Financial Management PDF Past Paper - Paper-20 - M Com (Final)

Financial Management Paper-20 M Com (Final) Directorate of Distance Education Maharshi Dayanand University ROHTAK – 124 001 2 jktuhfr foKku Copyright © 2004, Maharshi Dayanand University, ROHTAK All Rights Reserved. No part of this publication may be reproduced or stored in a retrieval system or transmitted in any form or by any means; electronic, mechanical, photocopying, recording or otherwise, without the written permission of the copyright holder. Maharshi Dayanand University ROHTAK – 124 001 Developed & Produced by EXCEL BOOKS PVT. LTD., A-45 Naraina, Phase 1, New Delhi-110028 Qklhokn 3 CONTENTS Chapter-1: Introduction to Financial Management 5 Chapter-2: Cost of Capital 25 Chapter-3: Operating and Financial Leverage 77 Chapter-4: Capital Budgeting 94 Chapter-5: Capital Budgeting Evaluation Techniques 112 Chapter-6: Capital Budgeting under Risk and Uncertainties 130 Chapter-7: Working Capital Management 165 Chapter-8: Cash Management and Marketable Securities 196 Chapter-9: Management of Receivables 223 Chapter-10: Inventory Management 244 Chapter-11: Capital Structure Theories 262 Chapter-12: Dividend Decisions 330 Chapter-13: Working Capital Financing 346 Chapter-14: Regulation of Bank Finance 380 4 jktuhfr foKku FINANCIAL MANAGEMENT MCom (Final) Paper-20 M. Marks : 100 Time : 3 Hrs. Note: There will be three sections of the question paper. In section A there will be 10 short answer questions of 2 marks each. All questions of this section are compulsory. Section B will comprise of 10 questions of 5 marks each out of which candidates are required to attempt any seven questions. Section C will be having 5 questions of 15 marks each out of which candidates are required to attempt any three question. The examiner will set the questions in all the three sections by covering the entire syllabus of the concerned subject. Course Inputs UNIT–I Evaluation of Finance, Objectives of the Firm-Profit Max, And Wealth Max, Functions of Financial Management, Organisation of the Finance Function, Cost of Capital: Definition and Concepts, Measurement, the weighted average cost of Capital; Leverage: Operating and Financial, Combined Leverage. UNIT–II Capital Budgeting, Meaning, Importance, Rational of Capital Budget, Nature of Investment Decision, The Administrative framwork, methods of appraisal, Capital Rationing, Inflation and Capital Budgeting; Capital budgeting underRisk and Uncertainties. UNIT–III Working Capital Management, Concept, Need, Determinants, Finance mix for working capital, Estimating working capiktal needs, Cash management; The Cash Budget, Techniques of cash management and marketable securities; Management of reseivables; Objectives, Factors affecting policies for managing accounts receivables; Inventory Management; Objectives, Inventory Management techniques. UNIT–IV Financing Decisions: Capital Structure Theories, taxation and capital structure; Planning the capital structure, Factors affecting capital structure, E.B.I.T.-E.P.S. anslysis, ROI-ROE analysis, Assessment of Debt Capacity, Capital Structure Policies in Practice. Dividend Decision: Theories of Dividends-traditional position, Gordon Model, Walter model, M.M. Model, Radical Model, Factors affecting dividend policy, stock dividends and stock splits, Repurchase of stock procedural and legal aspects of dividends. UNIT–V Sources of Working Capital Funds: Accurals, trade, credit, commercial banks advances, public deposits, Inter corporate deposits, short term loans from financial institution, right debentures for working capital, commercial papers and factoring. Regulation of Bank Finance:-Recommendations of Latest Committee. Introduction to Financial Management 5 Chapter-1 Introduction to Financial Management Companies do not work in a vacuum, isolated from everything else. It interacts and transacts with the other entities present in the economic environment. These entities include Government, Suppliers, Lenders, Banks, Customers, Shareholders, etc. who deal with the organisation in several ways. Most of these dealings result in either money flowing in or flowing out from the company. This flow of money (or funds) has to be managed so as to result in maximum gains to the company. Managing this flow of funds efficiently is the purview of finance. So we can define finance as the study of the methods which help us plan, raise and use funds in an efficient manner to achieve corporate objectives. Finance grew out of economics as a special discipline to deal with a special set of common problems. The corporate financial objectives could be to: 1. Provide the link between the business and the other entities in the environment and 2. Investment and financial decision making Let us first look at what we mean by investment and financial decision making. 1. Investment Decision: The investment decision, also referred to as the capital budgeting decision, simply means the decisions to acquire assets or to invest in a project. Assets are defined as economic resources that are expected to generate future benefits. 2. Financing Decision: The second financial decision is the financing decision, which basically addresses two questions: a. How much capital should be raised to fund the firm's operations (both existing & proposed) b. What is the best mix of financing these assets? Financing could be through two ways: debt (loans from various sources like banks, financial institutions, public, etc.) and equity (capital put in by the investors who are also known as owners/ shareholders). Shareholders are owners because the shares represent the ownership in the company. 6 Financial Management Funds are raised from financial markets. Financial markets is a generic term used to denote markets where financial securities are teat. These markets include money markets, debt market and capital markets. We will understand them in detail later in the 3rd chapter. Financing and investing decisions are closely related because the company is going to raise money to invest in a project or assets. Those who are going to give money to the company (whether lenders or investors) need to understand where the company is investing their money and what it hopes to earn from the investments so that they can assure themselves of the safety of their money. The questions that you may thinking about right now are "Why do we need to learn finance? Shall we not leave it to the people who are going to specialise in finance? Finance won't help me in the area that I am going to work in, so why learn?" This is to say that the knowledge of finance does not add any value to you. Is it so? Think about it. When you get your pocket money from your parents, you do not go out and blow the whole lot in one day because if you do, your parents are not going to give you more money to last through that month. You quickly learn that you need to plan your expenditure so that the money lasts throughout the month and you may actually plan to save some of it. Those who do not get enough to meet their requirements, think about some clever means to raise more money (like falling sick!). Alternatively if they need more money for the month because of certain special events (like Valentine's day) they can plan to borrow money for a month and repay in the next month. So you plan, raise and efficiently utilise funds that are your disposal (or at least try to). That a business organisation also needs to do the same can hardly be overemphasised. The scale of operations is much bigger and to efficiently manage funds at this scale, decisions cannot be taken without sound methodology. Finance teaches you this terminology. For managing these funds the first thing you would need is information. External information has to be collected from the environment and accounting provides internal information about the firm's operations. Accounting can be defined as an information and measurement system that identifies, records, and communicates relevant information about a company's economic activities to people to help them make better decisions. You would now agree that a company needs to manage its own funds efficiently but your question still remains "Why am I concerned with it?" Further arguing, you say that, "I am going to specialise in Marketing/ Information Technology/ Human Resource Management/ Operations Management and there is no need for me to learn finance. Also Finance is a separate function in my organisation (or the organisation that I am going to work for) and I am hardly going to use finance to work in my respective department." Introduction to Financial Management 7 Think again. Everything that you do has an impact on the profitability of the company (including drinking ten cups of coffee in a day!). So if you want to grow up to be the CEO of the company in a few years from now (which I undoubtedly think that you would love to) you should take the advice of the top CEOs. 79 per cent of the top CEOs rate Finance skills, as the most required for the CEO of the future. KPMG survey Better take the CEOs advice. But don't get the feeling that only the CEOs require the Finance Skills, all other functions of management also cannot do without finance and the financial information. Fields of Finance The academic discipline of financial management may be viewed as made up of five specialized fields. In each field, the financial manager is dealing with the management of money and claims against money. Distinctions arise because different organizations pursue different objectives and do not face the same basic set of problems. There are five generally recognized areas of finance. 1. Public Finance. Central, state and local governments handle large sums of money, which are received from many sources and must be utilized in accordance with detailed policies and procedures. Governments have the authority to tax and otherwise raise funds, and must dispense funds according to legislative and other limitations. Also, government do not conduct their activities to achieve the same goals as private organizations. Businesses try to make profits, whereas a government will attempt to accomplish social or economic objectives. As a result of these and other differences, a specialized field of public finance has emerged to deal with government financial matters. 2. Securities and Investment Analysis. Purchase of stocks, bonds, and other securities involve analysis and techniques that are highly specialized. An investor must study the legal and investment characteristics of each type of security, measure the degree of risk involved with each investment, and forecast probable performance in the market. Usually this analysis occurs without the investor having any direct control over the firm or institution represented by the form of security. The field of investment analysis deals with these matters and attempts to develop techniques to help the investor reduce the risk and increase the likely return from the purchase of selected securities. 3. International Finance. When money crosses international boundaries individuals, businesses, and governments must deal with special kinds of problems. Each country has its own national currency; thus a citizen of the United States must convert dollars to French francs before being able to purchase goods or services in Paris. Most governments have imposed restrictions on the exchange of currencies, and these may affect business transactions. Governments may be 8 Financial Management facing financial difficulties, such as balance-of-payments deficits, or may be dealing with economic problems, such as inflation or high levels of unemployment. In these cases, they may require detailed accounting for the flows of funds or may allow only certain types of international transactions. The study of flows of funds between individuals and organizations across national borders and the development of methods of handling the flows more efficiency are properly within the scope of international finance. 4. Institutional Finance. A nation’s economic structure contains a number of financial institutions, such as banks, insurance companies, pension funds, credit unions. These institutions gather money from individual savers and accumulate sufficient amounts for efficient investment. Without these institutions, funds would not be readily available to finance business transactions, the purchase of private homes and commercial facilities, and the variety of other activities that require organizations that perform the financing function of the economy. 5. Financial Management. Individual businesses face problems dealing with the acquisition of funds to carryon their activities and with the determination of optimum methods of employing the funds. In a competitive marketplace, businesses and actively manage their funds to achieve their goals. Many tools and techniques have been developed to assist financial managers to recommend proper courses of action. These tools help the manager determine which sources offer the lowest cost of funds and which activities will provide the greatest return on invested capital. Financial management is the field of greatest concern to the corporate financial officers and will be the major thrust of the approach we shall use in studying finance. An overview of the five fields of finance is given in Figure 1.1. Public Finance Securities and Investment Analysis l Used in central, state and local l Used by individual and institutional government. investors. l Examines taxes and other revenues. l Measures risk in securities transactions. l Pursues nonprofit goals. l Measures likely return. Institutional Finance International Finance l Examines banks, insurances l Studies economic transactions among companies and pension funds. nations. l Studies saving and capital formation. l Concerned with flows among countries. Financial Management l Studies financial problems in individual firms. l Seeks sources of low-cost funds. l Seeks profitable business activities. Figure 1.1 Various Fields of Finance Introduction to Financial Management 9 Objectives of the Firm - Profit Maximisation and Wealth Maximisation To put it simply, we might say that the goal of any business is to maximise the returns to the owners of the business. So the goal of finance is to help the business in maximising returns. But if you talk to the companies, you also hear about many other goals that they are pursuing at the same time. These goals could include maximisation of sales, maximisation of market share, maximisation of growth rates of sales, maximisation of the market price of the share (whether real or specifically pushed up to benefit the owners), etc. Individually speaking, managers would be more concerned with the money that they are making from the organisation and the benefits that they are receiving rather than care about what the owners are making! As there could be many goals for the organisation, we should try and summarise the organisational goals in financial terms so that we can call them the financial goals. They boil down to two: 1. Maximise profits or 2. Maximise wealth Maximise Profits Let us first look at profit maximisation. Profit (also called net income or earnings) can be defined as the amount a business earns after subtracting all expenses necessary for its sales. To put it in an equation form: Sales - Expenses = Profit If you want to maximise profits, there are only two ways to do it. Either you reduce your expenses (also called costs) or you increase the sales (also called revenues). Both of these are not easy to achieve. Sales can be increased by selling more products or by increasing the price of the products. Selling more products is difficult because of the competition in the market and you cannot increase the price of the products without adding more features or value to it (assuming a competitive market). If you are a competitive company, reducing expenses beyond a certain level is possible only by reducing the investments in advertising, research and development, etc. which ultimately leads to reduction in sales in the long term and threatens the survival of the company. Profit maximisation goal assumes that many of the complexities of the real world do not exist and is, therefore, not acceptable. Still, profit maximisation remains one of the key goals for the managers of the company because many managers' compensations are linked to the profits that the company is generating. Owners need to be aware of these goals and understand that it is the long- term viability of their companies that add value to them and not the short-term profitability. 10 Financial Management Therefore, the long-term survival of the company should not be sacrificed for the short- term benefits. Wealth Maximisation Shareholders' wealth can be defined as the total market value of all the equity shares of the company. So when we talk about maximising wealth we talk about maximising the value of each share. How the decisions taken by the organisation affects the value of the organisation is reflected in the figure 1.1. Figure 1.1: How Financial Decisions affect the Value of the Organisation The shareholders' wealth maximisation goal gives us the best results because effects of all the decisions taken by the company and its managers are reflected in it. In order to employee use this goal, we do not have to consider every price change of our shares in the market as an interpretation of the worth of the decisions that the company has taken. What the company needs to focus on is the affect that its decision should have on the share price if everything else was held constant. This conflict of the decisions by the managers and the decisions required by the owners is known as the agency problem. How are companies solving this problem will be discussed later. Scope of Financial Management The approach to the scope and functions of financial management is divided, for purposes of exposition, into two broad categories: (a) The Traditional Approach, and (b) The Modern Approach. Introduction to Financial Management 11 Traditional Approach The traditional approach to the scope of financial management refers to its subject- matter, in academic literature in the initial stages of its evolution, as a separate branch of academic study. The term ‘corporation finance’ was used to describe what is now known in the academic world as ‘financial management’. As the name suggests, the concern of corporation finance was with the financing of corporate enterprises. In other words, the scope of the finance function was treated by the traditional approach in the narrow sense of procurement of funds by corporate enterprise to meet their financing needs. The term ‘procurement’ was used in a broad sense so as to include the whole gamut of raising funds externally. Thus defined, the field of study dealing with finance was treated as encompassing three interrelated aspects of raising and administering resources from outside: (i) the institutional arrangement in the form of financial institutions which comprise the organization of the capital market; (ii) the financial instruments through which funds are raised from the capital markets and the related aspects of practices and the procedural, aspects of capital markets; and (iii) the legal and accounting relationships between a firm and its sources of funds. The coverage of corporation finance was, therefore, conceived to describe the rapidly evolving complex of capital market institutions, instruments and practices. A related aspect was that firms require funds at certain episodic events such as merger, liquidation, reorganization and soon. A detailed description of these major events constituted the second element of the scope of this field of academic study. That these were the broad features of the subject-matter of corporation finance is eloquently reflected in the academic writings around the period during which the traditional approach dominated academic thinking. Thus, the issue to which literature on finance addressed itself was how resources could best be raised from the combination of the available sources. The traditional approach to the scope of the finance function evolved during the 1920s and 1930s and dominated academic during the forties and through the early fifties. It has now been discarded as it suffers from serious limitations. The weaknesses of the traditional approach fall into two broad categories: (i) those relating to the treatment of various topics and the emphasis attached to them; and (ii) those relating to the basic conceptual and analytical framework of the definitions and scope of the finance function. The first argument against the traditional approach was based on its emphasis on issues relating to the procurement of funds by corporate enterprises. This approach was challenged during the period when the approach dominated the scene itself. Further, the traditional treatment of finance was criticised because the finance function was equated with the issues involved in raising and administering funds, the theme was woven around the viewpoint of the suppliers of funds such as investors, investment bankers and so on, that is, the outsiders. It implies that no consideration was given to the viewpoint of those who had to take internal financial decisions. The traditional treatment was, in other words, the outsider-looking-in approach. The limitation was that internal decision making (i.e. insider-looking out) was completely ignored. The second ground of criticism of the traditional treatment was that the focus was on financing problems of corporate enterprises. To that extent the scope of financial management was confined only to a segment of the industrial enterprises, as non- corporate organisations lay outside its scope. 12 Financial Management Yet another basis on which the traditional approach was challenged was that the treatment was built too closely around episodic events, such as promotion, incorporation, merger, consolidation, reorganisation and so on. Financial management was confined to a description of these infrequent happenings in the life of an enterprise. As a logical corollary, the day-to-day financial problems of a normal company did not receive much attention. Finally, the traditional treatment was found to have a lacuna to the extent that the focus was on long-term financing. Its natural implication was that the Issues involved in working capital management were not in the purview of the finance function. The limitations of the traditional approach were not entirely based on treatment or emphasis of different aspects. In other words, its weaknesses were more fundamental. The conceptual and analytical shortcoming of this approach arose from the fact that it confined financial management to issues involved in procurement of external funds, it did not consider the important dimension of allocation of capital. The conceptual framework of the traditional treatment ignored what Solomon aptly describes as the central issues of financial management. These issues are reflected in the following fundamental questions which a finance manager should address. Should an enterprise commit capital funds to certain purposes do the expected returns meet financial standards of performance? How should these standards be set and what is the cost of capital funds to the enterprise? How does the cost vary with the mixture of financing methods used? In the absence of the coverage of these crucial aspects, the traditional approach implied a very narrow scope for financial management. The modern approach provides a solution to these shortcomings. Modern Approach The modern approach views the term financial management in a broad sense and provides a conceptual and analytical framework for financial making. According to it, the finance function covers both acquisition of funds as well as their allocations. Thus, apart from the issues involved in acquiring-external funds, the main concern of financial management is the efficient and wise allocation of funds to various uses. Defined in a broad sense, it is viewed as an integral part of overall management. The new approach is an analytical way of viewing the financial problems of a firm. The main contents of this approach are what is the total volume of funds an enterprise should commit? What specific assets should an enterprise acquire? How should the funds required be financed? Alternatively, the principal contents of the modern approach to financial management can be said to be: (i) How large should an enterprise be, and how fast should it grow? (ii) In what form should it hold assets? and (iii) What should be the composition of its liabilities? The three questions posed above cover between them the major financial problems of a firm. In other words, financial management, according to the new approach, is concerned with the solution of three major problems relating to the financial operations of a firm, corresponding to the three questions of investment, financing and dividend decisions. Thus, financial management, in the modem sense of the term, can be broken down into three major decisions as functions of finance: (i) The investment decision, (ii) The financing decision, and (iii) The dividend policy decision. Introduction to Financial Management 13 The investment decision relates to the selection of assets in which funds will be invested by a firm. The assets which can be acquired fall into two broad group: (i) long- term assets which yield a return over a period of time in future, (ii) short-term or current assets, defined as those assets which in the normal course of business are convertible into without diminution in value, usually within a year. The first of these involving the first category of assets is popularly known in financial literature as capital budgeting. The aspect of financial decision making with reference to current assets or short-term assets is popularly termed as working capital management. Capital Budgeting is probably the most financial decision for a firm. It relates to the selection of an asset or investment proposal or course of action whose benefits are likely to be available in future over the lifetime of the project. The long-term assets can be either new or old/existing ones. The first aspect of the capital budgeting decision relates to the choice of the new asset out of the alternatives available or the reallocation of capital when an existing asset fails to justify the funds committed. Whether an asset will be accepted or not will depend upon the relative benefits and returns associated with it. The measurement of the worth of the investment proposals is, therefore, a major element in the capital budgeting exercise. This implies a discussion of the methods of appraising investment proposals. The second element of the capital budgeting decision is the analysis of risk and uncertainty. Since the benefits from the investment proposals extend into the future, their accrual is uncertain. They have to be estimated under various assumptions of the physical volume of sale and the level of prices. An element of risk in the sense of uncertainty of future benefits is, thus, involved in the exercise. The returns from capital budgeting decisions should, therefore, be evaluated in relation to the risk associated with it. Finally the evaluation of the worth of a long-term project implies a certain norm or standard against which the benefits are to be judged. The requisite norm is known by different names such as cut-off rate, hurdle rate, required rate, minimum rate of return and so on. This standard is broadly expressed in terms of the cost of capital. The concept and measurement of the cost of capital is, thus, another major aspect of capital budgeting decision. In brief, the main elements of capital budgeting decisions are: (i) the long-term assets and their composition, (ii) the business risk complexion of the firm, and (iii) concept and measurement of the cost of capital. Working Capital Management is concerned wit the management of current assets. It is an important and integral part of financial management as short-term survival is a prerequisite for long-term success. One aspect of working capital management is the trade-off between profitability and risk (liquidity). There is a conflict between profitability and liquidity. If a firm does not have adequate working capital, that is, it does not invest sufficient funds in current assets, it may become illiquid and consequently may not have the ability to meet its current obligations and, thus, invite the risk of bankruptcy. If the current assets are too large, profitability is adversely affected. The key strategies and considerations in ensuring a tradeoff between profitability and liquidity is one major dimension of working capital management. In addition, the individual current assets should be efficiently managed so that neither inadequate nor unnecessary funds are 14 Financial Management locked up. Thus, the management of working capital has two basic ingredients: (1) an overview of working capital management as a whole, and (2) efficient management of the individual current assets such as cash, receivables and inventory. The second major decision involved in financial management is the financing decision. The investment decision is broadly concerned with the asset-mix or the composition of the assets of a firm. The concern of the financing decision is with the financing-mix or capital structure or leverage. The term capital structure refers to the proportion of debt (fixed-interest sources of financing) and equity capital (variable-dividend securities/ source of funds). The financing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirements. There are two aspects of the financing decision. First, the theory of capital structure which shows the theoretical relationship between the employment of debt and the return of the shareholders. The use of debt implies a higher return to the shareholders as also the financial risk. A proper balance between debt and equity to ensure a trade-off between risk and return to the shareholders is necessary. A capital structure with a reasonable proportion of debt and equity capital is called the optimum capital structure. Thus, one dimension of the financing decision whether there is an optimum capital structure? And in what proportion should funds be raised to maximise the return to the shareholders? The second aspect of the financing decision is the determination of an appropriate capital structure, given the facts of a particular case. Thus, the financing decision covers two interrelated aspects: (1) capital structure theory, and (2) capital structure decision. The third major decision of financial management is the decision relating to the dividend policy. The dividend should be analysed in relation to the financing decision of a firm. Two alternatives are available in dealing with the profits of a firm: they can be distributed to the shareholders in the form of dividends or they can be retained in the business itself. The decision as to which course should be followed depends largely on a significant element in the dividend decision, the dividend payout ratio, that is, what proportion of net profits should be paid out to the shareholders. The final decision will depend upon the preference of the shareholders and investment opportunities available within the firm. The second major aspect of the dividend decision is the factors determining dividend policy of a firm in practice. To conclude, the traditional approach had a very narrow perception and was devoid of an integrated conceptual and analytical framework. It had rightly been discarded in current academic literature. The modern approach has broadened the scope of financial management which involves the solution of three major decisions, namely, investment, financing and dividend. These are interrelated and should be jointly taken so that financial decision-making is optimal. The conceptual framework for optimum financial decisions is the objective of financial management. In other words, to ensure an optimum decision in respect of these three areas, they should be related to the objectives of financial management. Introduction to Financial Management 15 Functions of Financial Management The traditional function of financial management has been limiting the role of finance to raising and administrating of funds needed by the company to meet their financial needs. It broadly covered: 1. Arrangement of funds through financial institutions 2. Arrangement of funds through financial instruments 3. Looking after the legal and accounting relationship between a corporation and its sources of funds This has outlived its utility. With the advent of technology and need to tighten ships because of competition, financial management became as much a science as art. Efficient allocation of funds became the imperative. The modern approach is an analytical way of looking at the financial problems of a firm with the main concerns like: 1. What is the total volume of funds committed 2. What specific assets should be acquired or divested 3. How should the funds required be financed and from which markets The above questions relate to four broad decision areas, these are: 1. Investment decision: Decisions relating to investment in both capital and current assets. The finance manager has to evaluate different capital investment proposals and select the best keeping in view the overall objective of the enterprise. Capital Budgeting is the typical name given to this decision. 2. Financing Decision: Provision of funds required at the proper time is one of the primary tasks of the finance manager. Identification of the sources, deciding which types of funds to raise (debt or equity), and raising them is one of the crucial tasks. 3. Dividend Decision: Determination of funds requirements and how much of it will be generated from internal accruals and how much to be sourced from outside is a crucial decision. Equity holders are the owners and require returns, and how much money to be paid to them is a crucial decision. 4. Working Capital Decision: The investment in current assets is a major activity that a finance manager is engaged in a day to day basis. How much inventory to keep, how much receivables can be managed, and what is the optimum cash levels, are three of the key questions that are dealt with regularly. 16 Financial Management All these decisions interact, investment decision cannot be taken without taking the financing decision, working capital decision also needs financing, dividend decision is a payout mechanism and has to be taken care of from financing. These tasks are divided and are taken care of by various entities. Objectives of Financial Management To make wise decisions a clear understanding of the objectives which are sought to be achieved in necessary. The objectives provide a framework for optimum financial decision-making. In other words, they are concerned with designing a method of operating the internal investment and financing of a firm. We discuss in this section the alternative approaches in financial literature. There are two widely-discussed approaches: (i) Profit maximisation approach and (ii) Wealth maximisation approach. It should be noted at the outset that the term ‘objective’ is used in the sense of a goal or decision criterion for the three decisions involved in financial management. It implies that what is relevant is not the overall objective or goal of a business but an operationally useful criterion by which to judge a specific set of mutually interrelated business decisions, namely, investment, financing and dividend policy. The second point that should be clearly understood to that the term objectives provides a normative framework. That is the focus in financial literature is on what a firm should try to achieve and on policies that should be followed if certain goals are to be achieve. The implication is that these are not necessarily followed by firms in actual practice. They are rather employed to serve as a basis for theoretical analysis and do not reflect contemporary empirical industry practices. Thus, the term is used in a rather narrow sense of what a firm should attempt to achieve with its investment, financing and dividend policy decisions. Profit Maximisation Decision Ceriterion According to this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided. In specific operational terms, as applicable to financial management, the profit maximisation criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented to the maximisation of profits. The term ‘profit’ can be used in two senses. As a owner-oriented concept it refers to the amount and share of national income which is paid to the owners of business, that is, those who supply equity capital. As a variant it is described as profitability. It is an operational concepts and signifies economic efficiency. In other words, profitability refers to a situation where output exceeds input, that is, the value created by the use of resources is more than the total of the input resources. Used in this sense, profitability maximisation would imply that a firm should be guided in financial decision making by one test; select assets, projects and decisions which are profitable and reject those which are not. In the current financial literature, there is a general agreement that profit maximisation is used in the second sense. The rationale & behind profitability maximisation, as a guide to financial decision making, is simple. Profit is a test of economic efficiency. It provides the yardstick by Introduction to Financial Management 17 which economic performance can be judged. Moreover, it leads to efficient allocation of resources, as resources tend to be directed to uses which in terms of profitability are the most desirable. Finally, it ensures maximum social welfare. The individual search for maximum profitability provides the famous ‘invisible hand’ by which total economic welfare is maximised. Financial management is concerned with the efficient use of an important economic resource (input), namely, capital. It is, therefore, argued that profitability maximisation should serve as the basic criterion for financial management decisions. The profit maximisation criterion has, however, been questioned and criticized on several grounds. The reasons for the opposition in academic literature all into two broad groups: (i) those that are based on misapprehensions about the workability and fairness of the private enterprise itself, and (2) those that arise out of the difficulty of applying this criterion management, refers to an explicit operational guide for the internal investment and financing of a firm and not the overall goal of business operations. We, therefore, focus on the second type of limitations to profit maximisation as an objective of financial management. The main technical flaws of this criterion are ambiguity, timing of benefits, and quality of benefits. Ambiguity. One practical difficulty with profit maximisation criterion for financial decision making is that the term-profit is a vague and ambiguous concept. It has no precise connotation. It is amenable to different interpretations by different people. To illustrate, profit may be short term or long term; it may be total profit or rate of profit; it may be before-tax or before-tax or after-tax; it may be return on total capital employed or total assets or shareholders equity and so on. If profit maximisation is taken to be the objectives, the question arises, which of these variable of profit should a firm try to maximise? Obviously, a loose expression like profit of operational criterion for financial management. Timing of Benefits. A more important technical objection to profit maximisation, as a guide to financial decision making, is that it ignores the differences in the time pattern of the benefits received from investment proposals or courses of action. While working out profitability, ‘the bigger the better’ principle is adopted, as the decision is based on the total benefits received over the working life of the asset, irrespective of when they were received. Consider Table 1.1 Table1.1Time-patternofBenefits(Profits) Alternative A (Rs. Lakhs) Alternative B (Rs. Lakhs) Period I 50 – Period II 100 100 Period III 50 100 Total 200 200 It can be seen from Table 1.1 that the total profits associated with the alternatives, A and B, are identical. If the profit maximisation is the decision criterion, both the alternatives would be ranked equally. But the returns form both the alternatives differ in one important respect, while alternative A provides higher returns in earlier years, 18 Financial Management the returns from alternative B are larger in later years. As a result, the two alternative courses of "action are not strictly identical. This is primarily because a basic dictum of financial planning is the earlier the better as benefits received sooner are more voluble than benefits'. received later. The reason for the superiority of benefits now over benefits later lies in the fact that the former can be reinvested to earn a return. This is referred to as time value of money. The profit maximisation criterion does not consider the distinction between returns received in different time periods and treats all benefits irrespective of the timing, as equally valuable. This not true in actual practice as benefits in early years should be valued more highly than equivalent benefits in later years. The assumption of equal value is inconsistent with the real world situation. Quality of Benefits. Probably the most important technical limitation of profit maximistion as an operational objective, is that it ignores the quality aspect of benefits associated with a financial course of action. The term quality here refers to the degree of certainty with which benefits can be expected. As a rule, the more certain the expected return, the higher is the quality of the benefits. Conversely, the more uncertain/ fluctuating is the expected benefits, the lower is the quality of the benefits. An uncertain and fluctuating return implies risk to the investors. It can be safely assumed that the investors are risk-averters, that is they want to avoid or at least minimise risk. They can, therefore, be reasonably expected to have a preference for a return which is more certain in the sense that it has smaller variance over the years. The problem of uncertainty renders profit maximisation unsuitable as an operational criterion for financial management as it considers only the size of benefits and gives no weight to the degree of uncertainty of the future benefits. This is illustrated in Table 1.2. Table 1.2 Uncertainty About Expected Benefits (Profits) State of Economy Alternative A Alternative B Recession (Period I) 9 0 Normal (Period II) 10 10 Boom (Period III) 11 20 Total 30 30 It is clear from Table 1.2 that the total returns associated with the two alternatives are identical in a normal situation but the range of variations is very wide in case of alternative B, while it is narrow in respect of alternative A. To put it differently, the earnings associated with alternative. B are more uncertain (risky) as they fluctuate widely depending on the state. of the economy. Obviously, alternative A is better in terms of risk and uncertainty, The profit maximisation criterion fails to reveal this, To conclude, the profit maximisation criterion is inappropriate and unsuitable as an operational objective of investment, financing and dividend decisions of a firm. It is not only vague and time value of money. It follows from the above that an appropriate operational decision criterion for financial management should (i) be precise and exact, (ii) be based on the ‘bigger the better’ principal, (iii) consider both quantity and quantity dimensions of benefits, and (iv) recognise the time value of money. The alternative to profit maximisation, that is wealth maximisation is one such measure. Introduction to Financial Management 19 Wealth Maximisation Decision Criterion This is also known as value maximisation or net present worth maximisation. In current academic literature value maximisation is almost universally accepted as an appropriate operations decision criterion for financial management decisions as it removes the technical limitations which characterise earlier profit maximisation criterion Its operational features satisfy all the three requirement of a suitable operation objective of financial courses of action, namely, exactness, quality of benefits and the time value of money. The value of an asset should be viewed in terms of the benefits it can produce. The worth of a course of action can similarly be judged in terms of the value of the benefits it produces less the cost of undertaking it. A significant element in computing the value of a financial course of action, is the precise estimation of the benefits associated with it. The wealth maximisation criterion is based on the measurement of benefits in the case of the profit maximisation criterion. Cash flow is a precise concept with a definite connotation. Measuring benefits in terms of case flow avoids the ambiguity associated with accounting profits. This is the first operational feature of the net present worth maximisation criterion. The second important feature of the wealth maximisation criterion is that it considers is that it considers both the quantity and quality dimensions of benefit. At the same, it also incorporates the time value of money. The operational implication of the uncertainty and timing dimensions of the benefits emanating from a financial decision is that adjustment should be made in the cash flow pattern, firstly, to incorporate risk and, secondly, to make an allowance for differences in the timing of benefits. The value of a course of action must be viewed in teams of its worth to those providing the resources necessary for its undertaking. In applying the value maximisation criterion, the term value is used in terms of worth to the owners, that is, ordinary shareholders. The capitalisation (discount) rate that is employed is, therefore, the rate that reflects the time and risk preferences of the result of higher risk longer time period. Thus, a stream of case flows that is quite certain might be associated with a rate a 5 per cent, while a very risky stream may carry a 15 per cent discount rate. For the above reason the net present value maximisation is superior to the profits maximisation as an operational objective. As a decision criterion, it involves a comparison of value to cost. An action that has a discounted value – reflecting both time and risk that exceeds its cost can be said to create value. Such actions should be undertaking. Conversely, actions, with lees value than cost, reduce wealth and should be alternative with the greatest net present value should be selected. In the words of Ezra Solomon, “The gross present worth of a course of action is equal to the capitalised value of the flow of future expected benefit, discounted (or capitalised) at a rate which reflects their certainty or uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does not meet this test should be rejected. Cost of Capital 25 Chapter-2 Cost of Capital Cost of Capital is the rate that must be earned in order to satisfy the required rate of return of the firm's investors. It can also be defined as the rate of return on investments at which the price of a firm's equity share will remain unchanged. Each type of capital used by the firm (debt, preference shares and equity) should be incorporated into the cost of capital, with the relative importance of a particular source being based on the percentage of the financing provided by each source of capital. Using of the cost a single source of capital as the hurdle rate is tempting to management, particularly when an investment is financed entirely by debt. However, doing so is a mistake in logic and can cause problems. Future Cost and Historical Cost Future cost of capital refers to the expected cost of funds to be raised to finance a project. In contrast, historical cost represents cost incurred in the past in acquiring funds. In financial decisions future cost of capital is relatively more relevant and significant. While evaluating viability of a project, the finance manager compares expected earnings from the project with expected cost of funds to finance the project. Likewise, in taking financing decisions, attempt of the finance manager is to minimise future cost of capital and not the costs already defrayed. This does not imply that historical cost is not relevant at all. In fact, it may serve as a guideline in predicting future costs and in evaluating the past performance of the company. Component Cost and Composite Cost A company may contemplate to raise desired amount of funds by means of different sources including debentures, preferred stock, and common stocks. These sources constitute components of funds. Each of these components of funds involves cost to the company. Cost of each component of funds is designated as component or specific cost of capital. When these component costs are combined to determine the overall cost of capital, it is regarded as composite cost of capital, combined cost of capital or weighted cost of capital, The composite cost of capital, thus, represents the average of the costs of each sources of funds employed by the company. For capital budgeting decision, composite cost of capital is relatively more relevant even though the firm may finance one proposal with only one source of funds and another proposal with another source. This is for the fact that it is the overall mix of financing over time which is materially significant in valuing firm as an ongoing overall entity. 26 Financial Management Average Cost and Marginal Cost Average cast represents the weighted average of the costs of each source of funds employed by the enterprise, the weights being the relative share of each source of funds in the capita! structure. Marginal cost of capital, by contrast refers to incremental cost associated with new funds raised by the firm. Average cost is the average of the component marginal costs, while the marginal cost is the specific concept used to comprise additional cost of raising new funds. In financial decisions the marginal cost concept is most significant. Explicit Cost and Implicit Cost Cost of capital can be either explicit cost or implicit. The explicit cost of any source of capital is the discount rate that equates the present value of the cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outlay. Thus, the explicit cost of capital is the internal rate of return of the cash flows of financing opportunity. A series of each flows are associated with a method of financing. At the time of acquisition of capital, cash inflow occurs followed by the subsequent cash outflows in the form, of interest payment, repayment of principal money or payment of dividends. Thus, if a company issues 10 per cent perpetual debentures worth Rs. 10,00,000, there will be cash inflow to the firm of the order of 10,00,00. This will be followed by the annual cash outflow of Rs. 1,00,000. The rate of discount, that equates the present value of cash inflows with the present value of cash outflows, would be the explicit cost of capital. The technique of determination of the explicit cost of capital is similar to the one used to ascertain IRR, with one difference, in the case of computation of the IRR, the cash outflows occur at the beginning followed by subsequent cash inflows while in the computation of the IRR, the cash outflows occur at the beginning followed by subsequent cash inflows, while in the computation of explicit cost of capital, cash inflow takes place at the beginning followed by a series of cash inflow subsequently. The formula used to compute the explicit cost of capital (C) is: n CO t CI0 =...(1) t =1 (1 + C) t Where, CI0 = net cash inflow in period O. COt = cash outflow in period under reference C = Explicit cost of capital The explicit cost of an interest bearing debt will be the discount rate that equates the present value of the contractual future payments of interest and principal with the net amount of cash received today. The explicit cost of capital of a gift is minus 100 per cent, since no cash outflow will occur in future. Cost of Capital 27 Similarly, explicit cost of retained earnings which involve no future flows to or from the firm is minus 100 per cent. This should not tempt one to infer that the retained earnings is cost free. As we shall discuss in the subsequent paragraphs, retained earnings do cost the firm. The cost of retained earnings is the opportunity cost of earning on investment elsewhere or in the company itself. Opportunity cost is technically termed as implicit cost of capital. It is the rate of return on other investments available to the firm or the shareholders in addition to that currently being considered. Thus, the implicit cost of capital may be defined as the rate of return associated with the best investment opportunity for the firm and its Shareholders that will be foregone if the project presently under consideration by the firm were accepted. In this connection it may be mentioned that explicit costs arise when the firm raises funds for financing the project. It is in this sense that retained earnings has implicit cost. Other forms of capital also have implicit costs once they are invested, Thus in a sense, explicit costs may also be viewed as opportunity costs. This implies that a project should be rejected if it has a negative present value when its cash flows are discounted by the explicit cost of capital. It is clear thus that the cost of capital is the rate of return a firm must earn on its investments for the market value of the firm to remain unchanged. Acceptance of projects with a rate of return below the cost of capital will decrease the value of the firm; acceptance of projects with a rate of return above the cost of capital will increase the value of the firm. The objective of the financial manager is to maximize the wealth of the firm’s owners. Using the cost of capital as a basis for accepting or rejecting investments is consistent with this goal. Risk A basic assumption of traditional cost of capital analysis is that the firm’s business and financial risk are unaffected by the acceptance and financing of projects. Business risk is related to the response of the firm’s earnings before interest and taxes, or operating profits, to changes in sales. When the cost of capital is used to evaluate investment alternatives, it is assumed that acceptance of the proposed projects will not affect the firm’s business risk. The types of projects accepted by a firm can greatly affect its business risk. If a firm accepts a project that is considerably more risky than average, suppliers of funds to the firm are quite likely to raise the cost of funds. This is because of the decreased probability of the fund suppliers’ receiving the expected returns on their money. A long-term lender will charge higher interest on loans if the probability of receiving periodic interest from the firm and ultimately regaining the principal is decreased. Common stockholders will require the firm to increase earnings as compensation for increases in the uncertainty of receiving dividend payments or ably appreciation in the value of their stock. In analyzing the cost of capital it is assumed that the business risk of the firm remains unchanged (i.e., that the projects accepted do not affect the variability of the firm’s sales revenues). This assumption eliminates the need to consider changes in the cost of specific sources of financing resulting from changes in business risk. The definition 28 Financial Management of the cost of capital developed in this chapter is valid only for projects that do not change the firm’s business risk. Financial risk is affected by the mixture of long-term financing, or the capital structure, of the firm. Firms with high levels of long-term debt in proportion to their equity are more risky than firms maintaining lower ratios of long-term debt to equity. It is the contractual fixed-payment obligations associated with debt financing that make a firm financially risky. The greater the amount of interest and principal (or sinking- fund) payments a firm must make in a given period, the higher the operating profits required to cover these charges. If a firm fails to generate sufficient revenues to cover operating charges, it may be forced into bankruptcy. As a firm’s financial structure shifts toward suppliers of funds recognize a more highly levered position the increased financial risk associated with the firm. They compensate for this increased risk by charging higher rates of interest or requiring greater returns, In short they react in much the same way as they would to increasing business risks. Frequently the funds supplied to a firm by lenders will change its financial structure, and the charge for the funds will be based on the changed financial structure. In the analysis of the cost of capital in this chapter, however, the firm’s financial structure is assumed to remain fixed. This assumption is necessary in order to isolate the costs of the various forms of financing. If the firm’s capital structure were not held constant, it would be quite difficult to find its cost of capital, since the selection of a given source of financing would change the costs of alternate sources of financing. The assumption of a constant capital structure implies that when a firm raises funds to finance a given project these funds are raised in the same proportions as the firm’s existing financing. The awkwardness of this assumption is obvious since in reality a firm raises funds in “lumps,” it does not raise a mixture of small amounts of various types of funds.’ For example, in order to raise Rs. l million a firm may sell either bonds, preferred stock, or common stock in the amount of Rs. l million; or, it may sell Rs. 400,000 worth of bonds, Rs. 100,000 worth of preferred stock, and Rs. 500,000 worth of common stock. Most firms will use the former strategy, but our analysis of cost of capital is based on the assumption that the firm will follow the latter strategy. More sophisticated approaches for measuring the cost of capital when a firm’s capital structure is changing rare available. The key factor affecting financing Costs Since the cost of capital is measured under the assumption that both the firm’s asset structure and its capital (financial) structure are fixed, the only factor that affects the various specific costs of financing is the supply and demand forces operating in the market for long-term funds. In other words, as a firm raises long-term funds at different points in time, the only factor affecting their cost is the riskless cost of the particular type of financing. Regardless of the type of financing used, the following relationship should prevail: kj = rj + b + f...(2) where kj = the specific cost of the various types of long-term financing, j Cost of Capital 29 rj = the riskless cost of the given type of financing, j b = the business risk premium f = the financial risk premium Equation 2 indicates that the cost of each specific type of capital depends on he riskless cost of that type of funds, the business risk of the firm, and the financial risk of the firm. Since the firm’s business and financial risk are assumed to be constant, the changing cost of each type of capital, j, over time should be affected only by changes in the supply of and demand for each type of funds, j. The cost of each type of capital to a given firm compared to the cost to another firm (i.e., the inter firm comparison) can differ because of differences in the degree of business and financial risk associated with each firm, since the riskless cost of the given type of funds remains constant. Different business and financial risk premiums are associated. with different levels of business and financial risk. These premiums are a function of the business risk, b, and financial risk, f, of a firm. For intra firm (i.e., time series) comparisons, the only differentiating factor is the cost of the type of financing, since business and financial risk are assumed to be constant An example may help to clarify these points. Example The W.T. L. Company’s cost of long-term debt two years ago was 8 percent. This 8 percent was found to represent a 4- percent risk less cost of long-term debt, a 2- percent financial risk premium. and a 2- petcent financial risk premium. Currently, the risk less cost of long-term debt is 6 percent. How much would you expect the W. T. L.’s cost of debt to be today, assuming that the risk structure of the firm’s assets (business risk) and its capital structure (financial risk) have remained unchanged? The previous business risk premium of 2 percent and financial risk premium of 2 percent will still prevail, since neither of these risks has changed in two years. Adding the 4 percent total risk premiums (i.e., the 2-percent business risk and the 2-percent financial risk premium) to the 6-percent riskless cost of long-term debt results in a cost of long- term debt to the W. T. L. Company of 10 percent. In this time-series comparison, where business risk and financial risk are assumed to be constant, the cost of the long- term funds changes only in response to changes in the riskless cost of a given type of funds. Let us now suppose that there is another company, the Plate Company, for which the risk less cost of long-term debt is the same as it is for W. T. L. The Plate Company has a 2-percent business risk premium and a 4-percent financial risk premium because of the high degree of leverage in its financial structure. Although both companies are in the same type of business (and thus have the same business risk premium of 2 percent), the cost of long-term debt to the Plate Company is 12 percent (i.e., the dpercent riskless cost of money. Although the relationship between lj, b, and t, is presented as linear in Equation A, this is only for simplicity; the actual relationship is likely to be much more complex mathematically. The only definite conclusion that can be drawn is that the cost of a 30 Financial Management specific type of financing for a firm is somehow functionally related to the riskless cost of that type of financing adjusted for the firm’s business and financial risk (i.e., that kj = f(r; b, f). The reader should recognize that the riskless cost of each type of financing, ‘I, may differ considerably. In other words, at a given point in time the riskless cost of debt may be 6 percent while the riskless cost of common stock may he 9 percent. The riskless cost is expected to be different for each type of financing, j· The risk less cost of different maturities of the same type of debt may differ, since longer-term Issues are generally viewed as more risky. Factors determining the cost of capital There are several factors that impact the cost of capital of any company. This would mean that the cost of capital of any two companies would not be equal. Rightly so as these two companies would not carry the same risk. l General economic conditions: These include the demand for and supply of capital within the economy, and the level of expected inflation. These are reflected in the riskless rate of return and is common to most of the companies. l Market conditions: The security may not be readily marketable when the investor wants to sell; or even if a continuous demand for the security does exist, the price may vary significantly. This is company specific. l A firm’s operating and financing decisions: Risk also results from the decisions made within the company. This risk is generally divided into two classes: n Business risk is the variability in returns on assets and is affected by the company's investment decisions. n Financial risk is the increased variability in returns to the common stockholders as a result of using debt and preferred stock. l Amount of financing required: The last factor determining the company's cost of funds is the amount of financing required, where the cost of capital increases as the financing requirements become larger. This increase may be attributable to one of the two factors: n As increasingly larger public issues are increasingly floated in the market, additional flotation costs (costs of issuing the security) and underpricing will affect the percentage cost of the funds to the firm. n As management approaches the market for large amounts of capital relative to the firm's size, the investors' required rate of return may rise. Suppliers of capital become hesitant to grant relatively large amounts of funds without evidence of management's capability to absorb this capital into the business. Generally, as the level of risk rises, a larger risk premium must be earned to satisfy company's investors. This, when added to the risk-free rate, equals the firm's cost of capital. Cost of Capital 31 Significance of the Cost of Capital It should be recognized at the outset that the cost of capital is one of the most difficult and disputed topics in the finance theory. Financial experts express conflicting opinions as to the way in which the cost of capital can be measured. It should be noted that it is a concept of vital importance in the financial decision-making. It is useful as a standard for: l evaluating investment decisions, l designing a firm’s debt policy, and l appraising the financial performance of top management. Investment evaluation The primary purpose of measuring the cost of capital is its use as a financial standard evaluating the investment projects. In the NPV method, an investment project is accepted if it has a positive NPY. The project’s NPV is calculated by discounting its cash flows by the cost of capital. In this sense, the cost of capital is the discount rate used for evaluating the desirability of an investment project. In the IRR method, the investment project is accepted if it has an internal rate of return greater than the cost of capital. In this context, the cost of capital is the minimum return on an investment project. It is also known as the cutoff, or the target, or the hurdle rate. An investment project that provides.positive NPV when its cash flows are discounted by the cost of capital makes a net contribution to the wealth of shareholders. If the project has zero NPV, it means that its a return just equal to the cost of capital, and the acceptance or rejection of the project will not affect the wealth of shareholders The cost of capital is the minimum required rate of return on the investment project that keeps the present wealth of shareholders unchanged. It may be, thus, noted that the cost of capital represents a financial standard for allocating the firm’s funds, supplied by owners and creditors, to the various investment projects in the most efficient manner. Designing debt policy The debt policy of a firm is significant influenced by the cost consideration. In designing the financing policy, that is, the proportion of debt and equity in the capital structure, the firm aims at cost of capital. The relationship between the cost of capital and the capital structure decision is discussed later on. The cost of capital can also be useful in deciding about the methods of financing at a point of time. For example, cost may be compared in choosing between leasing and borrowing. Of course, equally important considerations are control and risk. Performance appraisal Further, the cost of capital framework can be used to evluate the financial performance of top management. I Such an evaluation will involve a comparison of actual profitability of the investment projects undertaken by the firm with the project overall cost of capital, and the actual cost incurred by management in raising the required funds. The cost of capital also plays a useful role in dividend decision and investment in current assets. The chapters dealing with these decisions show their linkages the methods of financing with the cost of capital. 32 Financial Management Measurement Time Value of Money If an individual behaves rationally, then he would not equate money in hand today with the same value a year from now. In fact, he would prefer to receive today than receive after one year. The reasons sited by him for preferring to have the money today include: 1. Uncertainty of receiving the money later. 2. Preference for consumption today. 3. Loss of investment opportunities. 4. Loss in value because of inflation. The last two reasons are the most sensible ones for looking at the time value of money. There is a 'risk free rate of return' (also called the time preference rate) which is used to compensate for the loss of not being able to invest at any other place. To this a 'risk premium' is added to compensate for the uncertainty of receiving the cash flows. Required rate of return = Risk free rate + Risk premium The risk free rate compensates for opportunity lost and the risk premium compensates for risk. It can also be called as the 'opportunity cost of capital' for investments of comparable risk. To calculate how the firm is going to benefit from the project we need to calculate whether the firm is earning the required rate of return or not. But the problem is that the projects would have different time frames of giving returns. One project may be giving returns in just two months, another may take two years to start yielding returns. If both the projects are offering the same %age of returns when they start giving returns, one which gives the earnings earlier is preferred. This is a simple case and is easy to solve where both the projects require the same capital investment, but what if the projects required different investments and would give returns over a different period of time? How do we compare them? The solution is not that simple. What we do in this case is bring down the returns of both the projects to the present value and then compare. Before we learn about present values, we have to first understand future value. Future Value If we are getting a return of 10 % in one year what is the return we are going to get in two years? 20 %, right. What about the return on 10 % that you are going to get at the end of one year? If we also take that into consideration the interest that we get on this 10 % then we get a return of 10 + 1 = 11 % in the second year making for a total return of 21 %. This is the same as the compound value calculations that you must have learned earlier Cost of Capital 33 Future Value = (Investment or Present Value) * (1 + Interest) No. of time Periods The compound values can be calculated on a yearly basis, or on a half-yearly basis, or on a monthly basis or on continuous basis or on any other basis you may so desire. This is because the formula takes into consideration a specific time period and the interest rate for that time period only. To calculate these values would be very tedious and would require scientific calculators. To ease our jobs there are tables developed which can take care of the interest factor calculations so that our formulas can be written as: Future Value = (Investment or Present Value) * (Future Value Interest Factor n,i) where n = no of time periods and i = is the interest rate. Let us look at an example of how we calculate the future value: Example Rs 7000 are invested at 5% per annum compound interest compounded annually. What will be the amount after 20 years? Solution Here i = 0.05, P = 7000, and n = 20. Putting it in the formula we get: FV = 7000 x (1+0.05)20 FV = 7000 x 2.6533 = Rs 18573.1 We have taken a shortcut here. We looked at the future value of Rs 1 at the end of 20 years at 5% interest in the Future Value Interest Factor Table given at the end of this book (i.e. find the value of Future Value Interest Factor n,i)and found the figure to be 2.6533 and then substituted the figure here to get the answer. Another way of doing it would be to use a scientific calculator and calculate the value that comes out to be the same. A third way of doing this would be even more simple. Use a spreadsheet program. Let us see how we use Microsoft Excel to do the same. Step 1: Go to the Insert menu and choose function. You get a screen that looks like this: 34 Financial Management Step 2: In the financial function category choose FV (it stands for Future Value) and press OK. Step 3: You would get a screen that would look like this: Cost of Capital 35 Step 4: Insert the values as given in the example. Here r = I = 0.05, Nper is the number of periods = 20, Pmt is the periodic annuity (how to use it we will see a little later) = 0 in this case as there is no annual payment except the first one. Pv is the present value = Rs 7000 in this case and Type is a value representing the timing of the payment = 0 in this case as the investment is done at the end of the period 0 or at the start of the period 1. This also means that we get the returns at the end of the period 20 simultaneously when we make the last payment. Putting these values we get the following screen. Note that the result of the figures that you input is shown in the formula result section where it is Rs 18,573.08. Compare this with the figure that you get from using the value from the table, a difference of Rs 0.02. Negligible. What if the money was payable at the start of the period rather than at the end of the period? Here it does not matter as there is only one investment and that is also at the start of the first period. It would matter when we look at the future value of the annuity. But what is an annuity anyway? 36 Financial Management Future Value of an Annuity Annuity is defined as periodic payment every period for a number of periods. This periodic payment is the same every year only then it could be called an annuity. The compound value (future value) of this annuity can be calculated using a different formula: [(1 + i ) n − 1] Future Value = A i Here A is the constant periodic cash flow (annuity), i is the rate of return for one period and n is the number of time periods. The term within the brackets is the compound value factor of an annuity. We can also use the tables given at the end of the text book to calculate the compound values of the cash flows and the formula would change to: Future Value = Annuity * (Future Value Annuity Factorn,i) Extending the same example we used above, if we were going to pay Rs 7000 every year for the next 20 years what is the value at the end of 20 years if the interest rate was 5 % compounded annually. Example An annual payment of Rs 7000 is invested at 5% per annum compounded annually. What will be the amount after 20 years? Solution Here i = 0.05, P = 7000, and n = 20. Putting it in the formula we get: [(1 + 0.005) 20 − 1] Fugure Value = 7000 0.05 FV = 7000 x 33.066 = Rs 2,31,462 We have taken a shortcut here. We looked at the future value of Rs 1 at the end of 20 years at 5% interest in the Future Value Annuity Factor Table given at the end of this book (i.e. find the value of Future Value Annuity Factor n,i)and found the figure to be 33.066 (try finding the figure yourself) and then substituted the figure here to get the answer. Another way of doing it would be to use a scientific calculator and calculate the value that comes out to be the same. Let us see how we use Microsoft Excel to do the same. Insert the values as given in the example. Here r = I = 0.05, Nper is the number of periods = 20, Pmt is the periodic annuity = 7000. Pv is the present value = 0 in this case as it an annuity and Type is a value representing the timing of the payment = 0 in this case as the first investment is Cost of Capital 37 done at the end of the period 1. Note that in the earlier case this also means that we get the returns at the end of the period 20 simultaneously when we make the last payment. Putting these values we get the following screen. Can you find the answer? Yes, it is Rs 231,461.68 a difference of Rs 0.32 from the answer we got using the table above. A variation on this would be that the payment made at the start of the period instead of the end of the period. This means that you earn extra interest for one year. The formula is slightly different in that the whole value is multiplied by (1+i) resulting in the following formula: [(1 + i) n − 1] Future Value = A (1 + i) i In the excel spreadsheet we just have to change the type to 1 to get the desired result. The result now comes to Rs 243,034.76, which is nothing but the earlier figure of The result now comes to Rs 2,43,034.76, which is nothing but the earlier figure of Rs 2,31,461.68 multiplied by 1.05 (i.e. 1+i). 38 Financial Management Still this leaves one problem unanswered: If the projects have different time spans (which could be as far apart as 50 years or more) how do we use the results that we get from here to compare. It becomes very difficult. Also we cannot be too sure of the discounting rates and cash flows so getting comparable values would be difficult to say the least. To solve this problem we solve for the present value. Present Value When we solve for the present value, instead of compounding the cash flows to the future, we discount the future cash flows to the present value to match with the investments that we are making today. Bringing the values to present serves two purposes: 1. The comparison between the projects become easier as the values of returns of both are as of today, and 2. We can compare the earnings from the future with the investment we are making today to get an idea of whether we are making any profit from the investment or not. For calculating the present value we need two things, one, the discount rate (or the opportunity cost of capital) and two, the formula. The present value of a lump sum is just the reverse of the formula of the compound value of the lump sum: FutureValue Pr esentValue = (1 + i) n Or to use the tables the change would be: Present Value = Future Value * (Present Value Interest Factor n,i) where n = no of time periods and i is the interest rate. Let us look at an example of how we calculate the future value: Example Rs.2,00,000 is the amount that you require after 20 years for your retirement. How much should you invest now at 5% per annum compounded annually? Solution Here i = 0.05, FV = 2,00,000, and n = 20. Putting it in the formula we get: 200000 Pr esentValue = (1 + 0.05) 20 Cost of Capital 39 Solve this or use the present value table. Using the present value interest factor table we find that present value of Rs 1 of 20 years from now at 5% interest is 0.3769. Multiplying it with the future value Rs 2,00,000 we get: PV = 2,00,000 x 0.3769 = Rs 75,380 Let us see how we use Microsoft Excel to do the same. Step 1: Go to the Insert menu and choose function. In the financial function category choose PV (it stands for Present Value) and press OK. Step 3: You would get a seen that would look like this: 40 Financial Management Step 4: Insert the values as given in the example. Here r = I = 0.05, Nper is the number of periods = 20, Pmt is the periodic annuity (how to use it we will see a little later) = 0 in this case as there is no annual payment except the first one. Fv is the future value = Rs 2,00,000 in this case and Type is a value representing the timing of the payment = 0 in this case. Putting these values we get the following screen. Note that the result of the figures that you input is shown in the formula result section where it is Rs 75,377.89. Compare this with the figure that you get from using the value from the table, a difference of Rs 2.11. Negligible, but still higher than the differences we used to get in the future value. Can you tell why? This is because of the fact that while dividing you require numbers more than four digits to get accuracy. What if the money was payable at the start of the period rather than at the end of the period? Here it does not matter as there is only one future value and that is also at the start of the first period. It would matter when we look at the present value of the annuity. Present Value of an Annuity The present value of an annuity can be calculated by: [(1 + i ) n − 1] Pr esentValue = A i (1 + i ) n Or to use the tables the change would be: Present Value = Annuity * (Present Value Annuity Factor n,i) Let us see an example Example You have been promised an annual grant of Rs 7000 every year for the next 20 years Cost of Capital 41 If you can invest the amount at 5% per annum compounded annually what will be the amount you would require today to land up with the same position? Solution Here i = 0.05, A = 7000, and n = 20. Putting it in the formula we get: Using the shortcut from the table we get: [(1 + 0.05) 20 − 1] Pr esentValue = 7000 0.05(1 + 0.05) 20 PV = 7000 x 12.4622 = Rs 87,235.4 We looked at the present value of an annuity of Rs 1 for 20 years at 5% interest in the Present Value Annuity Factor Table given at the end of this book (i.e. find the value of Present Value Annuity Factor n,i)and found the figure to be 12.4622 (try finding the figure yourself) and then substituted the figure here to get the answer. Another way of doing it would be to use a scientific calculator and calculate the value that comes out to be the same. Let us see how we use Microsoft Excel to do the same. Insert the values as given in the example. Here r = I = 0.05, Nper is the number of periods = 20, Pmt is the periodic annuity = 7000 in this case. Fv is the future value = 0 in this case as it is an annuity and Type is a value representing the timing of the payment = 0 in this case as the first investment is done at the end of the period 1. Putting these values we get the following screen. Can you find the answer? Yes, it is Rs 87,235.47 a difference of Rs 0.07 from the answer we got using the table above. A variation on this would be that the payment made at the start of the period instead of the end of the period. This means that you earn extra interest for one year. The formula is slightly different in that the whole value is multiplied by (1+i) resulting in the following formula: 42 Financial Management [(1 + i ) n − 1] Pr esentValue = A (1 + i ) i(1 + i) n In the excel spreadsheet we just have to change the type to 1 to get the desired result. The result now comes to Rs 91,597.25, which is nothing but the earlier figure of Rs 87,235.47 multiplied by 1.05 (i.e. 1+i). Perpetuity If the annuity is expected to go on forever then it is called a perpetuity and then the above formula reduces to: A Pr esentValue = i Perpetuities are not very common in financial decision making as no project is expected to last forever but there could be a few instances where the returns are expected to be for a long indeterminable period. Especially when calculating the cost of equity perpetuity concept is very useful. For a growing perpetuity the formula changes to: A Pr esentValue = i−g All these calculations take into consideration that the cash flow is coming at the end of the period. Valuing Securities The objective of any investor is to maximise expected returns from his investments, Cost of Capital 43 subject to various constraints, primarily risk. Return is the motivating force, inspiring the investor in the form of rewards, for undertaking the investment. The importance of returns in any investment decision can be traced to the following factors: l It enables investors to compare alternative investments in terms of what they have to offer the investor. l Measurement of past returns enables the investors to assess how well they have done. l Measurement of historical returns also helps in estimation of future returns. Why are we discussing the return so much? The value of the security to an investor is directly proportional to the return that he is expected to get from that security. Higher the return expected, higher is the value. But what are we going to do with the value of the security? Well, value of the security is the price that you are going to pay for that security. This means that the present value of the security is that value which is dependent on the return from the security and the risk profile of that security. Now let us go further on return. The Components of Return Return is basically made up of two components: l The periodic cash receipts or income on the investment in the form of interest, dividends, etc. The term yield is often used in connection with the component of return. Yield refers to the income derived from a security in relation to its price, usually its purchase price. l The appreciation (depreciation) in the price of the asset is referred to as capital gain (loss). This is the difference between the purchase price and the price at which the asset can be, or is, sold. Measuring the Rate of Return The rate of return is the total return the investor receives during the holding period (the period when the security is owned or held by the investor) stated as a %age of the purchase price of the investment at the beginning of the holding period. In other words it is the income from the security in the form of cash flows and the difference in price of the security between and the end of the holding period expressed as a %age of the purchase price of the security at the beginning of the holding period. Hence, total return can be defined as: Cash Payment received + Price change over the period Total Returns = Purchase price of the asset 44 Financial Management The price change over the period, is the difference between the beginning (or purchase) price and the ending (or sales) price. This can be either positive (sales price exceeds purchase price) or negative (purchase price exceeds sales price). The general equation for calculating the rate of return for one year is shown below: K = [Dt + (Pt - Pt-1)] Pt-1 where K = Rate of Return Pt = Price of the security at time "t" i.e. at the end of the holding period. Pt-1 = Price of the security at time "t-1" i.e. at the beginning of the holding period or purchase price. Dt = Income or cash flows receivable from the security at time "t". Valuing Debt Securities Securities that promise to pay its investors a stated rate of interest and return the principal amount at the maturity date are known as debt securities. The maturity period is typically more than one year which is the key differentiating factor between them and the money market securities. Debt securities are usually secured. Debt securities differ according to their provisions for payment of interest and principal, assets pledged as a security and other technical aspects. In the case of bankruptcy of the corporation, the law requires that the debt holders should be paid off before the equity investors. A legal agreement, called a trust deed, is drawn between the security holders and the company issuing the debt securities. Every security issued under it has the same right and protection. Trust deed is a complicated legal document containing restrictions on the company, pledges made by the company, and several other details. The trustee, usually a large bank or a financial institution, ensures that the issuing corporation keeps its promises and obeys the restrictions of the contract. The trustee is the watchdog for the debt securities holders because it is impossible for the individual holders to keep an eye on the functioning of the company. Debt securities are different from term loans provided by the financial institutions and the banks to the company. Term loans are long term debt contracts under which a borrower agrees to make a series of interest and principal payments on specific dates to the lender. While this is true for debt securities also, term loans differ in one significant aspect that they are generally sold to one (or few) lenders especially financial institutions and banks, while debt securities (terms 'debentures' and 'bonds' will be used interchangeably for debt securities) are typically offered to the public. Another significant difference is that principal repayments in term loans are made along with the interest Cost of Capital 45 payments but in debt securities it is usually a lump sum payment at the end of the period (or a series of payments). Terms Associated with Debt Securities There are several terms which are used when we talk about debt securities. Before we take a look at different kinds of debt securities available in the Indian market, let us first understand these terms. Face Value/ Par Value Value of the security as mentioned on the certificate of the security. Face values and par values are two terms which are used interchangeably. Corporate debentures are usually issued with Rs.100 face values and Government bonds with Rs.1 lac face values. Altho

Financial Management PDF Past Paper - Paper-20 - M Com (Final)

Document Details

Tags

Related

Summary

Full Transcript

Upgrade to continue