Financial Management: Objectives, Methods, and Capital Budgeting, Exercises of Computer Science

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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).

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(g) To coordinate the activities of the finance department with the activities of other departments of the firm (cooperation). Functions of Financial Management

1. 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.

2. 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.

3. Choice of sources of funds: For additional funds to be procured, a company

has many choices like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions

c. 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.

4. 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.

5. Disposal of surplus: The net profits decision have to be made by the finance

manager. This can be done in two ways:

a. Dividend declaration - It includes identifying the rate of dividends and

other benefits like bonus.

b. Retained profits - The volume has to be decided which will depend upon

expansional, innovational, diversification plans of the company.

6. 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.

7. 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

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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.

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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. 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 = P 0 + P 1 /(1+IRR) + P 2 /(1+IRR) 2 + P 3 /(1+IRR) 3 +... +Pn/(1+IRR)n

where P 0 , P 1 ,... Pn equals the cash flows in periods 1, 2,... n, respectively; and

IRR equals the project's internal rate of return.

Let's look at an example to illustrate how to use IRR.

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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

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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.

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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 typical ly 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 acco mplishing

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.

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3 All direct expenses (expenses connected with purchase or production of goods) are considered in it. 3 All expenses connected with sales and administration (indirect expenses) of business are considered. 4 It does not start with the balance of any account. 4 It always starts with the balance of a trading account (gross profit or gross loss). 5 Its balance (G.P or G.L) is transferred to profit and loss account. 5 Its balance (N.P or N.L) is transferred to capital account in balance sheet.