ABOUT THE AUTHORS
Ravi M. Kishore obtained a Master of Commerce degree from Sri Venkateswara University Tirupati and a Bachelor of Laws degree from Nagarjuna University, Guntur. He was an Associate Member of the Institute of Cost and Management Accountants of India, Kolkata and a Fellow Member of the Institute of Company Secretaries of India, New Delhi.
He obtained a Post Graduate Diploma in Personal Management From Annamalai University. He has also completed the ISO 9000 Quality Management Systems Auditor/Lead Auditor course conducted by Lloyds Register Quality Assurance, London.
He has worked in medium and large manufacturing concerns for over 15 years in senior-level management positions, handling finance, accounting, and secretarial functions. He was also a Management Consultant who offered specialist services to the Corporate sector.
He has authored several textbooks for professional and academic courses on financial accounting, cost accounting, management accounting and financial management subjects.
Padma Sai Arora, a Ph.D. in Finance from Department of Financial Studies, University of Delhi South Campus is currently working as a Professor in Commerce at Keshav Mahavidyalaya, University of Delhi.
A graduate in Commerce from Sri Venkateswara College, University of Delhi and a post graduate from University of Delhi South Campus, Padma Sai earned her doctorate in Finance from Department of Financial Studies, University of Delhi. She is a Delhi University M.Com. gold medallist and a school topper. She was awarded the Mamta Gupta Memorial Gold Medal for being the best woman candidate in M.Com. 1997 and the M. C. Shukla Gold Medal for securing the highest marks in the aggregate of Organisational Theory, Organisational Behaviour, Business Environment and Business Policies in M.Com. 1997. She is the recipient of Prof. A.B. Ghosh prize for securing the highest percentage of marks in the aggregate of papers on Economics in M.Com. 1997 and Jai Narain Vaish prize for being the best candidate in M.Com. 1997. She was awarded the Mrs. Munan Kapoor Memorial scholarship for the year 1996-97 for topping M.Com. (Previous) Exam, University of Delhi and Merit-Cum-Means Scholarship for the years 1990-91 and 1991-92 by St. Mary’s Public School, Delhi.
Padma Sai Arora started her teaching career in 1998 from Hindu college, University of Delhi and taught in Delhi College of Arts and Commerce and Janaki Devi Memorial College before joining Keshav Mahavidyalaya, University of Delhi in the year 2000. She has also taught M. Com. Students in Department of Commerce, Delhi University and now has almost 25 years of experience in teaching. She has taught various subjects at undergraduate and post graduate level. Besides being a dedicated teacher, she is an ardent researcher. Continuing her interest in the Indian banking sector, the area of study in her M.Phil and Ph.D., she has been publishing a number of research papers on profitability, productivity and efficiency in Indian banking in national and international Scopus and
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UGC-CARE journals of repute. She is also a recognised research supervisor in the Department of Commerce, Delhi School of Economics, University of Delhi and presently has one scholar working under her supervision.
I-6 ABOUT THE AUTHORS
PREFACE
Financial Management embraces all functional areas of an organisation, be it production, marketing or human resource. Funds are to be raised and invested optimally ensuring that shareholders wealth is maximised. There is a myriad of issues faced by owners/managers in maintaining the financial health of the organisation ranging from how much funds are required to from where to raise the funds to what type of funds to raise (debt vs equity). Also, business environment is not risk free, it is dynamic. Hence, a careful analysis is required regarding risk return trade off. Decisions are to be taken today regarding expected returns in future. As future is not certain, time value of money needs to be taken into account. In recent times we have witnessed a phenomenal change in the way organisations are managed, more so in the case of joint stock companies. Globalisation has brought with it numerous opportunities. New ways of raising funds and investments has brought about a change in finance dynamics. Advancements in technology and digitalisation of operations have transformed every aspect of financial management. Information is available easily opening up avenues for multitude new entrepreneurs and start-ups. This has intensified competition. A small lapse by the organisation can result in losing its competitive advantage leading to huge losses. Innovative ‘out of the box’ thinking to maximize shareholder wealth has become the business mantra. Thus, it has become indispensable for managers to be groomed well in the skills required to manage finances.
Financial Management as a discipline is multidimensional and involves dimensions such as present value, risk-return analysis, capital budgeting, capital structure, dividend decisions and working capital. Looking at the expected implication(s) of various aspects, decisions are to be made. There are various techniques to analyse the impact of a finance decision on the shareholders’ wealth. This book has been designed in such a way as to explain in detail various principles and techniques of financial management. Each concept is explained in an easy-to-understand style. Solved miscellaneous illustrations are given for better understanding. The book describes each concept in detail. There are extensive descriptive explanations followed by figures and diagrams. Each Unit has an opening case to prepare the base for the financial principles and concepts that follow in the unit. The case study at the end of each chapter is easy to relate to and has been prepared to make way for great discussion. Students can test their knowledge after going through each chapter by solving practice questions. The book has a large number of MCQs also to help prepare for quiz/assignment. To make learning in line with industry trends, excerpts are given from annual reports of different existing companies. After going through the book, readers can go through annual reports of various companies and analyse the information in a better manner.
This book is intended for those who wish to grasp the fundamental principles and theory of financial management. Specifically, the book is aimed post graduate students in B-schools. As the topics are handled in a very simple manner with a lot of solved and unsolved questions, the book shall be very useful for undergraduate students in B.Com. (Hons), B.Com. (Prog.) and B.A.
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(Prog.) of various universities and professional institutes. The book is very much recommended for students who are looking for a book that follows a very simple approach to explain difficult financial management principles.
It is a matter of honour to present the summarised version of ninth edition of the book to the readers. Ravi M. Kishore’s book has always been an extremely popular book among students and teachers alike. The new edition draws heavily from the plus points of earlier editions and continues to explain the concepts in simple easy to understand manner. The book has been reorganised for introducing different concepts in a systematic manner. It comprises of Six Units comprising of nineteen chapters. Unit One presents Essentials of Financial Management to the readers. It comprises of three chapters namely Financial Management: An Overview, Basic Valuation Concepts and Strategic Financial Management. Important concepts and principles fundamental to financial management such as time value of money, interest rates, bond valuation and risk-return analysis are discussed in chapter 2. This chapter provides the foundation to understanding financial management in a proper way. Unit Two comprises of nine chapters that deal with analysis of financial statements through fund flow statement, cash flow statement and ratio analysis. Chapter eight explains how economic value added through various operations can be enhanced. Chapter nine describes operating and financial leverage and their impact on earnings per share. Unit Three deals with Investing in Capital assets and comprises of two chapters. Chapter ten explains principles and techniques of capital budgeting. Chapter eleven describes risk evaluation in capital budgeting decisions. Financing Decisions are explained in Unit Four comprising of two chapters that deal with cost of capital and capital structure theories and value of firm. Unit Five describes the dividend theories and policy in detail. Unit Six comprises of five chapters. Chapters 15 and 16 explain the basics of working capital and the estimation of working capital respectively. Chapter 17 deals with inventory management. Chapter 18 describes receivables management. Chapter 19 explains cash management in a detailed manner.
A schematic presentation of the book is given as under: Part
Part
I-8 PREFACE
1 Chapter 1: Financial Management An Overview -Approaches to F.M. -Financing Decisions -Agency Problem Concepts -Interest Rates -Risk Return Analysis Chapter 3 : Strategic Financial Planning
3
5 Chapter 14 – Dividend
2 Statements Funds Flow Analysis Chapter 6 – Financial Statement Analysis using Cash Flow analysis Chapter 7 – Financial Statement Chapter 8 – Financial Statement Analysis using economic Value Added Chapter 9 – Financial Statement Analysis using Financial and
4 Impact on Firm’s Earnings Per Share (EPS) Chapter 13 – Capital
Part
Part
Part
Part
6 Capital Chapter 17 – Inventory Management Chapter 18 – Receivables Management Chapter 19 – Cash Management
A Chapter-wise Schematic representation is presented below:
Review Questions:
A. True or False
B. Choose Correct Word
C. Choose Correct Answer
D. Discussion Questions
Practical Exercises
PREFACE I-9
Learning
Concepts
Summary Miscellaneous Illustrations
Outcomes Case Study
KeyWords
Case
Study
ACKNOWLEDGEMENTS
The present edition of the book owes its existence to the previous editions of Ravi M. Kishore’s book Financial Management. His vast knowledge as a teacher and author is deeply appreciated.
I place on record my sincere thanks to my parents and teachers for sharing their knowledge and wisdom. I shall always remain indebted to them.
My students have helped me grow as a teacher and a seeker of knowledge. Their contribution is deeply acknowledged.
I also take this opportunity to thank my husband Prof. Hitesh Arora for being a source of constant inspiration and encouragement. I acknowledge the efforts of my son Sailesh for giving me new ideas and situations for some of the case studies developed specially for this book. His regular reminders to complete the book on time used to bring a smile on my face and kept me motivated. Percy, the new addition to our family gave me the joy of his presence throughout. His undemanding companionship while completing the book is lovingly acknowledged.
The support and encouragement received from Prof. Madhu Pruthi, Principal Keshav Mahavidyalaya, University of Delhi is also acknowledged.
My sincere thanks to the entire team at Taxmann Publications Pvt. Ltd. India with special appreciation to the efforts of Mr. Sarvendra Singh who tirelessly helped me complete the work on schedule.
I offer my pranams and gratitude to Bhagwan Sri Sathya Sai Baba for giving me this wonderful opportunity.
PADMA SAI ARORASeptember, 2023
Email: padmasai.arora@keshav.du.ac.in; padmasai0111@yahoo.co.in
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PAGE About the Authors I-5 Preface I-7 Acknowledgements I-11 Contents I-15 PART
ESSENTIALS OF FINANCIAL MANAGEMENT CHAPTER 1 : Financial Management: An Overview 3 CHAPTER 2 : Basic Valuation Concepts: Time Value of Money, Interest Rates, Valuation of Bonds and Risk-Return Analysis 40 CHAPTER 3 : Strategic Financial Planning 115 PART TWO ANALYSIS OF FINANCIAL POSITION CHAPTER 4 : Analysis of Financial Statements 145 CHAPTER 5 : Statement of Changes in Financial Position: Funds Flow Analysis 165 CHAPTER 6 : Financial Statement Analysis Using Cash Flow Analysis 193 CHAPTER 7 : Financial Statement Analysis Using Ratio Analysis 227 CHAPTER 8 : Financial Statement Analysis Using Economic Value Added 274 CHAPTER 9 : Financial Statement Analysis Using Financial and Operating Ratios 290 PART THREE INVESTMENT DECISION CHAPTER 10 : Capital Budgeting 319 CHAPTER 11 : Risk Evaluation in Capital Budgeting 364 CHAPTER-HEADS I-13
ONE
I-14 PAGE
CHAPTER 12 : Cost of Capital and Impact on Firm’s Earning Per Share (EPS) 417 CHAPTER 13 : Capital Structure Theories and Value of Firm 451 PART FIVE DIVIDEND DECISIONS CHAPTER 14 : Dividend Theories and Value of Firm 497 PART SIX WORKING CAPITAL MANAGEMENT CHAPTER 15 : Basics of Working Capital 537 CHAPTER 16 : Estimating Working Capital 571 CHAPTER 17 : Inventory Management 602 CHAPTER 18 : Receivables Management 630 CHAPTER 19 : Cash Management 660
PART FOUR FINANCING DECISIONS
I-15 PAGE About the Authors I-5 Preface I-7 Acknowledgements I-11 Chapter-heads I-13 PART ONE ESSENTIALS OF FINANCIAL MANAGEMENT CHAPTER 1 FINANCIAL MANAGEMENT: AN OVERVIEW 1.1 Approaches to Financial Management 6 1.1.1 Traditional Approach 6 1.1.2 Modern Approach 7 1.2 Objectives of Financial Management 7 1.2.1 Profit Maximization 8 1.2.2 Wealth Maximization 8 1.2.3 Value Maximization 9 1.2.4 Other Objectives 10 1.3 Financial Decisions 11 1.3.1 Investment Decisions 11 1.3.2 Financing Decisions 12 1.3.3 Dividend Decisions 13 1.4 Finance Function 14 1.4.1 Functions of a Finance Manager 14 1.4.2 Finance Manager as a Facilitator 15 1.4.3 Need to Centralize Finance Function 16 1.4.4 Organization Chart of Finance Function 17 CONTENTS
I-16 CONTENTS PAGE 1.5 Separation of Management and Ownership and Agency Problem 18 1.5.1 Agency Theory Models 18 1.5.2 Agency Costs 18 1.5.3 Constituents of Agency Theory 18 1.5.4 Criticism of Agency Theory 19 1.6 Impact of Taxation, Inflation and Depreciation 20 1.6.1 Corporate Taxation 20 1.6.2 Impact of Inflation on Business Firm 23 1.6.3 Impact of Depreciation on Business Firm 23 1.7 Significance of Financial Management 24 CHAPTER 2 BASIC VALUATION CONCEPTS: TIME VALUE OF MONEY, INTEREST RATES, VALUATION OF BONDS AND RISK-RETURN ANALYSIS 2.1 Time Value of Money in Investment Decisions 41 2.1.1 Effects of Inflation on Decision-making 42 2.1.2 Present Value 42 2.1.3 Discount Factors 43 2.1.4 Compounding Rate and Capitalising Rate 43 2.1.5 Annuity 43 2.1.6 Future Value of Ordinary Annuity 44 2.1.7 Present Value of Ordinary Annuity 44 2.1.8 Present Value of Deferred Annuity 44 2.1.9 Present Value of Perpetuity 44 2.2 Interest Rate 45 2.2.1 Factors affecting Interest Rates 46 2.2.2 Theorems on Term Structure of Interest Rates 50 2.2.3 Yield to Maturity (YTM) 51 2.2.4 Factors Determining Yield on Stocks 52 2.2.5 Computation of Yield of Stocks 53 2.2.6 Simple Interest 53 2.2.7 Compound Interest 54 2.2.8 Amortization 54 2.2.9 Sinking Fund 55
CONTENTS I-17 PAGE 2.3 Valuation of Bonds 55 2.3.1 Related Terms in Bond Valuation 55 2.3.2 Bond Value 57 2.3.3 Theorems in Bond Valuation 58 2.4 Risk Analysis 59 2.4.1 Business Risk and Financial Risk 60 2.4.2 Risk Analysis in Project Selection 60 2.4.3 Risk Minimization through Portfolio Selection 61 2.4.4 Utility Function, Indifference Curves and Risk Taking 62 2.4.5 Risk and Required Return 64 2.4.6 Risk-Return Relationship 65 2.4.7 Costing and Risk 67 2.4.8 Risk-Return Trade Off 67 CHAPTER 3 STRATEGIC FINANCIAL PLANNING 3.1 Strategic Financial Planning 115 3.1.1 Strategy 116 3.1.2 Steps in Strategic Planning 117 3.2 Economic Environment of Business 118 3.3 Strategic Financial Management 119 3.4 Financial Planning 120 3.4.1 Financial Planning Environment 120 3.4.2 Financial Planning Process 121 3.5 Limitations of Financial Planning 122 3.6 Forecasting 123 3.6.1 Financial Forecasting Techniques 124 3.6.2 Benefits of Financial Forecasting 125 3.7 External Fund Requirement (EFR) 126 3.8 Internal Growth Rate (IGR) 126 3.9 Sustainable Growth Rate (SGR) 126 3.10 Financial Engineering 127 3.10.1 Features of Financial Engineering 128
I-18 CONTENTS PAGE
TWO ANALYSIS OF FINANCIAL POSITION CHAPTER 4 ANALYSIS OF FINANCIAL STATEMENTS 4.1 Financial Statements 146 4.1.1 Financial Statements Analysis 147 4.1.2 Types of Financial Statement Analysis 147 4.1.3 Methods of Analyzing Financial Statements 148 4.2 Comparative Financial Statements 148 4.3 Common-Size Financial Statements 149 CHAPTER 5 STATEMENT OF CHANGES IN FINANCIAL POSITION: FUNDS FLOW ANALYSIS 5.1 Identification of Fund and Flow 165 5.1.1 Meaning of ‘Fund’ and ‘Flow’ 166 5.1.2 Identification of Flow of Funds 167 5.2 Statement of Sources and Application of Funds 167 5.2.1 Sources of Funds or Funds Generated from Operations 168 5.2.2 Funds Raised from Shares, Debentures and Long-term Loans 170 5.2.3 Sale of Fixed Assets and Long-term Investments 170 5.3 Applications of Funds 170 5.4 Statement of Changes in Working Capital 171 5.4.1 Statement of Changes in Working Capital 172 5.5 Comparison with Financial Statements 173 5.5.1 Funds Flow Statement and Balance Sheet: Distinction 173 5.5.2 Funds Flow Statement and Income Statement: Distinction 173 5.6 Benefits of Funds Flow Analysis 174 5.7 Drawbacks of Funds Flow Analysis 175
PART
CONTENTS I-19 PAGE CHAPTER 6 FINANCIAL STATEMENT ANALYSIS USING CASH FLOW ANALYSIS 6.1 Meaning of Cash Flow Statements 193 6.1.1 Uses of Cash Flow Statement 194 6.1.2 Limitations of Cash Flow Statement 194 6.2 Comparison with Funds Flow Statement and Cash Budget 195 6.2.1 Funds Flow and Cash Flow: Distinction 195 6.2.2 Cash Flow and Cash Budget: Distinction 196 6.3 Classification of Cash Flows 197 6.3.1 Cash Flows from Operating Activities 197 6.3.2 Cash Flows from Investing Activities 197 6.3.3 Cash Flows from Financing Activities 198 6.4 Treatment of Special Items 198 6.4.1 Foreign Currency Cash Flows 198 6.4.2 Extraordinary Items 199 6.4.3 Interest and Dividends 199 6.4.4 Taxes on Income 199 6.4.5 Investments in Subsidiaries, Associates and Joint Ventures 199 6.4.6 Acquisition and Disposal of Subsidiaries and Other Business Units 200 6.4.7 Non-cash Transactions 200 6.5 Preparation of Cash Flow Statement 200 6.5.1 Data Required for Preparation of a Cash Flow Statement 200 6.5.2 Procedure for Preparation of Cash Flow Statement 200 6.5.3 Reporting of Cash Flows from Operating Activities 201 CHAPTER 7 FINANCIAL STATEMENT ANALYSIS USING RATIO ANALYSIS 7.1 Liquidity Ratios 228 7.1.1 Current Ratio 228 7.1.2 Quick/Liquid/Acid Test Ratio 229 7.2 Leverage Ratios 229 7.2.1 Debt-Equity Ratio 229 7.2.2 Shareholders Equity Ratio 230
I-20 CONTENTS PAGE 7.2.3 Long-term Debt to Shareholders Net Worth Ratio 230 7.2.4 Capital Gearing Ratio 230 7.2.5 Fixed Assets to Long-Term Funds Ratio 231 7.2.6 Proprietary Ratio 231 7.2.7 Interest Cover 231 7.2.8 Debt Service Coverage Ratio (DSCR) 231 7.2.9 Dividend Cover 232 7.3 Asset Management Ratios 232 7.3.1 Inventory Turnover Ratio 232 7.3.2 Inventory Ratio 233 7.3.3 Debtors Turnover Ratio 233 7.3.4 Debtors Collection Period 233 7.3.5 Creditors Turnover Ratio 233 7.3.6 Creditors Payment Period 233 7.3.7 Fixed Assets Turnover Ratio 234 7.3.8 Total Assets Turnover Ratio 234 7.3.9 Working Capital Turnover Ratio 234 7.3.10 Sales to Capital Employed Ratio 234 7.3.11 Bad Debts to Sales Ratio 235 7.4 Profitability Ratios 235 7.4.1 Gross Profit Margin 235 7.4.2 Net Profit Margin 236 7.4.3 Cash Profit Ratio 236 7.4.4 Return on Total Assets 237 7.4.5 Return on Shareholders’ Funds or Return on Net worth 237 7.4.6 Return on Equity (ROE) 237 7.4.7 Return on Capital Employed (ROCE) 237 7.5 Operating Ratios 239 7.5.1 Absolute Liquid/Super Quick Ratio 239 7.5.2 Defensive-Interval Ratio 240 7.6 Market Based Ratios 240 7.6.1 Earnings Per Share (EPS) 240 7.6.2 Cash Earnings Per Share 241 7.6.3 Dividend Payout Ratio 241 7.6.4 Dividend Yield 241
CONTENTS I-21 PAGE 7.6.5 Book Value 241 7.6.6 Price Earnings Ratio (P/E Ratio) 242 7.6.7 Price to Book Value Ratio (P/BV Ratio) 242 7.7 Du Pont Analysis 242 7.8 Importance of Ratio Analysis 244 7.9 Factors Affecting Efficacy of Ratios 245 7.10 Non-Financial Performance Measures 246 CHAPTER 8 FINANCIAL STATEMENT ANALYSIS USING ECONOMIC VALUE ADDED 8.1 Economic Value Added (EVA) 274 8.1.1 How to Calculate EVA? 275 8.1.2 Means of Enhancing EVA 276 8.1.3 Steps in Implementing EVA 276 8.1.4 Superiority of EVA 276 8.1.5 Drawbacks of EVA 277 8.2 Market Value Added (MVA) 278 8.3 Shareholder Value Analysis (SVA) 278 8.4 Value Based Management (VBM) 279 8.4.1 Methods of VBM 280 CHAPTER 9 FINANCIAL STATEMENT ANALYSIS USING FINANCIAL AND OPERATING RATIOS 9.1 Operating Leverage 290 9.1.1 Degree of Operating Leverage (DOL) 291 9.2 Financial Leverage 291 9.2.1 Degree of Financial Leverage (DFL) 292 9.2.2 Impact of Financial Leverage on EPS 292 9.2.3 Impact of Financial Leverage on WACC 293 9.2.4 Impact of Financial Leverage on ROE and ROA 293 9.3 Total Leverage 293 9.3.1 Degree of Total Leverage (DTL) 294
I-22 CONTENTS PAGE 9.4 Structural Leverage 294 9.4.1 Debt-Equity Ratio 295 9.4.2 Total Debt to Equity Ratio 295 9.4.3 Debt to Net Worth Ratio 295 9.5 Interest Cover and Income Gearing 295 9.5.1 Interest Cover 295 9.5.2 Income Gearing 296 9.6 Trading on Equity and Gearing 296 9.6.1 Debt and Equity: Distinction 296 9.6.2 Trading on Equity 297 9.6.3 Gearing 297
CHAPTER 10 CAPITAL BUDGETING 10.1 Meaning of Capital Budgeting 319 10.2 Methods of Capital Budgeting 320 10.2.1 Payback Period Method 320 10.2.2 Accounting Rate of Return Method 322 10.2.3 Net Present Value Method 323 10.2.4 Internal Rate of Return Method 325 10.2.5 Profitability Index Method 326 10.2.6 Discounted Payback Period Method 327 10.2.7 Adjusted Present Value Method 327 10.3 Capital Rationing 328 10.3.1 Meaning 328 10.3.2 Factors Leading to Capital Rationing 329 10.3.3 Situations of Capital Rationing 330 10.4 Impact of Inflation on Capital Budgeting 330 10.5 Impact of Corporate Taxation on Capital Budgeting 331 10.6 Impact of Investment Incentives on Capital Budgeting 332 10.7 Impact of Non-Financial Factors in Capital Investment Decisions 333
PART THREE INVESTMENT DECISION
CONTENTS I-23 PAGE CHAPTER 11 RISK EVALUATION IN CAPITAL BUDGETING 11.1 Risk and Uncertainty 364 11.1.1 Objectives of Risk Management 365 11.1.2 Steps in Risk Management Process 366 11.2 Probability and Expected Value 366 11.2.1 Basic Tenets of Probability Theory 366 11.2.2 Advantages of Expected Value 367 11.2.3 Disadvantages of Expected Value 367 11.3 Optimistic, Most Likely and Pessimistic Estimates 368 11.4 Value of Information 368 11.4.1 Value of Perfect Information 368 11.4.2 Value of Imperfect Information 369 11.5 Standard Deviation of Cash Flows 369 11.5.1 Hillier’s Model for Risk Analysis 369 11.6 Sensitivity Analysis 370 11.6.1 Advantages of Sensitivity Analysis 371 11.6.2 Disadvantages of Sensitivity Analysis 371 11.7 Certainty Equivalent (CE) 371 11.8 Risk Adjusted Discount Rate (RADR) 371 11.8.1 RADR and CE : Distinction 372 11.9 Decision Tree 373 11.9.1 Rules and Conventions of Drawing Decision Tree 373 11.9.2 Steps in Drawing Decision Tree 374 11.10 Simulation 375 11.10.1 Steps in Monte Carlo Simulation 376 11.10.2 Application of Simulation 377 11.10.3 Advantages of Simulation 377 11.10.4 Disadvantages of Simulation 378 11.10.5 Hertz Simulation Model 379 11.11 Project Beta 379 11.11.1 Capital Structure and Beta Values 380
I-24 CONTENTS PAGE
CHAPTER 12 COST OF CAPITAL AND IMPACT ON FIRM’S EARNING PER SHARE (EPS) 12.1 Meaning of Cost of Capital 417 12.1.1 Different Categories of Long-term Funds 418 12.1.2 Importance of Cost of Capital in Decision-making 418 12.2 Cost of Equity Share Capital (Ke) 419 12.2.1 Dividend Yield Method 420 12.2.2 Dividend Growth Method 420 12.2.3 Price Earning Method 421 12.2.4 Capital Asset Pricing Model 421 12.3 Cost of Retained Earnings (Kr) 421 12.3.1 Opportunity Cost Approach 422 12.3.2 Rights Offer Approach 422 12.4 Cost of Preference Share Capital (KP) 423 12.4.1 Cost of Irredeemable Preference Shares 423 12.4.2 Cost of Redeemable Preference Shares 423 12.5 Cost of Debentures and Term-Loans (KD) 424 12.5.1 Nominal and Real Cost of Debt 424 12.5.2 Cost of Perpetual Debt 425 12.5.3 Cost of Redeemable Debt 425 12.5.4 Cost of Zero Coupon Bonds 425 12.5.5 Cost of Convertible Debentures 426 12.5.6 Cost of Floating Rate Debt 426 12.6 Weighted Average Cost of Capital (WACC) 426 12.6.1 Simple WACC 427 12.6.2 WACC Based on Book Values and Market Values 427 12.6.3 WACC Considering Tax Shield 427 12.6.4 Use of WACC in Investment Appraisal 428 12.7 Opportunity Cost of Capital 428 12.7.1 Opportunity Cost of Equity Funds 429 12.7.2 Opportunity Cost of Debt Funds 429
PART FOUR FINANCING DECISIONS
CONTENTS I-25 PAGE 12.8 Marginal Cost of Capital 429 12.8.1 Marginal Cost of Capital and WACC 429 CHAPTER 13 CAPITAL STRUCTURE THEORIES AND VALUE OF FIRM 13.1 Equity and Debt in Capital Structure 451 13.1.1 Equity Funds 452 13.1.2 Debt Funds 453 13.2 Factors Determining Capital Structure 453 13.3 Optimum Capital Structure 455 13.4 Capital Structure Theories 456 13.4.1 Net income Approach 456 13.4.2 Net Operating Income Approach 458 13.4.3 WACC Approach (Traditional View) 459 13.4.4 Modigliani and Miller Approach (Modern View) 461 13.5 Static Trade-Off Theory 467 13.5.1 Financial Distress and Agency Costs 467 13.5.2 Financial Distress and Bankruptcy Costs 468 13.5.3 Agency Costs 469 13.6 Pecking Order Theory 469 13.6.1 Assumptions 470 13.7 Modified Pecking Order Theory 470 13.8 Debt-Equity Ratio Approach 471 13.9 EBIT-EPS Approach 471 13.9.1 Financial Break-even 472 13.9.2 Financial Indifference Point 472 13.10 Financial and NEDC Risks Trade-Off Approach 473 13.10.1 Assumptions 473 13.10.2 Financial Risks 473 13.10.3 NEDC Risks 474
I-26 CONTENTS PAGE
CHAPTER 14 DIVIDEND THEORIES AND VALUE OF FIRM 14.1 Meaning and Kinds of Dividend 497 14.1.1 Meaning of Dividend 497 14.1.2 Dividend Terminology 498 14.1.3 Kinds of Dividend 498 14.2 Determinants of Dividend Policy 499 14.3 Dividend Payout Policies 502 14.3.1 Constant Dividend Payout Policy 502 14.3.2 Constant Dividend Rate Policy 503 14.3.3 Optimum Dividend Policy 504 14.4 Dividend Growth Model 505 14.4.1 Assumptions 505 14.4.2 Criticism 506 14.5 Walter’s Valuation Model 506 14.5.1 Assumptions 507 14.5.2 Implications of Walter’s Model 507 14.6 Modigliani and Miller’s Dividend Irrelevancy Model 508 14.6.1 Basic Tenets 508 14.6.2 Assumptions 509 14.6.3 Computation of Market Price of Share 509 14.6.4 Assumptions 510 14.7 Capital Asset Pricing Model 510 14.8 Gordon and Linter’s Theory 511 14.9 Other Theories on Dividend Policy 511 14.9.1 Tax Differential Theory 511 14.9.2 Residual Theory 511 14.9.3 100% Payout Theory 512 14.9.4 100% Retention Theory 512 14.9.5 Investor Rationality Theory 512 14.9.6 Span of Control Theory 512
PART FIVE DIVIDEND DECISIONS
CONTENTS I-27 PAGE
CHAPTER 15 BASICS OF WORKING CAPITAL 15.1 Working Capital 539 15.1.1 Meaning of Working Capital 539 15.1.2 Objectives of Working Capital Management 540 15.1.3 Current Assets and Current Liabilities 540 15.1.4 Classification of Working Capital Gross and Net Working Capital 541 15.2 Working Capital Management 544 15.2.1 Overtrading 544 15.2.2 Under Capitalization 545 15.2.3 Over Capitalization 546 15.2.4 Symptoms of Poor Working Capital Management 546 15.2.5 Measures to Overcome Working Capital Crunch 546 15.3 Operating Cycle 547 15.3.1 Computation of Operating Cycle Period 548 15.3.2 Reasons for Prolonged Operating Cycle 548 15.3.3 Measures to Reduce Operating Cycle 549 15.4 Working Capital Policies 550 15.4.1 Restricted Policy 551 15.4.2 Relaxed Policy 551 15.4.3 Moderate Policy 551 15.5 Strategies in Financing Working Capital 551 15.5.1 Conservative Strategy 551 15.5.2 Aggressive Strategy 552 15.5.3 Hedging Strategy 553 15.5.4 Zero Working Capital Strategy 554 CHAPTER 16 ESTIMATING WORKING CAPITAL 16.1 Determinants of Working Capital Need 571 16.2 Working Capital Estimation Methods 573
PART SIX WORKING CAPITAL MANAGEMENT
I-28 CONTENTS PAGE 16.2.1 Percentage of Sales Method 573 16.2.2 Regression Analysis Method 573 16.2.3 Operating Cycle Method 574 16.2.4 Individual Components Method 574 16.3 Approaches to Working Capital Estimation 577 16.3.1 Estimation of Working Capital Need in Seasonal Industries 578 16.3.2 Inflationary Tendency 578 16.3.3 Estimation of Working Capital Need in Shift Operations 579 16.4 Working Capital Leverage 580 CHAPTER 17 INVENTORY MANAGEMENT 17.1 Inventory Policy and Stock Control 602 17.1.1 Classification of Inventory 603 17.1.2 Features of Ideal Inventory Policy 603 17.1.3 Requirements of Stock Control 603 17.1.4 Impact of Inflation on Inventory Holding 604 17.2 Input-Output and Stock Turnover Ratio 604 17.2.1 Input-Output Ratio 604 17.2.2 Stock Turnover Ratio 605 17.3 Economic Order Quantity 605 17.3.1 Assumptions of EOQ 606 17.3.2 Ordering Costs 606 17.3.3 Carrying Costs 606 17.3.4 Stock-out Costs 607 17.3.5 EOQ with Discounts 608 17.4 Inventory Levels 608 17.4.1 Reorder Level 608 17.4.2 Minimum Stock Level 608 17.4.3 Maximum Stock Level 609 17.4.4 Danger Level 609 17.4.5 Average Stock Level 609 17.5 Techniques of Inventory Analysis 609 17.5.1 ABC Analysis 609
CONTENTS I-29 PAGE 17.5.2 VED Analysis 612 17.5.3 FNSD Analysis 612 17.6 Pull System and JIT in Inventory Management 613 CHAPTER 18 RECEIVABLES MANAGEMENT 18.1 Meaning and Importance of Receivables Management 630 18.2 Trade Credit 631 18.2.1 Types of Credit 631 18.2.2 Costs of Granting Credit 631 18.2.3 Administration Costs of Receivables 632 18.2.4 Costs of Denying Credit 632 18.3 Steps in Evaluation of Increase in Credit Term 633 18.4 Cash Discount 633 18.4.1 Debtors Payment Terms 633 18.4.2 Economics of Offering Cash Discount 634 18.4.3 Steps in Evaluation of Increase in Cash Discount 635 18.5 Analysis of Receivables 635 18.5.1 Measuring Day’s Sales in Terms of Debtors 635 18.6 Credit Control 638 18.6.1 Credit Control Department 638 18.6.2 Establish Credit Policy 638 18.6.3 Establish Credit Standards 639 18.6.4 Assess Credit Risk 639 18.6.5 Establish Effective Administration of Debtors 640 18.6.6 Establish Credit Status 640 18.6.7 Check Credit Limit 640 18.6.8 Authorization 640 18.6.9 Referral 641 18.6.10 Issuing the Delivery Note, Invoicing 641 18.6.11 Settlement 641 18.6.12 Assess Customer Creditworthiness 642 18.6.13 Establish Policy on Bad Debts 643
I-30 CONTENTS PAGE CHAPTER
19.1 Motives for Holding Cash 661 19.2 Meaning of Cash Assets Management 662 19.3 Cash Surplus and Cash Deficit 663 19.3.1 Reasons for Cash Surplus 663 19.3.2 Reasons for Cash Deficit 664 19.3.3 Effects of Cash Deficit 664 19.3.4 Methods of Improving Liquidity 665 19.4 Baumol’s EOQ Cash Management Model 666 19.4.1 Assumptions 668 19.4.2 Limitations 668 19.5 Miller-Orr’s Stochastic Cash Management Model 668 19.5.1 Assumptions 670 19.5.2 Limitations 670 19.6 Marketable Securities 671 19.6.1 Objectives of Investment in Marketable Securities 671 19.6.2 Principles in Selecting Marketable Securities 671 19.7 Management of Float 672 19.7.1 Sources of Float 672 19.7.2 Types of Float 673 19.8 Modes of Cash Management 676 19.8.1 Electronic Cash Management System 676 19.8.2 Virtual Banking 678 19.8.3 Setting Cash Balance 679 19.8.4 Cash Cycle 679 19.8.5 Zero Balance Account 679 19.8.6 Money Market Banking 679 19.8.7 Petty Cash Imprest System 680 19.9 Treasury Management 680 19.9.1 Evolving Role of Treasury as a Profit Center 681 19.9.2 Role and Functions of Treasurer 682 19.9.3 Centralized or Decentralized Treasury Management 684 19.9.4 Cash Managment and Treasury Management: Distinction 685
19 CASH MANAGEMENT
Part One Essentials of Financial Management FINANCE
underpins every transaction in a business organisation. It is the life
1
(a b c d e i (ii a and (b
and is divided the concept and various theories of interest rate structure. It also discusses the
2 P
Financial Management: An Overview
Financial Management is concerned with efficient use of an important economic resource namely: capital funds. It is the study of the problems in the use of use and acquisition of funds.Ezra
Learning Outcomes
3
CHAPTER
1
Solomon (1978)
Tata Steel’s Takeover of Corus
Particulars
4 P
Global
Deals
Steel
Target Buyer Value
Big Merger and Takeover
in
Industry
($ bn.), Year
Top Five Global Steel Ranking Company Capacity (million tons)
Industry’s Response
Shareholder’s Response
Strategic Reasons
iron ore and steel slabs. (g
base both in Europe and India. (h
5
a b c d e f
i j
Discussion:
1.1 APPROACHES TO FINANCIAL MANAGEMENT
1.1.1 Traditional Approach
provisions.
6 P k) level. (l m n
(i (ii (iii
1.1.2 Modern Approach
i ii
(iii) pattern of financing the assets.
Remember:
The basic responsibility of the finance manager is not only to acquire funds needed by the firm but also to invest those funds in profitable ventures in order to maximize firm’s wealth.
1.2 OBJECTIVES OF FINANCIAL MANAGEMENT
7
(i ii) value addition and iii iv
1.2.1 Profit Maximization
ensure that these are carried out.
i) concept
ii iii) ignores the
ii) fails to consider the social responsibility of business.
vi
1.2.2 Wealth Maximization
ii) it is consistent
iii) it suggests the regular and consistent
8 P v vi vii viii ix)
(
(a
b
iv v
(i
iv v vi
The gross present worth of a course of action is equal to the capitalized value of the flow of future expected benefit, discounted (or capitalized) at a rate which reflects certainty or uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits.
1.2.3 Value Maximization
9 (vii viii) profit ix
benefits attached to E. 2 2 n n A2 A n .
i.e
Remember:
The prime goal for company form of organization is to maximize the market value of equity shares of the company. The market price of a share serves as an index of the performance of the company. It takes into account present and prospective future earnings per share, risk associated with the business, dividend and retention policies of the firm, level of gearing etc. The shareholder’s wealth is maximized only when the market value of the share is maximized. In the present context, the term ‘wealth maximization’ of Financial Management is redefined as ‘value maximization’.
1.2.4 Other Objectives
1.2.4.1
1.2.4.2
10 P Short term funds Long term funds used to used to Acquire temporary working capital Acquire fixed assets and permanent working capital Generate net cash inflows from operation Service debt obligations Dividend distribution Retained earnings available for re-investment Value maximization of equity shareholders through increase in stock market price of share Firm’s wealth maximization
FIGURE 1.1: FIRM’S CASH FLOW AND VALUE MAXIMIZATION
Sales Maximization
Growth Maximization
1.2.4.3 Maximization of Return on Investment (ROI)
1.2.4.4 Social Objectives
theories cannot be ignored.
1.3 FINANCIAL DECISIONS
1.3.1 Investment Decisions
‘internal investment’ represents ‘external investment’
hurdle rate
11
a b c
etc
1.3.2 Financing Decisions
12 P
i.e. (i (ii (iii (iv viz (v (vi (vii
1.3.3 Dividend Decisions
13 (viii (ix (x (xi (xii (xiii (xiv (xv (xvi (xvii (xviii (xix (xx (xxi (xxii (xxiii correction.
a) b (i) ii) Consideration of iii iv
Remember:
To Sum Up, the corporate finance theory has broadly categorized the financial decisions into investment, financing and dividend decisions. All these financial decisions aim at the maximization of shareholders’ wealth through maximization of firm’s wealth. The investment, finance and dividend decisions are interrelated to each other and, the Finance Manager while taking any decision, should consider the impact from all the three angles simultaneously.
tenets
1.4 FINANCE FUNCTION function is handled by specialists.
1.4.1 Functions of a Finance Manager Provision of Capital by the business.
financial analysts and shareholders.
Credit and Collectionsto direct the granting of credit and the collection of accounts due to Insurance
14 P v dividend
decisions.
(i (ii (iii (iv
Planning for Control control of operations.
or action concerning any phase of the operation of the business as agencies.
Protection of Assetsto ensure protection of assets for the business through internal con Managing Funds
Cost Control budgets and standards.
services of the concern.
Forecasting Profits
‘strategic leader’ able to use net
15
1.4.2 Finance Manager as a Facilitator
1.4.3 Need to Centralize Finance Function
necessity.
16 P
(i (ii (iii
(v (vi
(iv) Coordination goals.
1.4.4 Organization Chart of Finance Function
Board of Directors
Managing Director/ President
Finance Director/Chief Finance Officer
Financial Controller Manager Accounts Manager Credit Manager Taxation
Internal Auditor Treasurer
Management Accounting
accounts
accounts ledger ledger
accounting
accounting credit
credit
Cash Manager Corporate Finance & Funding Manager
Foreign Exchange Manager
funds
selling foreign currencies
credit overdue accounts
refunds
planning
costs
forecasting control capital control
surplus funds
finance
finance
17
FIGURE 1.2: ORGANISATION CHART OF FINANCE FUNCTION
Financial Management | Theory | Problems | Cases
AUTHOR : RAVI M. KISHORE, PADMA SAI ARORAPUBLISHER : TAXMANN
DATE OF PUBLICATION : SEPTEMBER 2023
EDITION : 9TH EDITION
ISBN NO : 9789357780841
NO. OF PAGES : 728
BINDING TYPE : PAPERBACK
Description
This book adopts an enhanced business-oriented methodology for teaching and learning financial management. Aimed at fostering an in-depth and comprehensive understanding of the subject, it takes a holistic approach that melds theory with practical applications to real-world scenarios. The structure of this book is meticulously designed to elaborate on the diverse principles and techniques of financial management. Upon completion, readers will be equipped to scrutinize the annual reports of various companies and analyze the information more effectively.
This book is designed for individuals seeking to understand financial management’s core principles and theories. Primarily, it is tailored for postgraduate students enrolled in business schools. Additionally, undergraduate students pursuing B.Com. (Hons.), B.Com. (Prog.), and B.A. (Prog.) from various universities and professional institutes will also find this book beneficial.
The Present Publication is the 9th Edition, authored by Ravi M. Kishore and Prof. (Dr) Padma Sai Arora, with the following noteworthy features:
u [Principles and Techniques of Financial Management] are explained in a detailed manner
u [Easy-to-understand Style] has been followed throughout the book to explain the concepts in detail
u [Extensive Descriptive Explanations] are presented in this book, followed by figures and diagrams
u [Cases to Prepare the Base for Financial Principles and Concepts] is included in each of the six parts
u [Case Studies] at the end of each chapter is easy to relate to and has been prepared to make way for discussions
u [Solved Miscellaneous Illustrations] are given for better understanding
u [Practice Questions] Readers can test their knowledge after going through each chapter by solving practice questions
u [Multiple Choice Questions (MCQs)] have also been incorporated to help prepare for quiz/assignment
u [Learning in line with Industry Trends] has been incorporated in this book by giving annual reports of different companies
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