FINANCIAL MANAGEMENT

Q.1 TCS has emerged as India's most admired company ahead of Hindustan Unilever,
ITC, and Infosys, says global management consultancy Hay Group. TCS replaced last
year's winner group company Tata Steel by scoring highest on parameters such as
corporate governance, financial soundness, and talent management. Two criteria in
particular, Leadership, and Creating Shareholder Value separated the winners.
How do you think effective interaction between HR and finance department of a firm
helps in achieving its skills?
Do you think that TCS has preferred the profit maximization approach over the
wealth maximization approach
ANS : Financial management means maximisation of economic welfare of its
shareholders. Maximisation of economic welfare means maximisation of
wealth of its shareholders. Shareholders wealth maximisation is reflected in
the market value of the firms shares. Experts believe that, the goal of
financial management is attained when it maximises the market value of
shares. There are two versions of the goals of financial management of the
firm Profit Maximisation and Wealth Maximisation.
Let us now discuss the goals of financial management in detail.
1.3.1 Profit maximisation
Profit maximisation is based on the cardinal rule of efficiency. Its goal is to
maximise the returns with the best output and price levels. A firms
performance is evaluated in terms of profitability. Profit maximisation is the
traditional and narrow approach, which aims at maximising the profit of the
concern. Allocation of resources and investors perception of the companys
performance can be traced to the goal of profit maximisation. Profit
maximisation has been criticised on many accounts:
The concept of profit lacks clarity. What does profit mean?
o Is it profit after tax or before tax?
o Is it operating profit or net profit available to shareholders?
In this sense, profit is neither defined precisely nor correctly. It creates
unnecessary conflicts regarding the earning habits of the business
concern. Differences in interpretation of the concept of profit thus expose
the weakness of profit maximisation.
Profit maximisation neither considers the time value of money nor the net
present value of the cash inflow. It does not differentiate between profits
of current year with the profits to be earned in later years.
The concept of profit maximisation fails to consider the fluctuations in
profits earned from year to year. Fluctuations may be attributed to the

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business risk of the firm. Risks may be internal or external which will
affect the overall operation of the business concern.
The concept of profit maximisation apprehends to be either accounting
profit or economic normal profit or economic supernormal profit.
Profit maximisation as a concept, even though has the above-mentioned
drawbacks, is still given importance as profits do matter for any kind of
business. Ensuring continued profits ensure maximisation of
shareholders wealth.
2 Wealth maximisation
The term wealth means shareholders wealth or the wealth of the persons
those who are involved in the business concern. Wealth maximisation is
also known as value maximisation or net present worth maximisation. This
objective is an universally accepted concept in the field of business.
Wealth maximisation is possible only when the company pursues policies
that would increase the market value of shares of the company. It has been
accepted by the finance managers as it overcomes the limitations of profit
maximisation.
The following arguments are in support of the superiority of wealth
maximisation over profit maximisation:
Wealth maximisation is based on the concept of cash flows. Cash flows
are a reality and not based on any subjective interpretation. On the other
hand, profit maximisation is based on accounting profit and it also
contains many subjective elements.
Wealth maximisation considers time value of money. Time value of
money translates cash flow occurring at different periods into a
comparable value at zero period. In this process, the quality of cash flow
is considered critical in all decisions as it incorporates the risk associated
with the cash flow stream. It finally crystallises into the rate of return that
will motivate investors to part with their hard earned savings. Maximising
the wealth of the shareholders means positive net present value of the
decisions implemented.
Let us now look at some of the key definitions.
Positive net present value can be defined as the excess of present value
of cash inflows of any decision implemented over the present value of
cash out flow.
Time value factor is known as the time preference rate; that is, the sum
of risk free rate and risk premium.

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Risk free rate is the rate that an investor can earn on any government
security for the duration under consideration.
Risk premium is the consideration for the risk perceived by the investor
in investing in that asset or security.
Required rate of return is the return that the investors want for making
investment in that sector.
Q.2
ANS:
A) The current price of an Ashok Leyland share is Rs. 30. The company is
expected to pay a dividend of Rs. 2.50 per share which goes up
annually at 6%. If an investors required rate of return is 11%, should he
or she buy this share or not?

Solution:
P = D1 (1+g) / Ke-g = 2.5(1+0.06) / 0.11-0.06 = Rs. 53
The investor should certainly buy this share at the current price of Rs. 30
as the valuation model says the share is worth Rs. 53.

B) A bond with a face value of Rs. 100 provides an annual return of 8%

and pays Rs. 125 at the time of maturity, which is 10 years from now. If
the investors required rate of return is 12%, what should be the price of
the bond?
Solution:
P = Int*PVIFA (12%, 10y) + Redemption value*PVIF (12%, 10y)
= 8*PVIFA (12%, 10y) + 125*PVIF (12%, 10y)
= 8*5.65 + 125*0.322
= 45.2 + 40.25 = Rs. 85.45
The price of the bond should be Rs. 85.45.

Q.3
a) How do you think the trend of capital structure across the Indian corporates
affect the economy as a whole?
b) What proportion of debt and equity should be taken up in the capital structure
of a firm?

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c) Discuss the theories that are propounded to understand the relationship
between financial leverage and value of the firm.
Ans: As we are aware, equity and debt are the two important sources of longterm
sources of finance of a firm. The proportion of debt and equity in a
firms capital structure has to be independently decided case to case.
A proposal, though not being favourable to lenders, may be taken up if they
are convinced with the earning potential and long-term benefits.
What proportion of equity and debt should be taken up in the capital
structure of a firm? The answer is tricky and is based on the understanding
and interpretation of the relationship between the financial leverage and firm
valuation or financial leverage and cost of capital. Many theories have been
propounded to understand the relationship between financial leverage and
firm value.
Assumptions
The following are some common assumptions made:
The firm has only two sources of funds, debt and ordinary shares
There are no taxes, both corporate and personal
The firms dividend payout ratio is 100%, that is, the firm pays off the
entire earnings to its equity holders and retained earnings are zero
The investment decisions of a company are constant, that is, the firm
does not invest any further in its assets
The operating profits/EBIT are not expected to increase or decrease
All investors shall have identical subjective probability distribution of the
future expected EBIT
A firm can change its capital structure at a short notice without the
incurrence of transaction costs
The life of the firm is indefinite
Based on the assumptions regarding the capital structure, we derive the
following formulae:
Cost of Debt
Debt capital being constant, Kd is the cost of debt which is the discount
rate at which the discounted future constant interest payments are equal
to the market value of debt, that is,
Kd = I/B
where, I refers to total interest payments and B is the total market value
of debt.
Therefore value of the debt B = I/Kd

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Cost of Equity
As mentioned above, it is assumed that there is a 100% dividend payout
and constant earnings. Such being the case, the cost of equity is the
discount rate at which the discounted future dividend/earnings are equal to
the market value of equity.
Cost of equity capital Ke = (D1/P0) + g
where D1 is dividend after one year, P0 is the current market price and
g is the expected growth rate.
Retained earnings being zero, g = br where r is the rate of return on
equity shares and b is the retention rate, therefore g is zero. Now we
know Ke = E1/P0 + g and g being zero, so Ke = NI/S where NI is the net
income to equity holders and S is market value of equity shares.
Firm Value
The net operating income being constant, overall cost of capital is
represented as K0 = W1 K1 + W2 K2.
That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the
debt, S is the market value of equity and V is the total market value of
the firm and can be given as (B+S).
The above equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, (K1
being the debt component and Ke being the equity component) which
can be expressed as:
K0 = I + NI/V or EBIT/V
or in other words, net operating income/market value of firm.
In the following pages we will understand what happens when the financial
leverage changes and its impact on Kd, Ke, and K0.
1. Net income approach
Net Income (NI) approach is suggested by Durand. He is of the view that
capital structure decision is relevant to the valuation of the firm. Any change
in the financial leverage will have a corresponding change in the overall cost
of capital and also the total value of the firm. As the ratio of debt to equity
increases, the Weighted Average Cost of Capital (WACC) declines and
market value of firm increases. According to this approach, a firm can
minimise the overall WACC and maximise the value of a firm by increasing
the proportion of debt in its capital structure.
The NI approach is based on 3 assumptions. They are:
no taxes
the cost of debt is less than the cost of equity and remains constant
use of debt does not change the risk perception of investors
We know that,
K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
Where, B is the market value of Debt and S, the market value of equity.
The following graphical representation of NI approach may help us

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understand this better. It can be understood from the given graphical representation
that as the
market value of debt-to-equity ratio (B/S) increases, K0 decreases. This is
because the proportion of debt, the cheaper source of finance, increases in
the capital structure.

Q.4 ) HPCL was established in 1952, operates from 500 different locations,
including refineries, terminals, LPG plants, aviation service facilities, etc. They
developed a Lotus Notes workflow tool and deployed it across the organisation so
that any capital investment proposal from any operating location in the country
can be routed to relevant reviewers and approving authorities. With the
implementation of the new online system, the total cost savings as a result of
reduced man-hours amounts to about Rs 25 lakh per annum.
1. What do you think would have been the complexities involved in
implementing this new project at HPCL?
2. What are the various phases in the capital budgeting process? To what extent
do you believe that automation can ease out the process?
Ans: In this section, we will discuss the capital budgeting process. After the
screening of proposals for potential involvement is over, the company
should take up the following aspects of capital budgeting process:
A proposal should be commercially viable. The following aspects are
examined to ascertain the commercial viability of any investment
proposal:
1.Market for the product
2.Availability of raw materials
3.Sources of raw materials
4.The elements that influence the location of a plant, i.e., the factors to
be considered in the site selection
Infrastructural facilities such as roads, communication facilities, financial
services such as banking and public transport services
Ascertaining the demand for the product or services is crucial. It is done by
market appraisal. In appraisal of market for the new product, the following
details are compiled and analyzed:
Consumption trends
Competition and players in the market
Availability of substitutes
Purchasing power of consumers
Regulations stipulated by government on pricing the proposed products

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or services
Production constraints
Relevant forecasting technologies are employed to get a realistic picture of
the potential demand for the proposed product or service. Many projects fail
to achieve the planned targets on profitability and cash flows, if the firm
could not succeed in forecasting the demand for the product on a realistic
basis. Capital budgeting process involves three steps Financial appraisal, Technical
appraisal and Economic appraisal

Phases of Capital Expenditure Decisions

In this section, we will discuss the phases of capital expenditure decisions.
There are various phases involved in capital budgeting decisions such as:
Identification of investment opportunities
Evaluation of each investment proposal
Examination of the investments required for each investment proposal
Preparation of the statements of costs and benefits of investment
proposals
Estimation and comparison of the net present values of the investment
proposals that have been cleared by the management on the basis of
screening criteria
Examination of the government policies and regulatory guidelines, for
execution of each investment proposal screened and cleared based on
the criteria stipulated by the management
Budgeting for capital expenditure for approval by the management
Implementation
Post-completion audit

Q.5) a) Indicate whether the operating cycle in the following industries is short
(less than 30 days), medium (less than 6 months) or long (more than 6 months)
Steel, rice, vegetables, fruits, jewelry, processed food, furniture, mining, flowers
and textiles
b) Companies with the shortest working capital cycles have current ratios much
lower than the firms with longer cycles. What is your view on this statement?
How do you think the operating cycle affects operating profit margins?

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c) Discuss the relationship between working capital management and market
performance of a company? Do you think the kind of relationship varies
depending on the type of industry?
Ans:
Indicate whether the operating cycle in the following industries is short
(less than 30 days), medium (less than 6 months) or long (more than 6
months)
Steel, rice, vegetables, fruits, jewelry, processed food, furniture, mining,
flowers and textiles
Hint:
Short: vegetables, fruits, flowers
Medium: rice, fruits, processed food,
Long: Steel, jewelry, furniture, mining, textiles
C) we will discuss the concept of operating cycle of a firm and
its implications on the working capital. The time gap between acquisition of
resources and collection of cash from customers is known as the operating
cycle. It is also referred to as the working capital cycle.
Operating cycle of a firm involves the following elements:
Acquisition of resources from suppliers
Payment disbursements to suppliers
Conversion of raw materials into finished products
Sale of finished products to customers
Collection of cash from customers for the goods sold
Figure 1 depicts the phases of an operating cycle.

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The five phases of the operating cycle occur on a continuous basis. The
successive events that typically take place in an operating cycle have been
depicted above. On perusal, it can be understood that the funds invested in
operations are recycled back into cash and further operations. There is no
synchronisation between the activities in the operating cycle.
Cash outflows occur before the occurrences of cash inflows in operating
cycle.
Cash outflows are certain. However, cash inflows are uncertain because of
uncertainties associated with effecting sales as per the sales forecast and
ultimate timely collection of amount due from the customers to whom the
firm has sold its goods.
Need for Working Capital
In this section, we will discuss the need for working capital. The need for
working capital arises on account of two reasons:
To finance operations during the time gap between sale of goods on
credit and realisation of money from customers of the firm
To finance investments in current assets for achieving the growth target
in sales
Therefore, to finance the operations in operating cycle of a firm, working
capital is required. Negligence of management on working capital may result
in technical insolvency and even liquidation of a business unit. Inefficient
working capital management may cause either inadequate or excessive
working capital, which is dangerous.
Following are some adversities that may affect the firm in case of
inadequate working capital:

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Growth may be stunted. It may become difficult for the enterprise to
undertake profitable projects due to non-availability of working capital.
Implementation of operating plans may become difficult and
consequently the profit goals may not be achieved.
Cash crisis may emerge due to paucity of working funds.
Operating inefficiencies may creep in due to difficulties in meeting day to
day commitments.
Optimum capacity utilisation of fixed assets may not be achieved due to
non-availability of the working capital.
The business may fail to honour its commitment in time, thereby
adversely affecting its credibility. This situation may lead to business
closure.
The business may be compelled to buy raw materials on credit and sell
finished goods on cash. In the process it may end up with increasing
cost of purchases and reducing selling prices by offering discounts. Both
these situations would affect profitability adversely.
Non-availability of stocks due to non-availability of funds may result in
production stoppage.
Fixed assets may not be efficiently used due to lack of working funds,
thus lowering the rate of return on investments in the process.
While under-assessment of working capital has disastrous implications on
business, over-assessment of working capital also has its own dangers.
Some of the issues that may crop up due to excessive working capital are
as follows:
Excess of working capital may result in unnecessary accumulation of
inventories.
It may lead to offer too liberal credit terms to buyers and very poor
recovery system and cash management.
It may make management complacent leading to its inefficiency.
Over-investment in working capital makes capital less productive and
may reduce return on investment.
Thus, the working capital is the lifeline of any business unit. Working capital
is very essential for success of a business and therefore, it needs efficient
management and control. Each of the components of the working capital
needs proper management to optimise profit. When we are trying to
understand the need for working capital, it is also important to identify some
of the significant factors that affect the composition of working capital or
current assets.
Factors that affect working capital are as follows:
Nature of business/industry
Size of business/scale of operations
Growth prospects
Nature of raw material used

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Business/manufacturing cycle
Process technology used
Operating cycle and rapidity of turnover
Operating efficiency
Nature of finished goods
Profit margin and profit appropriation
Policies on depreciation, taxation and dividends
Government regulations
We will take a better look at such factors in the upcoming section 11.7. In
the next section, we will proceed to learn about the concept of operating
cycle of a firm and its implications on working capital management.