Financial Management

Notes 31 Pages

Savitribai Phule Pune University

Bachelor of Business Administration

AYK

Contributed by

Alpa Yash Khare

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Financial Management
M.Com, NET, KSET

Financial Management

Prepared By
Shahenaz Banu. S
Assistant Professor, Department of Commerce
M.E.S. Institute of Management, Rajajinagar, Bangalore – 10

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Table of Contents
Chapter 4: Investment & Dividend Decision ..................................................................................... 4
Investment Decision ................................................................................................................................... 4
Investment .............................................................................................................................................................. 4
Capital Budget ....................................................................................................................................................... 4
Types of Expenditure .......................................................................................................................................... 4
Significance/Features of Capital Budgeting........................................................................................................ 4
Need & Objective ................................................................................................................................................ 5
Capital Budgeting Process .................................................................................................................................. 5
Types of Capital Budgeting decisions ................................................................................................................. 5
Information required for Capital Budgeting ....................................................................................................... 6
Calculation of Initial Investment/Cash flow ....................................................................................................... 6
Capital Budgeting .................................................................................................................................................. 7
Factors Influencing Capital Budgeting ............................................................................................................... 7
Kinds of Capital Budgeting Decisions ................................................................................................................ 8
Information required for Capital Budgeting ....................................................................................................... 8
Required Rate of Returns .................................................................................................................................. 10
Methods of Capital Budgeting .......................................................................................................................... 11
Accounting Rate of Return (ARR) .................................................................................................................... 13
Net Present Value Method ................................................................................................................................. 15
Profitability Index Method ................................................................................................................................. 16
Dividend decisions ................................................................................................................................... 17
Advantages of issuing bonus shares .................................................................................................................. 19
Disadvantages of issuing bonus shares: ............................................................................................................ 19
Factors affecting dividend decision................................................................................................................... 19
Dividend policy.................................................................................................................................................... 20
Types of dividend policies ................................................................................................................................ 20
Chapter – 5: Working capital management ..................................................................................... 23
Classification of working capital .................................................................................................................. 23
Need, advantages and importance of WC .................................................................................................... 24
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Dangers of excess WC .................................................................................................................................. 24
Dangers of inadequate WC ........................................................................................................................... 24
Determinants of WC ..................................................................................................................................... 25
Working capital management ....................................................................................................................... 25
Working capital cycle/ operating cycle .................................................................................................................. 25
Cash management ......................................................................................................................................... 26
Need, objectives or motives of holding cash ......................................................................................................... 26
Importance of cash management ........................................................................................................................... 27
Receivables management .............................................................................................................................. 27
Cost of maintaining receivables ............................................................................................................................. 27
Factors influencing size of receivables .................................................................................................................. 28
Needs and Importance of Receivables Management ............................................................................................. 28
Components of inventory ....................................................................................................................................... 28
Inventory management ................................................................................................................................. 28
Risk and cost of holding inventory ........................................................................................................................ 29
Sources of working capital ........................................................................................................................... 29
Assignment questions ......................................................................................................................... 30

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Financial Management
Chapter 4: Investment & Dividend Decision

Investment Decision
Investment
 Application of Funds in Long Term Assets
 Investments Considers
i) Risk = Possibility of Suffering Loss
ii) Return = Monetary Reward
Capital Budget
 Summary of planned Invest in Long-term asset=Capital Budget
 Long-term Asset used in Production=Capital
 Plan that outlines the Project Expenditure=Budget
Types of Expenditure
1) Revenue Expenditure:
Benefits exhausts within 1 year
E.g.: Repair/Replacement of permanent Fixed Asset
2) Capital Expenditure:
Expenditure incurred for getting benefits for more than 1 year.
E.g.: Acquiring Physical Asset
Capital Expenditure can be of:
i) Expansion
ii) Diversification
iii) Replacement & Modernization
iv) Research & Development
Significance/Features of Capital Budgeting
1) Investment on Capital Expenditure
2) Long Term commitment of Funds
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3) Risk & Uncertainty
4) Strategies & Expensive
5) Irreversible decision
Need & Objective
1) Estimation of Capital Expenditure
2) Prioritizing Investment Proposals
3) Maximum Profits & Minimum Risk
4) Control our Capital Expenditure
5) Facilitates Co-ordination of Inter-Departmental projects
Capital Budgeting Process
By which companies access how to fund operations & new ventures through movement & management of assets
Steps:
 Determine Investment Proposals
 Screening Investment Proposals
 Assessment of Investment Proposal [Benefits,Cost,Risk]
Types of Capital Budgeting decisions
 Accept or Reject Decisions
1) Independent Projects
2) Don’t Compete with each other
 Mutually Exclusive Decisions
1) Compete with each other
2) Acceptance of One Project leads to rejection of other Projects.
 Capital Rationing Decisions
1) Ranking of the Projects
2) Insufficient Funds

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Information required for Capital Budgeting
1) Cash Flows: Movement of Money in & out of Business
2) Required Rate of Interest
Calculation of Initial Investment/Cash flow
Particular
Amt(Rs)
Cost of Asset
XXX
(+)Installation/Insurance/Transportation/Duties/Other Expenses
XXX
(+)Opportunity Cost
XXX
(+)Additional Working Capital
XXX

XXX
(-)Scrap Value
XXX
Initial Investment/Cash Flow
XXX

Notes:
Investment Decision
Investment Decision refers to application of funds on long-term assets in anticipation of future benefits &
maximization of long-term profitability.
The following are 2 major considerations on investment Decisions; i.e. Risk & Returns.
Risk is possibility of suffering Loss & Returns is Monetary Rewards.
Capital Budgeting
It is a financial tool to evaluate the value of long-term project, when trying to decide between investments,
Capital Budget analysis allow to ascertain risk & return of the Investment.
Investment Decisions

Risk
CB
Return
Provides
Techniques to
determine Risk &
Returns of
Investment
Investment
Decision

Subject To
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Subject:
 Significance/Features
 Need & Objective
 Steps on CB/Process

Capital Budgeting
According to Richards & Greenlaw “The Capital budgeting generally refers to acquiring inputs with long-term
returns”.
According to Charles.T.Horngreen “Capital budgeting is long term planning for making & financing proposed
capital outlet”.
Capital budgeting primarily involves making investment decisions in capital expenditure. Usually, in business
there are 2 types of expenditure. They are:
1) Revenue Expenditure:
It is the amount spent on generating sales revenue & maintaining revenue generating assets. The benefits of
this expenditure are exhausted within 1 year. Thus, revenue expenses are incurred for meeting day-to-day
expenses of a business. E.g.: Loss from sale of fixed asset, expenses incurred for repairs, renewal &
replacement of permanent assets, interest on loan borrowed for business, expenses incurred for manufacture
& distribution of finished goods.
2) Capital Expenditure:
It is the amount spent to maintain or increase the scope of business operation. The benefits from capital
expenditure to be over a period of time greater than one year.
E.g.: Money spent to acquire physical assets such as equipment, property or Industrial building.
Types of Capital Expenditure:
The Capital expenditure proposals can be on the form of revenue generating proposals or cost reducing
proposals. They are categorized as follows:
 Expansion
 Diversification
 Replacement & Modernization
 Research & Development

Factors Influencing Capital Budgeting
 Availability of Funds
 Structure of Capital
 Taxation policy
 Government policy
 Lending policies of Financial Institutions
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 Immediate Need of Project
 Earnings
 Capital Return
 Economic value of the Project
 Working Capital
 Trend of Earnings
 Accounting Practice

Kinds of Capital Budgeting Decisions
1) Accept or Reject Decision:
Accept or Reject investment decisions are also referred as independent project.
Independent investments serve different purpose & don’t compete with each other. In other words the cash
flows of these projects are unrelated or independent of one other. A firm may accept an investment proposal
if the expected returns is more than the cut off rate fixed by the management. The cut-off rate is usually the
cost of capital of the firm. Therefore all the investment decision which gives more return than the cost of
capital is acceptable. Which the investment decision which give less return than the cost of capital are rejected.

2) Mutually Exclusive Decisions:
This is quiet opposite to independent projects. In mutually exclusive decision. Investment proposal compete
with each other. Which means the acceptance of one automatically rejects the other decisions.
E.g.: A firm is in need of increased production capacity. Could obtain it by
 Expanding its plan
 Acquiring other companies
 Outsourcing with another company for production
Clearly accepting any 1 option will eliminate the immediate need for either of other.

3) Capital Rationing Decisions:
Some organization may have various profitable investment proposals but may not have sufficient funds. In
situations like this a firm has only 1 option to rank them as per their profitability & then accept them. Therefore
Capital Rationing is a process of allocating capital resources in favor of desired proposals based on availability
of funds & importance of investment proposal.

Information required for Capital Budgeting
 Cash Flow
It means movement of money in & out of the business. It signifies incoming (i.e. Cash inflows) & outgoing
(i.e. Cash outflows) of money from the operating
Activities of an organization. In the context of capital budgeting cash flow, refers to the revenue generated
from the investment proposal after deducting relevant expenses.
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Steps in calculation of initial investment/ cash outlet:

Net Annual cash in hand/Operation cash flow:
This denotes benefits recurred in the form of revenue from the investment proposal. Thus, cash flow is the
money flowing inside the business on account of investment made in a proposal, within a given period of time.
These cash inflows can be similar every year [even] throughout the life of the investment proposal or it may differ
every year [uneven].

For revenue increasing investment proposal

Particular
Amt(Rs)
Sales Revenue
XXX
Less: Expenses(fixed & variable)
XXX
Cash flow before Depreciation & Tax(CFBDT)
XXX
Less: Depreciation
XXX
Cash flow after depreciation & before tax
XXX
Less: Tax
XXX
Cash flow after Depreciation & Tax(CFADT)
XXX
Add: Depreciation
XXX
Net Cash flow(NCF) or before depreciation & after tax(CFBDAT)
XXX
Therefore, NCF=Sales-Exp-Dep-Tax+Dep(CFBDAT)

Notes:
The logic behind deducting & again adding it back is, firstly deducting depreciation would lower the tax burden
& secondly it should be added back as it is non-cash based transaction.
Instead of the term cash inflow profit can also be used.

Particular
Amt(Rs)
Cost of the asset
XXX
(+)Installation, Insurance, Transportation, Duties, Financial Cost
XXX
(+)Opportunity Cost (if any)
XXX
(+)Additional Working Cost
XXX

XXX
(-)Scrap value(only in the case of Replacement Decisions)
Note: Treatment of Salvage varies according to different methods of
capital budgeting

XXX
Initial investment/Cash Outlay
XXX
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For cost reduction Investment Proposal
Particular
Amt(Rs)
1) Estimated Savings

 Saving on account of decrease in wages
XXX
 Saving from sales of scrap
XXX
[A] Total Savings
XXX
2) Estimated Additional cost

 Additional cost of maintenance
XXX
 Additional cost of supervision
XXX
 Additional depreciation
XXX
 Cost of Indirect Material
XXX
[B] Total Additional Cost
XXX
Net savings before tax(A-B)
XXX
Less: Income Tax
XXX
Net Savings after Tax
XXX
Add: Additional Depreciation
XXX
Net Savings after Tax or Cash Flow
XXX

Terminal Cash flow:
Terminal Cash flow refers to the amount generated from the investment proposal at the end of its life in addition to
annual cash flow. Terminal Cash Flow can be in the following forms:
1) Scrap/Residual Value: It is the estimated value that an asset will realize upon its sales at the end of its useful
life. It is the last stage of an asset or projects cash flows that will occur only at the projects termination or ending.
2) Working Capital: Some assets require additional working capital to operate (taken into account at the beginning
of the project when calculating the initial investment). On account of termination of project or end of assets life,
working capital requirement associated with assets or project also ends resulting in cash inflow. This means the
working capital utilized during the life of the asset or project will be realizable by the firm.
Formula: Salvage value + Working Capital Requirement
Required Rate of Returns
It is the minimum percentage of returns earned from the investment proposal that will motivate a company to invest
money into a particular asset or project. A firm may accept an investment proposal of the expected return is more
than the cut off rate fixed by the management. The cut off rate is cost of capital of the firm, therefore all the
investment decisions which give more returns than the cost of capital are acceptable while the investment decision
which give less return than the cost of capital are rejected.

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