Q.1.
A.1.
Definition:
One needs money to
make money. Finance is the life-blood of business and there must be a
continuous flow of funds in and out of a business enterprise. Money makes the
wheels of business run smoothly. Sound plans, efficient production system and
excellent marketing network are all hampered in the absence of an adequate and
timely supply of funds.
Sound financial
management is as important in business as production and marketing. A business
firm requires finance to commence its operations, to continue operations and
for expansion or growth. Finance is, therefore, an important operative function
of business.
Meaning of Financial Management:
Financial management may be defined as planning,
organising, directing and controlling the financial activities of an
organisation. According to Guthman and Dougal, financial management means, “the
activity concerned with the planning, raising, controlling and administering of
funds used in the business.” It is concerned with the procurement and utilisation
of funds in the proper manner.
Objectives of Financial Management:
Financial
management is one of the functional areas of business. Therefore, its
objectives must be consistent with the overall objectives of business. The
overall objective of financial management is to provide maximum return to the
owners on their investment in the long- term.
This is known as
wealth maximisation. Maximisation of owners’ wealth is possible when the
capital invested initially increases over a period of time. Wealth maximisation
means maximising the market value of investment in shares of the company.
Wealth of
shareholders = Number of shares held ×Market price per share.
In order to
maximise wealth, financial management must achieve the following specific
objectives:
(a) To ensure availability of sufficient funds
at reasonable cost (liquidity).
(b) To ensure
effective utilisation of funds (financial control).
(c) To ensure
safety of funds by creating reserves, re-investing profits, etc. (minimisation
of risk).
(d) To ensure
adequate return on investment (profitability).
(e) To generate
and build-up surplus for expansion and growth (growth).
(f) To minimise
cost of capital by developing a sound and economical combination of corporate
securities (economy).
(g) To coordinate
the activities of the finance department with the activities of other
departments of the firm (cooperation).
Functions of Financial
Management
- Estimation of capital
requirements: A finance manager has to
make estimation with regards to capital requirements of the company. This
will depend upon expected costs and profits and future programmes and
policies of a concern. Estimations have to be made in an adequate manner
which increases earning capacity of enterprise.
- Determination of capital
composition: Once the estimation have
been made, the capital structure have to be decided. This involves short-
term and long- term debt equity analysis. This will depend upon the
proportion of equity capital a company is possessing and additional funds
which have to be raised from outside parties.
- Choice of sources of funds: For
additional funds to be procured, a company has many choices like-
- Issue of shares and debentures
- Loans to be taken from banks and
financial institutions
- Public deposits to be drawn like in
form of bonds.
Choice of
factor will depend on relative merits and demerits of each source and period of
financing.
- Investment of funds: The
finance manager has to decide to allocate funds into profitable ventures
so that there is safety on investment and regular returns is possible.
- Disposal of surplus: The
net profits decision have to be made by the finance manager. This can be
done in two ways:
- Dividend declaration - It includes
identifying the rate of dividends and other benefits like bonus.
- Retained profits - The volume has to be
decided which will depend upon expansional, innovational, diversification
plans of the company.
- Management of cash: Finance
manager has to make decisions with regards to cash management. Cash is
required for many purposes like payment of wages and salaries, payment of
electricity and water bills, payment to creditors, meeting current
liabilities, maintainance of enough stock, purchase of raw materials, etc.
- Financial controls: The
finance manager has not only to plan, procure and utilize the funds but he
also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit
control, etc.
Q.1.
A.1.(b)
There are 3
methods used in ranking investment proposals. The payback method, internalrate
of return and net present value. The net present value method is the most
acceptableand commonly used approach. Of the many methods for ranking
investment proposals(1)The payback period methods, being the number of years
(or time periods) required toreturn the original investment. The payback period
is usually determined on anundiscounted basis, but discounted payback periods
must also be established for aproject. The net present value (NPV) method:
being the present value of future benefitsdiscounted at the appropriate cost of
capital, minus the present value of the capital cost ofthe investment. The
internal rate of return (IRR) method: being the discount rate whichequates the
present value of benefits to the present value of the capital expenditure.5.The
payback period shows the number of years required to recover the project’s cost
orhow long it takes to get the entity’s money back.6.The payback method is easy
to understand. The focus is on liquidity. If the initialinvestment cannot be
recouped soon, it will not qualify. This method is preferred byindustries
involved in technological developments. The downside of this method is that
isfails to discern the most economic solution to the capital budgeting
problem.7.
Let’s review a
problem.Assume a
$100,000 investment and the following cash flows fortwo alternatives. In year 1
Investment A has a $30,000 cash flow and Investment Bshows a $40,000 cash flow.
In year 2 Investment A’s cash flow is $50,000 and B is$30,000. Year 3 shows
$20,000 and $15,000 respectively, year 4 $60,000 and $15,000. Inyear 5
investment A does not show a cash flow but investment B shows a $50,000
cashflow. Which of the two alternatives would you select under the payback
method?8.As shown in the solution Investment X will have a payback in 3 years
versus the 4 yearpayback in Investment Y. Using the payback method, Investment
X would be selected.9.The higher the discount rate the lower the net present
value. NPV discounts back theinflows over the life of the investment to
determine whether they equal or exceed therequired investment.Basic discount
rate is usually the cost of the capital to the firm.Inflows must provide a
return that at least equals the cost of financing those returns.
A.2.
A.3(i)
Fixed assets are
long-term, tangible assets such
as land, equipment, buildings, furniture and vehicles. Fixed assets are parts
of the company that help with production and are components that last over time
in the company. They are physical assets that
can be seen. They are not used for liquidation purposes
to contain debt within a business or cashed out in any way to aid a business
financially.
Current assets are
the general inventory of a company, including cash, accounts
receivable, insurance claims, investments, and intangible or
non-physical items. Current assets account for the worth of a company, showing
the earnings-to-debt ratio by the year's end. Each current asset has the
ability to be cashed out to financially help the business or liquidated to save
the company from debt or bankruptcy.
Fixed and current assets are recorded on a balance sheet,
which is a statement showing the worth of a company at a certain point in time.
The balance sheet shows the company's spending habits and inventory compared to
its income. This helps the company determine where to cut back expenses and how
to plan future budgets.
The three main categories to fill out on a balance sheet are assets,
liabilities and owner's equity. The assets are the
fixed and current assets. Liabilities are items causing debt to the company,
and equity is the value of shares issued by a company. Each balance sheet is
filled out annually so that potential investors or banks know if the company as
a whole is a liability or investment opportunity.
A.3.(ii)
A spot exchange rate is the
price to exchange one currency for another for immediate delivery. The spot rates represent the prices buyers
pay in one currency to purchase a second currency.
Although the spot exchange rate is for delivery on the
earliest value date, the standard settlement date for most spot
transactions is two business days after the transaction date.
The spot exchange rate is the
price paid to sell one currency for another for delivery on the earliest
possible value date.
Background
The foreign exchange market is the largest
and most liquid market in the world, with over $5 billion changing hands daily.
The most actively traded currencies are the U.S. dollar; the euro, which is
used in many continental European countries including Germany, France, and
Italy; the British pound; Japanese yen; and Canadian dollar.
Trading takes place
electronically around the world between large, multinational banks. Other
active market participants include corporations, mutual funds, hedge funds, insurance companies and
government entities. Transactions are for a wide range of purposes, including
import and export payments, short- and long-term investments, loans and speculation.
A.3.(iii)
Hurdal rate
In capital budgeting, hurdle rate is the minimum rate that a company
expects to earn when investing in a project. Hence the hurdle rate is also
referred to as the company's required rate of return or target rate. In order
for a project to be accepted, its internal rate of return must equal or exceed
the hurdle rate.
The hurdle rate is also used to discount a project's cash flows in the
calculation of net present value.
The minimum hurdle rate is usually the company's cost of capital (a
blend of the cost of debt and the cost of equity). However, the hurdle rate
will be increased for projects with greater risk and when the company has an
abundance of investment opportunities.
BREAKING DOWN 'Hurdle Rate'
In capital budgeting, projects are evaluated either by discounting futurecash flows to the present by the hurdle rate, so as to ascertain the net present value of the project, or by computing the internal rate of return (IRR) on the project and comparing this to the hurdle rate. If the IRR exceeds the hurdle rate, the project would most likely go ahead.
In capital budgeting, projects are evaluated either by discounting futurecash flows to the present by the hurdle rate, so as to ascertain the net present value of the project, or by computing the internal rate of return (IRR) on the project and comparing this to the hurdle rate. If the IRR exceeds the hurdle rate, the project would most likely go ahead.
For example, a company with a hurdle rate of 10% for acceptable
projects, would most likely accept a project if it has an internal rate of
return of 14% and does not have a significantly higher degree of risk.
Alternately, discounting the future cash flows of this project by the hurdle
rate of 10% would lead to a large and positive net present value, which would
also lead to the project's acceptance.
Discount Rate
The interest rate charged to commercial banks and other depository
institutions for loans received from the Federal Reserve Bank’s discount
window. The discount rate also refers to the interest rate used in discounted
cash flow (DCF) analysis to determine the present value of future cash flows.
The discount rate in DCF analysis takes into account not just the time value of
money, but also the risk or uncertainty of future cash flows; the greater the
uncertainty of future cash flows, the higher the discount rate. A third meaning
of the term “discount rate” is the rate used by pension plans and insurance
companies for discounting their liabilities.
A.3.(iv)
nternal
rate of return (IRR) is the interest rate at which the net present
value of all the cash flows (both positive and negative) from a
project or investment equal zero.
Internal rate of return is used to evaluate the
attractiveness of a project or investment.
If the IRR of a new project exceeds a company’s required rate of return, that
project is desirable. If IRR falls below the required rate of return, the
project should be rejected.
HOW IT WORKS (EXAMPLE):
The formula for IRR is:
0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 +
P3/(1+IRR)3 + . . . +Pn/(1+IRR)n
where P0, P1, . . . Pn equals
the cash flows in periods 1, 2, . . . n, respectively; and
IRR equals the project's internal rate of return.
IRR equals the project's internal rate of return.
Let's look at an example to illustrate how to use IRR.
Assume Company XYZ must decide whether to purchase a piece of
factory equipment for $300,000. The equipment would only last three years, but
it is expected to generate $150,000 of additional annual profit during
those years. Company XYZ also thinks it can sell the equipment for scrap
afterward for about $10,000. Using IRR, Company XYZ can determine whether the
equipment purchase is a better use of its cash than
its other investment options, which should return about 10%.
Here is how the IRR equation looks in this scenario:
0 = -$300,000 + ($150,000)/(1+.2431) + ($150,000)/(1+.2431)2 +
($150,000)/(1+.2431)3 + $10,000/(1+.2431)4
The investment's IRR is 24.31%, which is the rate
that makes the present value of the investment's cash
flows equal to zero. From a purely financial standpoint, Company XYZ should
purchase the equipment since this generates a 24.31% return for the Company
--much higher than the 10% return available from other investments.
Under payback method, an investment project is accepted or
rejected on the basis of payback period. Payback period means the period of
time that a project requires to recover the money invested in it. It is
mostly expressed in years.
Unlike net present value and internal rate of
return method, payback method does not take into account the time
value of money.
According to payback method, the project that promises a quick recovery
of initial investment is considered desirable. If the payback period of a
project is shorter than or equal to the management’s maximum desired
payback period, the project is accepted, otherwise rejected. For example, if a
company wants to recoup the cost of a machine within 5 years of purchase, the
maximum desired payback period of the company would be 5 years. The purchase of
machine would be desirable if it promises a payback period of 5 years or less.
Q.4.
A.4.(i)
What is
'Capital Budgeting'
Capital budgeting is the
process in which a business determines and evaluates potential expenses or
investments that are large in nature. These expenditures and investments
include projects such as building a new plant or investing in a long-term
venture. Often times, a prospective project's lifetime cash inflows and
outflows are assessed in order to determine whether the potential returns
generated meet a sufficient target benchmark, also known as
"investment appraisal."
Ideally, businesses should
pursue all projects and opportunities that enhance shareholder value. However, because the amount
of capital available at any given time for new projects is limited, management
needs to use capital budgeting techniques to determine which projects will
yield the most return over an applicable period of time. Various methods of
capital budgeting can include throughput analysis, net
present value (NPV), internal
rate of return (IRR), discounted
cash flow (DCF) and payback period.
There are three popular methods
for deciding which projects should receive investment funds over other projects.
These methods are throughput analysis, DCF
analysis and payback period analysis.
A.4.(ii)
Cash management has changed significantly over
the past 2 decades for two reasons. First, from the early 1970s to the late
1980s, there was an upward trend in interest rate that increased the
opportunity cost of holding cash. This encouraged financial manager to search
for more efficient ways of managing cash. Second, technological developments, particularly
computrised electronic funds transfer mechanism changed the way cash is
managed.
Most cash management activities are performed jointly by the firm and its banks. Effective cah management encompasses proper management of cah inflow, and outflows, which entails (1) improving forecasts of cash flows, (2) synchronizing cash inflows and outflows, (3) usinig floats, (4) accelearing collections, (5) getting available funds to where they are needed, and (6) controlling disbursement. Most businesses are conducted by large firms, many sources and make payments from a number of different cities or even countries. For example, companies such as IBM, General Motros, and Hewlett-Packard have manufacturing plants all around the world, even more sales offices, but most of the payments are made from the cities where manufacturing occurs, or else from the headoffice. Thus a major corporation mightnhave hundreads of bank accounts, and since there is no reason to think that inflows and outflows will balance in each account, a system must be in place to transfer funds from where they come into where they are needed, to arrange loans to cover net corporate shortfalls, and to invest net corporate surpluses without delay.
A.4.(iii)
Net present value (NPV) is defined
as an investment measure that tells an investor whether the investment is
achieving a target yield at a given initial investment. NPV also quantifies the
adjustment to the initial investment needed to achieve the target yield assuming
everything else remains the same. Formally, the net present value is simply the
summation of cash flows (C) for each period (n) in the holding period (N),
discounted at the investor’s required rate of return (r):
If
all of this math scares you don’t worry, we’ll walk through some detailed
examples next that will leave you with a solid intuition and understanding of
NPV.
NPV
Intuition
What’s
the intuition behind NPV? Here’s a simple way to think about the net present
value:
NPV = Present Value – Cost
The
net present value is simply the present value of all future cash flows,
discounted back to the present time at the appropriate discount rate, less the
cost to acquire those cash flows. In other words NPV is simply value minus cost.
A.4.(iv)
Many real estate investors determine the value of an income property by using the capitalization rate, aka cap rate. It is probably the one most misused concept in real estate investing.
While brokers, sellers, and lenders are fond of quoting deals based on the cap rate, the way it is typically used, they really shortcut the true use of a valuable tool. A broker prices a property by taking the Net Operating Income (NOI), dividing it by the sales price, and voila!--there's the cap rate.
Example:
Say the property has an NOI of $125,000, and the price is $1,125,000.
$125,000/ $1,125,000 = 11.1% cap rate
But what does that number tell you? Does it tell you what your return will be if you use financing? No. Does it take into account the different finance terms available to different investors? No. Then just what does it show?
What the cap rate above represents is merely the projected return for one year as if the property were bought with all cash. Not many of us buy property for all cash, so we have to break the deal down, usually by trial and error, to find the cash on cash return on our actual investment using leverage (debt).
Then we calculate the debt service, subtract it from the NOI, and calculate our return. If the debt terms, loan-to-value, or our return requirement change, then the whole calculation must be performed again. That's not exactly an efficient use of time or knowledge.
Q.5.
A.5.(i) Outstanding Expenses
Outstanding expenses are those expenses which have been incurred
and consumed during an accounting period and are due to be paid, but
are not paid. Examples include outstanding salary, outstanding rent, etc.
Outstanding expenses are recorded in the books at the end of an accounting
period to show true numbers of a business.
Outstanding expense is a personal account and is shown on
the liability side of a balance sheet.
Expenses are amounts paid for goods or services purchased.
According to the accrual concept of accounting, transactions are recorded in
the books of accounts at the time of their occurrence and not when the actual
cash or a cash equivalent is received or paid. Therefore, payments are not necessarily
made immediately, they may be late or in advance. Outstanding expenses and
prepaid expenses are both a result of this.
A.5.(ii)
Master Budget
Definition
The master budget is the
aggregation of all lower-level budgets produced by a company's various
functional areas, and also includes budgeted financial
statements, a cash forecast, and a financing plan. The master budget
is typically presented in either a monthly or quarterly format, and usually
covers a company's entire fiscal year.
An explanatory text may be included with the master budget, which explains the
company's strategic direction, how the master budget will assist in
accomplishing specific goals, and the management actions needed to achieve the
budget. There may also be a discussion of the headcount changes that are
required to achieve the budget.
A master budget is the central
planning tool that a management team uses to direct the activities of a
corporation, as well as to judge the performance of its various responsibility
centers. It is customary for the senior management team to review a
number of iterations of the master budget and incorporate modifications until
it arrives at a budget that allocates funds to achieve the desired results.
Hopefully, a company uses participative
budgeting to arrive at this final budget, but it may also be
imposed on the organization by senior management, with little input from other
employees.
A.5.(iii)
Dividend policy is
the set of guidelines a company uses to decide how much of its earnings it will
pay out to shareholders. Some evidence suggests that investors are not
concerned with a company's dividend policy since they can sell a portion of
their portfolio of equities if they want cash. This evidence is called the
"dividend
irrelevance theory," and it essentially indicates that an
issuance of dividends should have little to no impact on stock price. That
being said, many companies do pay dividends, so let's look at how they do it.
There are three main approaches to dividends: residual, stability or a hybrid of the two.
Residual Dividend Policy
Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met. These companies usually attempt to maintain balance in their debt/equity ratios before making any dividend distributions, deciding on dividends only if there is enough money left over after all operating and expansion expenses are met.
There are three main approaches to dividends: residual, stability or a hybrid of the two.
Residual Dividend Policy
Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met. These companies usually attempt to maintain balance in their debt/equity ratios before making any dividend distributions, deciding on dividends only if there is enough money left over after all operating and expansion expenses are met.
A.5.(iv)
Trading Account
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Profit and Loss Account
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1
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It is the
first stage of final accounts.
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1
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It is the
second stage of the final accounts.
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2
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It shows the
gross result (gross profit or gross loss) of the business.
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2
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It shows the
net results (net profit or net loss) of the business.
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3
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All direct
expenses (expenses connected with purchase or production of goods) are
considered in it.
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3
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All expenses
connected with sales and administration (indirect expenses) of business are
considered.
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4
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It does not
start with the balance of any account.
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4
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It always
starts with the balance of a trading account (gross profit or gross loss).
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5
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Its balance
(G.P or G.L) is transferred to profit and loss account.
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5
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Its balance
(N.P or N.L) is transferred to capital account in balance sheet.
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