Financial Management

Financial management is mainly concerned with the

proper management of funds. The finance manager
must see that funds are procured in such a manner that
risk, cost and control considerations are properly
balanced and there is optimum utilization of funds.
According to Soloman, “Financial
management is concerned with the
efficient use of economic resources”.
According to Phillippatus, “Financial
management is concerned with
management decision that result in
acquisition and financing of long-term
and short-term credits for the firm”.
Objectives of Financial Management
 Basic Objectives
 Other Objectives

Basic Objectives: The basic objectives are

 Profit Maximisation

 Maintenance of liquid assets

 Wealth Maximisation
Other Objectives
 Ensuring a fair return to shareholders
 Building up reserves for growth and
expansion
 Ensuring maximum operational efficiency by
efficient and effective utilization of finances.
 Ensuring financial discipline in the
organization
Scope of Financial Management
 Estimating financial requirement
 Deciding capital structure
 Selecting a source of finance
 Selecting a pattern of Investment
 Proper cash management
 Implementing financial controls
 Proper use of surpluses
Need of Financial Management or
Financial Decisions
 Financing Decisions
 Investment Decisions
 Dividend Decisions
Functional Areas of Financial
Management
 Determining Financial Needs
 Selecting the source of Funds
 Financial Analysis and Interpretation
 Cost-volume-profit Analysis
 Capital Budgeting
 Working Capital Management
 Profit Planning and Control
 Dividend Policy
Sources of Finance
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Share Capital: Long term funds can be raised from share capital. According to Section
86 of Companies Act, 1956, a company can issue only two types of shares i.e. (a)
Preference shares and (b) Equity shares

SHARES

 Equity Shares Preference Shares


Cumulative Preference Shares

Non-cumulative Preference Shares

Participating Preference Shares

Non-participating Preference Shares

Convertible Preference Shares

Non-convertible Preference Shares
Equity Shares
Equity shareholders are known as the real owners of
the business. They have a control over the working
of the company. Equity shares are paid dividend
after the preference shares. Equity capital is paid
after meeting all other claims. They do not have a
right to get a fixed percentage of dividends. The
dividend is dependent upon the amount of profits
available. When there is no profit, they do not get
any dividend.
Merits of Equity Shares
 Company need not have the forced obligation to
pay dividend to equity shareholders.
 Equity share is a permanent source of funds which
facilitate flexibility in usage of funds.
 The obligation to repay the equity capital arises
only at the time of liquidation of the company.
 The shareholders can participate in the management
of the company through voting rights.
 Equity shares can be issued without creating any
charge over the assets.
Demerits of Equity Shares:
 Equity shares always associated with the expectations of the investors. It
is practically a difficult task to fulfill the expectations of the investors.
 Equity shareholders have to bear all the losses at the time of liquidation.
 Interruptions of many persons are involved in the company working. So,
in some cases, it creates delay in decision-making.
 When the finance has to be raised for less risky projects, then this is not a
good source of raising finance.
 If only equity shares are issued then the company can not avail the
benefits of trading on equity.
 Investors who have a desire to invest in safe or fixed returns have no
attraction of such shares.
Preference Shares: Preference shares are those shares which are entitled to a priority in the
payment of dividends at a fixed rate and the return of the capital in the event of winding up of the
company.
Preference shares may be of the following kinds:

 Cumulative Preference Shares: Cumulative preference shares are those

shares on which fixed dividend cumulate till it is fully paid up. It means
that on these shares, if a dividend is not paid in one year then that dividend
will be combined in the next year. For e.g. In the year 2005, if company is
unable to pay dividend of Rs.5000 then in the year 2006, the company
have to pay 5000 of year 2005 and then 5000 of year 2006.
 Non-cumulative Preference Share: Such shares do not have the privilege
of the accumulation of unpaid dividend. In other words, if profits during a
particular year is not sufficient, the arrear lapses.
 Participating Preference Shares: These shares get dual benefit on the
capital, first a fixed rate of dividend is given and then a fraction of surplus
profits left after paying dividend to equity shareholders. The surplus profits
are distributed between the preference shares and equity shares.
 Non-participating Preference shares: These shares are entitled to a
fixed rate of dividend and do not have a right on surplus profits.

 Convertible Preference Shares: These are the shares which entitle to

convert them in to equity shares within a certain time period.

 Non- Convertible Preference Shares: These shares do not have the

right to convert these shares into equity.
 Redeemable Preference Shares: These shares are redeemable or repaid
within a stipulated period.
Merits of Preference Shares:
 It provides preferential right to pay dividend and the
repayment of the capital.
 Preference shares provide a long term capital.
 There is no liability to redeem the preference shares except
redeemable preference shares.
 It earns a fixed rate of dividend.
 Preference shares although carry no voting right but the
holders of such shares can vote on matters directly affecting
their rights.
 Redeemable preference shares have the added advantage of
repayment of capital when there are surplus funds with the
company.
Demerits of Preference Shares:
 It is an expensive source of finance as compared to
debt because generally the investors expect a high
return of dividend then the interest on debentures.
 Cumulative preference shares become a permanent
burden so far as the payment of dividend is
concerned.
 Preference shares have no charge on the assets so it
looses the interest of the investors.
Debentures:
 A debenture is an acknowledgement of debt.
It is a certificate issued by the company under
its seal acknowledging a debt due to its
debenture holders. On debentures a fixed rate
of interest is paid at regular intervals. Usually
these are secured by some asset of the
company. A debenture holder is a creditor of
the company.
Types of Debentures:
 Simple or Naked or Unsecured Debentures: These debentures are not
given any security on debentures.

 Secured or Mortgage Debentures: These debentures are given security

on assets of the company.

 Bearer Debentures: These debentures are easily transferable. Anybody

who holds these debentures becomes the owner of such debentures.

 Registered Debentures: Registered debentures are those debentures

which are registered with the company. These debentures can not be
transfer by mere delivery but a proper procedure is required for transfer.
Both transferor and transferee are expected to sign the transfer voucher.

 Redeemable Debentures: These debentures are to be redeemed on the

expiry of a certain period. The interest on debentures is paid periodically
but the principle amount is returned after a fixed period.
Advantages of Debentures
 The rate of interest on debentures is usually low than the preference shares and equity
shares.

 The interest on debentures is tax-deductible and hence the cost of debentures is less as
compared to preference shares and equity shares.

 Debt financing does not result in the dilution of control because debenture holders do not
have voting right.

 Many companies prefer issue of debentures because of fixed rate of interest attached to
it.

 As debentures provide a fixed return to investors so the investors get stable return out of
it.

 It is a safer investment because debentures have a charge on some asset.

 Many investors prefer debentures because of a definite maturity period.

Disadvantages of Debentures:
 The fixed interest charges and repayment of principle
amount on maturity are legal obligations of the company. If
a company doesn’t get the profits then also they have to pay
to the debenture holders.
 Charges on assets usually restrict the company from using
this source of finance.
 Debenture holders don’t get the voting right and hence its
investors don’t have any controlling power on the
management.
 Debenture holders are merely creditors and not the owners
of the company.
Lease Financing
 In addition to debt and equity financing, lease
financing has emerged as another important source
for long-term financing. Leasing is an agreement
that provides a firm with the use and control over
assets without buying and owning the same. It is a
form of renting assets. The firm considered leasing
the assets than buying the assets. In comparing
leasing with financing, the cost of leasing the assets
will be compared with the cost of financing the asset.
Retained earnings or ploughing back
of profits
 Retained earnings is a technique of financial
management under which all the profits a
company are not distributed among the
shareholders as dividend, but a part of it is
retained or reinvested in the company. This
process of retained profits year after year are
known as ploughing back of profits.
Necessity of Retained Earnings
 For the replacement of old assets which have
become obsolete.
 For the expansion and growth of business.
 For contributing towards the fixed as well as
working capital needs of the company.
 For making the company self-dependent of
finance from outside sources.
 For redemption of loan and debentures.
Advantages of Retained Earnings:
From Companies Point of View
 A Cushion to absorb the shocks of the
economy
 Economical method of financing
 Helps on following stable dividend policy
 Flexible financial structure
 Makes the company self-dependent
 Enables to redeem the long-term liabilities
From Shareholders point of view
 Increase in the value of shares
 Safety of Investment
 No dilution of control
 Evasion of super tax
Disadvantages of Retained Earnings:
 Over-capitalization
 Creation of Monopolies
 Misuse of retained earnings
 Manipulation in the value of shares
 Evasion of Taxes
 Dissatisfaction among Shareholders
Lease Financing
Leasing is an agreement that provides a firm with the use and
control over assets without buying the same. It is a contract
between the owner of the asset (lessor) and the user (lessee) of
the asset. The lessee pays the lease rent periodically to the lessor
as regular fixed payments over a period of time.At the expiry of the
lease period, the asset reverts back to the lessor who is the legal
owner of the asset.
Types of Leasing
 Operational Lease
 Financial Lease
Operational Lease
 It is a short-term lease on a period to period basis.
The lease period in such a contract is less than the
usual life of the asset.
 The lease is usually cancellable by the lessee.
 The lessee usually has the option of renewing the
lease after the expiry of lease period.
 The lessor is generally responsible for maintenance,
insurance and taxes of the asset.
Financial Lease
A lease is classified as financial lease if it
ensures the lessor for amortisation of the
entire cost investment plus the expected
return on capital outlay during the term of the
le
Financial Lease
 The present value of the total lease rentals payable
during the period of the lease exceeds or is equal to
the substantially the whole of the fair value of the
leased asset.
 As compared to the operational lease, a financial
lease is for a long period of time.
 It is usually non-cancellable by the lessee prior to its
expiration date.
 The lesse is generally responsible for maintenance,
insurance and service of the asset.
Forms of Lease Financing
 Sale and Lease back
 Direct leasing
 Leveraged Leasing
 Straight Lease and Modified Lease
 Primary and secondary Lease
Sale and Lease Back
 A sale and lease back is an arrangement
involves the sales of an asset already owned
by a firm and leasing of the same asset back
to the vendor from the buyer. This form of
arrangement enables a firm to receive cash
from the sale of asset and also retain the
economic use of the asset in consideration of
periodic lease payments.
Direct Leasing
Under Direct leasing, a firm acquires the use of
asset that it does not already own. A direct
lease may be arranged either from the
manufacturer or through the leasing company.
Leveraged lease
 A leveraged lease is an arrangement under
which the lessor borrows funds, for
purchasing the asset, from a third party called
lender, which is usually a bank or finance
company. The loan usually secured by the
mortgage of the asset and the lease rentals to
be received from the lessee.
Straight Lease and Modified Lease
 Straight lease requires the lessee firm to pay
lease rentals over expected life of the asset
and does not provide for any modifications to
the terms and conditions of the basic lease.
 Modified Lease, on the other hand, provides
several options to the lessee during the lease
period. For e.g., the option of terminating
lease may be provided by either purchasing
the asset or returning the same.
Primary and Secondary Lease (Front-
ended and back-ended Lease)
 Under primary and secondary Lease, The
lease rentals are charged in such a manner
that the lessor recovers the cost of asset and
acceptable profits during the initial period of
the lease and then secondary lease is provided
at nominal rentals. In other words, the rent
charged in the primary period are much more
than that of the secondary period.
Advantages of lease to the Lessee
 Avoidance of Initial Cash Outlay
 Minimum Delay
 Easy source of finance
 Shifting the risk of obsolesence
 Enhanced Liquidity
 Tax planning and Advantage
 Higher return on capital employed
 Convenience and Flexibility
Disadvantages
 Higher Cost
 Risk of being deprived of the use of asset
 Loss of ownership incentives
 Penalty on termination of lease
 Loss of salvage value of the asset
 No alteration or change in asset
Advantages of Leasing to the Lessor
 Higher profits
 Tax Benefits
 Quick Returns
 Increased Sales
Limitations of Leasing to the Lessor
 High risk of Obsolescence
 Competitive Market
 Price-level Changes
 Management of cash flows
 Increased cost due to the loss of user benefit
 Long-term investment
Capital Budgeting
Capital budgeting is the process of making
investment decisions in capital expenditure.
Capital Expenditure
 A capital expenditure may be defined as an expenditure the
benefit of which are expected to be received over period of
time exceeding one year. For e.g.
 Cost of acquisition of permanent asset as land and
building, plant and machinery etc.
 Cost of addition, expansion, improvement or alteration of
permanent asset.
 Cost of replacement of permanent asset.
 Research and development project costs etc.
Capital Budgeting involves the
planning and control of capital
expenditure. It is the process of
deciding whether or not to commit
resources to a particular long term
projects whose benefits are to be
realised over a period of time.
Charles T. Horngreen has defined capital budgeting as,
“Capital budgeting is a long term planning for making
and financing proposed capital outlays.”
Need and importance of Capital
Budgeting
 Large Investment
 Long-term Commitment of Funds
 Irreversible Nature
 Long-term effect on Profitability
 Difficulties of investment Decisions
 National Importance
Capital Budgeting Process
 Identification of Investment Proposals
 Screening the Proposal
 Evaluation of Various Proposals
 Fixing Priorities
 Final Approval and Presentation of Capital
Expenditure Budget
 Implementing Proposal
 Performance Review
Kinds of Capital budgeting Decisions
 Accept Reject Decisions
 Mutually Exclusive Project Decisions
 Capital Rationing Decisions
 Mutually Exclusive Project Decisions
 Capital Rationing Decisions
Methods of Capital budgeting
 Traditional Methods  Time-adjusted Methods
 Pay-back period  Net Present Value
Method Method
 Improvement of  Internal Rate of Return
traditional approach to Method
pay-back period  Profitability Index
Method Method
 Rate of Return Method
Factors Influencing Capital
Expenditure Decisions
 Urgency
 Degree of Certainty
 Legal factors
 Intangible Factors
 Availability of Funds
 Future Earnings
 Research and Development Projects
Cost of Capital
Cost of capital is the minimum rate of return
expected by its investors. A decision to invest in
a particular project depends upon the cost of
capital.
Cost of capital may be defined as the cost of
obtaining funds, i.e. the average rate of return that
the investors in a firm would expect for supplying
funds to the firm.

According to Soloman, “Cost of capital is the minimum

required rate of earnings or cut-off rate of capital
expenditure”.
According to Hampton, “ The rate of return the firm
requires from investment in order to increase the value
of the firm in the market place”.
Significance of Cost of Capital
 As an acceptance criteria in Capital Budgeting
 As a determinant of capital mix in capital structure
decisions
 As a basic for evaluating the financial performance
 As a basis for taking other financial decisions
Computation of Cost of Capital
 Cost of Debt
Kd=I/P
Where, Kd= Before tax Cost of Debt
I= Interest
P= Principal Amount
If debt is issued at Premium or Discount
Kd= I/NP (Where NP= Net Proceeds)
Cost of Redeemable Debt
 Before Tax cost of Debt
Kdb=
Cost of Preference Shares
 Kp= D/P
Kp=CostofPreferenceShare
D=Annual PreferenceDividend

P=PreferenceShareCapital
 Redeemable Preference Share
Kpr =D+MV-NP
Where Kpr = Cost of Redeemable Preference Share
D= Annual Preference Dividend
MV= Maturity Value of Preference Share
NP= Net Proceeds of Preference Shares
Cost of Equity Shares
 Ke= D/NP
Ke= Cost of Equity Capital
D= Expected dividend per share
NP= Net proceeds per share
Dividend yield plus growth in dividend method
Ke=D/NP+G
Ke= Cost of Equity Capital
D= Expected dividend per share
NP= Net proceeds per share
G= Rate of growth in dividends
Cost of Retained Earnings
 Kr= D/NP+G
Where Kr= Cost of Retained Earnings
D= Expected Dividend
NP= Net Proceeds of Share Issue
G= Rate of Growth
Capital Structure
The proportion of debt and equity is known as
capital structure.
Theories of Capital Structure
 Net Income Approach
 Net Operating Income Approach
 Traditional Approach
 Modigliani and Miller Approach
Net Income Approach
 According to this approach, a firm can minimise the weighted
average cost of capital and increase the value of the firm as
well as market price of equity share by using debt financing.
The theory propounds that a company can increase its value
and reduce the overall cost of capital by increasing the
proportion of debt in its capital structure. The basic
Assumptions are:
 The cost of debt is less than the cost of equity.
 There are no taxes.
 The risk perception of investors is not changed by the use of
debt.
Net Operating Income Approach
 According to this approach, change in capital
structure of a company does not affect the market
value of the firm and the overall cost of capital
remains constant irrespective of the method of
financing. The main assumptions are:
 The market capitalises the value of the firm as a
whole.
 The business risk remains constant at every level of
debt-equity mix.
 There are no corporate taxes.
Traditional Approach
 According to this theory, the value of the firm
can be increased initially or the cost of capital
can be decreased by using more debt as the
debt is a cheap source of finance. Beyond a
particular point, the cost of equity increases
because increased debt increases the financial
risk of equity shareholders.
Modigliani and miller approach
 In the absence of Taxes
The theory proves that the cost of capital is not
affected by the changes in the capital
structure. The reason argued is that though
debt is cheaper to equity, with increased use
of debt as a source of finance, the cost of
equity increases.
When the corporate taxes are assumed
to exist
 The value of the firm will increase or the cost
of capital will decrease with the use of debt
on account of deductibility of interest charges
for tax purposes.
Factors determining Capital Structure
 Financial Leverage or  Asset Structure
Trading on Equity  Purpose of Financing
 Growth and stability of  Period of Finance
sales  Personal Considerations
 Cost of Capital  Corporate Tax rate
 Nature and Size of Firm  Legal Requirements
 Control
 Flexibility
 Requirement of Investors
 Capital Market
Requirements
Meaning of Working
Capital
Working capital refers to that part of the firm’s
capital which is required for financing short-
term or current assets such as cash,
marketable securities, debtors and inventories.
Concepts of working capital
 Gross working capital
 Net working Capital
Gross working Capital
 The term working capital refers to gross
working capital and represents the amount of
funds invested in current assets. Thus, the
gross working capital is the capital
investment in the current assets of the
enterprise.
Net working Capital
 Net working capital is the excess of current
assets over current liabilities
Net working Capital= Current assets- Current Liabilities
Classification of Working Capital
 Permanent or Fixed working Capital
 Temporary or Variable Working capital
Kinds of Working Capital
Advantages of Working Capital
 Solvency of the Business
 Goodwill
 Easy Loans
 Cash Discounts
 Regular Supply of Raw material
 Regular payment of Salaries and Wages
 Ability to face Crisis
 High Morale
Factors Determining Working Capital
Requirements
 Nature or Character of Business
 Size of Business
 Production Policy
 Length of Production Cycle
 Seasonal Variations
 Working Capital Cycle
 Rate of stock Turnover
 Credit policy
Business Cycles
Rate of growth of business
Earning Capacity
Price level Changes
Other Factors
Financing of Long-term working
Capital
 Shares
 Debentures
 Public Deposits
 Ploughing Back of Profits
 Loans from Financial Institutions
Financing of short-term Working
Capital
 Indigenous Bankers
 Trade Credits
 Instalment Credit
 Advances
 Accrued Expenses
 Deferred Incomes
 Commercial Papers
 Commercial banks
Management of Earnings
The term management of earnings means how
the earnings of a firm are utilised i.e. how much
is paid to the shareholders in the form of
dividends and how much is retained in the
business.
Scope of management of earnings
 Management of earnings includes:
 Determination of Profits
 Determination of Surpluses
 Creation of Reserves
 Provision of Depreciation
 Declaration of Dividend
 Retained Earnings
Sources of Profits
 Income from Business
 Income from other sources
 Income from Investment
Kinds and Sources of Surpluses
 Earned Surpluses
 Capital Surpluses
 Surpluses from Unrealised appreciation of assets
 Surpluses from realised appreciation of assets
 Surpluses from Mergers
 Surpluses from reduction of Share Capital
 Surpluses from Secret Reserves
Reserves
 The term Reserves refers to the amount set
aside out of profits. The amount may be set
aside to cover any liability, contingency,
commitments or depreciation in the value of
the assets.
Classification of Reserves
 General Reserves
 Special Reserves
 Capital Reserves
 Revenue Reserves
 Assets Reserves
 Liability Reserves
 Funded Reserves
 Sinking Fund Reserves
 Secret Reserves
 Proprietary Reserves
Meaning of Ploughing Back of Profits
 Ploughing Back of Profits is a technique
under which all the profits of the firm are not
distributed amongst the shareholders as
dividend, but a part of it is retained or
reinvested in the company. This process of
retaining profits year after year and their
utilisation in the business is known as
ploughing Back of Profits.
Dividend Policy
 Dividend refers to that part of the profits
which is distributed by the company among
the shareholders. It is the reward of the
shareholders for investment made by them in
the shares of the company.
Types of Dividend
 Regular Dividend Policy
 Stable Dividend policy
 Irregular Dividend policy
 No dividend Policy
Forms of Dividend
 Cash Dividend
 Bond Dividend
 Property Dividend
 Stock Dividend
Bonus Shares
 A company can pay to its shareholders
dividend in the form of cash or shares.
Sometimes, a company is not in a position to
the dividend in cash in that cases company
pays the dividend in the form of shares,
Known as Bonus Shares.
Advantages of Bonus Shares
 From Company’s point of view
It makes available capital to carry a profitable business.
It is felt that financing helps the company to get rid
itself of market fluctuations.
When a company pays bonus to its shareholders in the
value of shares and not in cash, its liquid resources
are maintained and working capital is not affected
It is cheaper method of raising additional capital for the
expansion of the business.
From shareholder’s point of view
 The bonus shares are permanent source of
income to the investors.
 The investors can easily sell these shares and
get immediate cash, if they desire so.
 Even if the rate of dividend falls, the total
amount of dividend may increase as the
investor gets dividend on a large number of
shares.
Disadvantages of Bonus Shares
 The reserves of the company after bonus
shares decline and leaves lesser security to the
investors.
 The fall in future rate of dividend results in
the fall of the market price of shares.
 The issue of bonus shares leads to a drastic
fall in the future rate of dividend.