Financial Management

Q1. What are the goals of financial management? Financial management is an academic discipline which is concerned with decision-making. This decision is concerned with the size and composition of assets and the level and structure of financing. In order to make right decision, it is necessary to have a clear understanding of the objectives. Such an objective provides a framework for right kind of financial decision making. The objectives are concerned with designing a method of operating the Internal Investment and financing of a firm. There are two widely applied approaches, viz. (a) Profit maximization and (b) Wealth maximization. The term objective is used in the sense of an object, a goal or decision criterion. The three decisions Investment decision, financing decision and dividend policy decision are guided by the objective. Therefore, what is relevant is not the over-all objective but an operationally useful criterion: It should also be noted that the term objective provides a normative framework. Therefore, a firm should try to achieve and on policies which should be followed so that certain goals are to be achieved. It should be noted that the firms do not necessarily follow them. Profit Maximization as a Decision Criterion Profit maximization is considered as the goal of financial management. In this approach, actions that Increase profits should be undertaken and the actions that decrease the profits are avoided. Thus, the Investment, financing and dividend also be noted that the term objective provides a normative framework decisions should be oriented to the maximization of profits. The term profit is used in two senses. In one sense it is used as an owner-oriented. In this concept it refers to the amount and share of national Income that is paid to the owners of business. The second way is an operational concept i.e. profitability. This concept signifies economic efficiency. It means profitability refers to a situation where output exceeds Input. It means, the value created by the use of resources is greater that the Input resources. Thus in all the decisions, one test is used I.e. select asset, projects and decisions that are profitable and reject those which are not profitable. The profit maximization criterion is criticized on several grounds. Firstly, the reasons for the opposition that are based on misapprehensions about the workability and fairness of the private enterprise itself. Secondly, profit maximization suffers from the difficulty of applying this criterion in the actual real-world situations. The term objective refers to an explicit operational guide for the internal investment and financing of a firm and not the overall business operations. We shall now discuss the limitations of profit maximization objective of financial management. 1) Ambiguity: The term profit maximization as a criterion for financial decision is vague and ambiguous concept. It lacks precise connotation. The term profit is amenable to different interpretations by different people. For example, profit may be long-term or short-term. It may be total profit or rate of profit. It may be net profit before tax or net profit after tax. It may be return on total capital employed or total assets or shareholders equity and so on. 2) Timing of Benefits: Another technical objection to the profit maximization criterion is that It Ignores the differences in the time pattern of the benefits received from Investment proposals or courses of action. When the profitability is

worked out the bigger the better principles adopted as the decision is based on the total benefits received over the working life of the asset, Irrespective of when they were received. The following table can be considered to explain this limitation. 3) Quality of Benefits Another Important technical limitation of profit maximization criterion is that it ignores the quality aspects of benefits which are associated with the financial course of action. The term quality means the degree of certainty associated with which benefits can be expected. Therefore, the more certain the expected return, the higher the quality of benefits. As against this, the more uncertain or fluctuating the expected benefits, the lower the quality of benefits. The profit maximization criterion is not appropriate and suitable as an operational objective. It is unsuitable and inappropriate as an operational objective of Investment financing and dividend decisions of a firm. It is vague and ambiguous. It ignores important dimensions of financial analysis viz. risk and time value of money. An appropriate operational decision criterion for financial management should possess the following quality. a) It should be precise and exact. b) It should be based on bigger the better principle. c) It should consider both quantity and quality dimensions of benefits. d) It should recognize time value of money. Wealth Maximization Decision Criterion Wealth maximization decision criterion is also known as Value Maximization or Net Present-Worth maximization. In the current academic literature value maximization is widely accepted as an appropriate operational decision criterion for financial management decision. It removes the technical limitations of the profit maximization criterion. It posses the three requirements of a suitable operational objective of financial courses of action. These three features are exactness, quality of benefits and the time value of money. i) Exactness: The value of an asset should be determined In terms of returns it can produce. Thus, the worth of a course of action should be valued In terms of the returns less the cost of undertaking the particular course of action. Important element in computing the value of a financial course of action is the exactness in computing the benefits associated with the course of action. The wealth maximization criterion is based on cash flows generated and not on accounting profit. The computation of cash inflows and cash outflows is precise. As against this the computation of accounting is not exact. ii) Quality and Quantity and Benefit and Time Value of Money: The second feature of wealth maximization criterion is that. It considers both the quality and quantity dimensions of benefits. Moreover, it also incorporates the time value of money. As stated earlier the quality of benefits refers to certainty with which benefits are received In future. The more certain the expected cash in flows the better the quality of benefits and higher the value. On the contrary the less certain the flows the lower the quality and hence, value of benefits. It should also be noted that money has time value. It should also be noted that benefits received in earlier years should be valued highly than benefits received later. The operational implication of the uncertainty and timing dimensions of the benefits associated with a financial decision is that adjustments need to be made in the cash flow pattern. It should be made to incorporate risk and

to make an allowance for differences in the timing of benefits. Net present value maximization is superior to the profit maximization as an operational objective. It involves a comparison of value of cost. The action that has a discounted value reflecting both time and risk that exceeds cost is said to create value. Such actions are to be undertaken. Contrary to this actions with less value than cost, reduce wealth should be rejected. It is for these reasons that the Net Present Value Maximization is superior to the profit maximization as an operational objective. PROFIT MAXIMIZATION VS WEALTH MAXIMIZATION PROFIT MAXIMISATION It is one of the basic objectives of financial management. Profit maximization aims at improving profitability, maintaining the stability and reducing losses and inefficiencies. Profit in this context can be seen in 2 senses. 1. Profit maximization for the owner. 2. Profit maximization is for others. 1. Normally profit is linked with efficiency and so it is the test of efficiency. However this concept has certain limitations like ambiguity i.e. the term is not clear as it is nowhere defined, it changes from person to person. 2. Quality of profit normally profit is counted in terms of rupees. Normally amt earned is called as profit but it ignores certain basic ideas like wastage, efficiency, employee skill, employees turnover, product mix, manufacturing process, administrative setup. 3. Timing of benefit / time value of profit in inflationary conditions the value of profit will decrease and hence the profits may not be comparable over a longer period span. 4. Some economists argue that profit maximization is sometimes leads to unhealthy trends and is harmful to the society and may result into exploitation, unhealthy competition and taking undue advantage of the position. WEALTH MAXIMISATION One of the traditional approaches of financial management , by wealth maximization we mean the accumulation and creation of wealth , property and assets over a period of time thus if profit maximization is aimed after taking care , of its limitations it will lead to wealth maximization in real sense, it is a long term concept based on the cash flows rather than profits an hence there can be a situation where a business makes losses every year but there are cash profits because of heavy depreciation which indirectly suggests heavy investment in fixed assets and that is the real wealth and it takes into account the time value of money and so is universally accepted.

Q2. Explain the factors affecting plan. To help your organization succeed, you should develop a plan that needs to be followed. This applies to starting the company, developing new product, creating new department or any undertaking that affects the companys future. There are several factors that affect planning in an organization. To create an efficient plan, you need to understand the factors involved in the planning process. Organizational planning is affected by many factors: Priorities In most companies, the priority is generating revenue, and this priority cansometimes interfere with the plannin g process of any project. For example, if you are in theprocess of planning a large expansion project and your largest customer suddenly threatens to take their business to your competitor, then you might have to shelve the expansion planning until the customer issue is resolved. When you start the planningprocess for any project, you need to assign each of the issues facing the company a priority rating. That priority rating will determine what issues will sidetrack you from the planning of your pro ect, and which issues can wait until the process is complete. Company Resources Having an idea and developing a plan for your company can help your company to grow and succeed, but if the company does not have the resources tomake the plan come together, it can stall progress. One of the first steps to any planning process should be an evaluation of the resources necessary to complete the project, compared to the resources the company has available. Some of the resources to consider are finances, personnel, space requirements, access to materials and vendor relationships. Forecasting A company constantly should be forecasting to help prepare for changes in themarketplace. Forecasting sales revenues, materials costs, personnel costs and overheadcosts can help a company plan for upcoming projects. Without accurate forecasting, it can be difficult to tell if the plan has any chance of success, if the company has the capabilities to pulloff the plan and if the plan will help to strengthen the companys standing within theindustry. For exampl e, if your forecasting for the cost of goods has changed due to asudden increase in material costs, then that can a ffect elements of your product roll-outplan, including projected profit and the long-term commitment you might need to make to a supplier to try to get the lowest price possible. Contingency Planning To successfully plan, an organization needs to have a contingency plan in place. If the company has decided to pursue a new product line, there needs to be a part of the plan that addresses the possibility that the product linewill fail. The reallocation of company resources, the acceptable financial losses and the pote ntial public relationsproblems that a failed product can cause all need to be part of the organizational planningpr ocess from the beginning.

Q3. Explain the time value of money? What Is Time Value? If you're like most people, you would choose to receive the $10,000 now. After all, three years is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later. But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now because over time you can earn more interest on your money. Back to our example: by receiving $10,000 today, you are poised to increase the future value of your money by investing and gaining interest over a period of time. For Option B, you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for Option B, on the other hand, would only be $10,000. So how can you calculate exactly how much more Option A is worth, compared to Option B? Let's take a look. Future Value Basics If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which of course is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount: Future value of investment at end of first year: = ($10,000 x 0.045) + $10,000 = $10,450 You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation:

Original equation: ($10,000 x 0.045) + $10,000 = $10,450 Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450 Final equation: $10,000 x (0.045 + 1) = $10,450

The manipulated equation above is simply a removal of the like-variable $10,000 (the principal amount) by dividing the entire original equation by $10,000. If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have $10,920:

Future value of investment at end of second year: = $10,450 x (1+0.045) = $10,920.25 The above calculation, then, is equivalent to the following equation: Future Value = $10,000 x (1+0.045) x (1+0.045) Think back to math class and the rule of exponents, which states that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following:

We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this:

This calculation shows us that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:

Present Value Basics If you received $10,000 today, the present value would of course be $10,000 because present value is what your investment gives you now if you were to spend it today. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future. To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P variable with present value (PV) and manipulated as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the $10,000 to be received in one year is represented as the following: Present value of future payment of $10,000 at end of year two:

Note that if today we were at the one-year mark, the above $9,569.38 would be considered the future value of our investment one year from now. Continuing on, at the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following: Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today's present value of the $10,000 expected from a three-year investment earning 4.5%:

So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from Option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future value of Option B.

Present Value of a Future Payment Let's add a little spice to our investment knowledge. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let's find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:

In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an $18,000 payment in four years would be calculated as the following: Present Value

From the above calculation we now know our choice is between receiving $15,000 or $15,386.48 today. Of course we should choose to postpone payment for four years! The Bottom Line These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times

Q6. What are the assumptions of MM approach? Miller and Modigliani Model assume that the dividends are irrelevant. Dividend irrelevance implies that the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firms investment policy, its dividend policy may have no influence on the market price of the shares, according to this model. Assumptions of MM model 1. Existence of perfect capital markets and all investors in it are rational. Information is available to all free of cost, there are no transactions costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities and there are no floatation costs. 2. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends. 3. A firm has a given investment policy which does not change. It implies that the financing of new investments out of retained earnings will not change the business risk complexion of the firm and thus there would be no change in the required rate of return. 4. Investors know for certain the future investments and profits of the firm (but this assumption has been dropped by MM later).

Argument of this Model 1. By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additional funds. 2. MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever is gained by the investors as a result of increased dividends will be neutralized completely by the reduction in the market value of the shares. 3. The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model. 4. That investors are indifferent between dividend and retained earnings implies that the dividend decision is irrelevant. With dividends being irrelevant, a firms cost of capital would be independent of its dividend-payout ratio. 5. Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant.

MM Model: Market price of the share in the beginning of the period = Present value of dividends paid at the end of the period + Market price of share at the end of the period. P0 = 1/(1 + ke) x (D1 + P1) Where: P0 = Prevailing market price of a share ke = cost of equity capital Dividend to be received at the end of D1= period 1 and Market price of a share at the end of P1 = period 1.

Value of the firm, nP0 Where: n =

(n + n) P1 I +E (1 + ke)

n= I = E =

number of shares outstanding at the beginning of the period change in the number of shares outstanding during the period/ additional shares issued. Total amount required for investment Earnings of the firm during the period.

Example: A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100 each. The firm is expecting to pay a dividend of $5 per share at the end of the current financial year. The company's expected net earnings are $250,000 and the new proposed investment requires $500,000. Prove that using MM model, the payment of dividend does not affect the value of the firm. Solution: 1. Value of the firm when dividends are paid: i. Price per share at the end of year 1: P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($5 + P1) P1 = $105 Amount required to be raised from the issue of new shares: n P1 = I (E nD1) => $500,000 ($250,000 - $125,000) => $375,000 Number of additional shares to be issued: n = $375,000 / 105 => 3571.42857 shares (unrounded) Value of the firm: => (25,000 + 3571.42857) (105) $500,000 + $250,000 (1 + 0.10) => $2,500,000 2. Value of the firm when dividends are not paid: i. Price per share at the end of year 1: P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($0 + P1) P1 = $110 Amount required to be raised from the issue of new shares: => $500,000 ($250,000 -0) = $250,000

ii.

iii.

iv.

ii.

iii.

Number of additional shares to be issued: => $250,000/$110 = 2272.7273 shares (unrounded) Value of the firm: => (25,000 + 2272.7273) (110) - $500,000 + $250,000 (1 + 0.10) => $2,500,000

iv.

Thus, according to MM model, the value of the firm remains the same whether dividends are paid or not. This example proves that the shareholders are indifferent between the retention of profits and the payment of dividend. Limitations of MM model: 1. The assumption of perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs. 2. Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content of dividends, iii) preference for current income and iv) sale of stock at uncertain price.

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