Financial Management and Risk Analysis PDF

1 FINANCIAL MANAGEMENT AND RISK ANALYSIS Working capital: The term working capital denotes that part of the total capital of the business which is employed in short term or current operations. In other words, working capital means that part of the permanent capital, left in the business...

1 FINANCIAL MANAGEMENT AND RISK ANALYSIS Working capital: The term working capital denotes that part of the total capital of the business which is employed in short term or current operations. In other words, working capital means that part of the permanent capital, left in the business for supporting the day-to-day normal operations. Types of working capital: 1. Gross and net working capital: Gross working capital is the sum total of all the current assets. But net working capital is the excess of current assets over current liabilities, i.e., current assets – current liabilities. For determining the rate of return on the investment in working capital, the concept of gross working capital is more important. Again, to judge the financial soundness of the organization or to ascertain the current financial position of the business, the net working capital concept is used. We may designate the 2 categories of working capital as quantitative (gross) and qualitative (net). 2. Positive and negative working capital: According to gross working capital concept, working capital is always positive as it is the sum total of the current assets. But as per the net working capital concept, it can be either positive or negative. When sum total of current assets > sum total of current liabilities, it is positive. But if total of current assets < sum total of current liabilities, it is negative. 3. Permanent/fixed working capital and variable/seasonal working capital: Permanent working capital constitutes the minimum value of current assets that the business must hold to conduct the day-to-day business, even during relatively dull/slack season. The nature of this type of investment is like long term investment in fixed assets. The main sources of permanent working capital are share capital, debentures, long term loans, retentions of profits in the form of reserves etc. Variable/seasonal working capital means the additional working capital required to cater the needs of the more active business seasons. The sources of variable working capital are bank overdraft, cash credits from banks, short term bank loans, public deposits, credit from suppliers or trade credit etc. Factors affecting the working capital requirement: 1. General nature of the business 2. Size of the business 3. Production cycle 4. Business cycle 5. Turnover of inventory 6. Credit policy 7. Growth and expansion of business 8. Seasonal variations 9. Business cycle fluctuations 10. Rise in price level 11. Operating efficiency 12. Hazards and contingencies inherent in a particular type of business  2 Different capital budgeting techniques: 1. Without considering time value of money: a) Payback period method b) Accounting/average rate of return 2. With considering time value of money: a) Discounted payback period method b) Net present value method c) Internal rate of return method d) Profitability index method NPV method: Net Present Value (NPV) is a capital budgeting method that helps determine the profitability of a project or investment. It's used to calculate the present value of future cash flows by comparing the present value of cash inflows to the present value of cash outflows. Net present value (NPV) is used to calculate the current value of a future stream of payments from a company, project, or investment. To calculate NPV, you need to estimate the timing and amount of future cash flows and pick a discount rate equal to the minimum acceptable rate of return. If NPV of a project is positive, we generally accept that project. But if it is a negative, we reject that project. But when more than one projects are in competition, the project with highest positive NPV should be chosen. Advantages include: NPV provides an unambiguous measure. It estimates wealth creation from the potential investment in today’s dollars, given the applied discount rate. NPV accounts for investment size. It works for comparing marginal forestry investments to multi-billion-dollar projects or acquisitions. NPV is straightforward to calculate (especially with a spreadsheet). NPV uses cash flows rather than net earnings (which includes non-cash items such as depreciation). NPV recognizes the time value of money (unlike cash-on-cash returns or simple payback period). For forestry investments, which tend to be long-term, this is critically and entirely appropriate. NPVs are additive. If you have multiple projects and excess capital, you can add up projects to get a sense of aggregate wealth creation from all investable projects. Disadvantages include:  3 A discount rate must be selected. NPV also assumes the discount rate is the same over the life of the investment or project. Discount rates, like interest rates, can and do change year-to-year. Consider capitalization (“cap”) rates in commercial real estate. Benchmarks move. Opportunity costs change and differ across investors. NPV assumes you can accurately assess and predict future cash flows. While your crystal ball may prove infallible, mine has shown cracks at times. For some, it is an intuitively difficult concept to grasp. Payback period method: The payback period is the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point. People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter the payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows The payback period is the length of time it takes to recover the cost of an investment or the length of time an investor needs to reach a breakeven point. Shorter paybacks mean more attractive investments, while longer payback periods are less desirable. The payback period is calculated by dividing the amount of the investment by the annual cash flow. Account and fund managers use the payback period to determine whether to go through with an investment. One of the downsides of the payback period is that it disregards the time value of money. Payback Period=Average Annual Cash Flow/Cost of Investment​ Advantages: Simplicity: The primary advantage of this method is its simplicity. The calculations involved in the Pay-back Period Method are basic, making it easy for non-specialists to understand and use. Liquidity Management: The Pay-back Period Method helps in evaluating the effect of a project or an investment on a company's liquidity by indicating when the original investment is expected to be regained. This aspect of the method is particularly crucial for smaller, cash-strapped businesses. Risk Assessment: Given that investments with shorter pay-back periods are usually less risky, this method assists in establishing and comparing the relative risk of various projects. This can guide businesses in determining the range of risk they are willing to take on. Planning tool: The information provided by the Pay-back Period Method can be valuable for future planning. By offering an estimate of when the investment will start  4 generating profits, it allows businesses to plan their future investments or resource allocation more effectively. Therefore, these benefits make the Pay-back Period Method an attractive option for many businesses in evaluating their investment decisions. Disadvantages: Ignore Profitability After Pay-back: This method does not consider the cash inflows that occur after the pay-back period. It does not account for the total profitability of an investment or a project over its lifetime. An investment could have a longer pay-back period, but it may be more profitable in the long run. Disregard Time Value of Money: The Pay-back Period Method also neglects the concept of the time value of money. It treats all cash inflows, whether occurring sooner or later, as equivalent, which isn't correct as cash in hand today is worth more than the same amount in the future. Subjective Nature: Determining the acceptable pay-back period can be a subjective process and might vary substantially from one firm to another, or even from one project to another within the same firm. While the method does have these drawbacks, it does not denote that the Pay-back Period Method is redundant. Instead, understanding these limitations helps in using the method more effectively, often in conjunction with other investment appraisal techniques.