm than the equity finance because investors
expect lower rate of return, and interest payments are tax-deductible.
2) Debenture issue does not cause dilution of ownership control by
company's present management.
3) There is a certainty of finance for specified period.
4) By issuing debentures company gets an opportunity to trading on equity.
5) The debentures may be issued out of necessity. In such a situation, it may
be compelled to mortgage assets to raise funds.
6) During the periods of inflation, debenture issue benefits the company. Its
obligation of paying interest and principal which are fixed decline in real
terms.
Debentures have some limitations like.

1) A company with highly fluctuating earnings takes a great risk by issuing

debentures which may entail a great strain on its resources, and company
may face the consequences of liquidation.
2) It increases the financial leverage, which may be disadvantageous for
firms which have fluctuating sales and earnings.
3) Debentures must be paid on maturity, so it involves substantial cash
outflows at some point.
4) Debenture indenture may contain restrictive covenants which may limit
the company's operating flexibility in future.

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Term Loans

Term loans are loans for more than a year maturity. Generally, in India, they are available for a
period of 6 to 10 years. In some cases, the maturity could be as long as 25 years. Interest on
term loans is tax-deductible. Mostly, term loans are secured through an equitable mortgage on
immovable assets. Term loans secured specifically by the assets acquired using the term loan
funds, is called primary security. Term loans are also generally secured by the company's
current and future assets. This is called secondary or collateral security. In addition to asset
security, lender like financial institutions (FIs), add a number of restrictive covenants (asset
related, liability related, cash flow related and/or control related) to protect itself further. FIs in
India are normally insisting on the option of converting loans into equity, and specify the
repayment schedule at the time of entering into loan agreement (in principle) with borrower.

Difference between Term Loan and Debentures

The term loans and debentures both represent long term debt with a maturity more than one year.
Both have contractual rate of interest. Term loans are always secured by way of mortgage on
assets of the firm, while the debentures may be secured or unsecured. The interest expenses are
tax-deductible expense. Both provide the benefit of trading on equity to the shareholders.
Debenture holders do not have voting rights; therefore; debenture issue does not cause dilution
of ownership. Term loans directly do not cause dilution of ownership, but they impose some
restrictive covenants on working of the firm, so the decision making freedom of board of
directors reduces to that extent. Debenture and term loan both result in legal obligation of
payment of interest and principal; if not paid, the lenders can force the company into liquidation.
Both increase the financial leverage, which may particularly be disadvantageous to those firms
which have fluctuating sales and earnings.

33 | P a g e A n o v e r v i e w o f F i n a n c i a l M a n a g e m e n t / D r J o t h i
M/Ambo University, Woliso Campus