MB0045 – Financial Management

Q1. What are the 4 finance decisions taken by a finance manager.

Ans. A firm performs finance functions simultaneously and continuously in the normal
course of the business. They do not necessarily occur in a sequence. Finance
functions call for skilful planning, control and execution of a firm’s activities.
Let us note at the outset hat shareholders are made better off by a financial
decision that increases the value of their shares, Thus while performing the
finance function, the financial manager should strive to maximize the market
value of shares. Whatever decision does a manger takes need to result in
wealth maximization of a shareholder.

Investment Decision

Investment decision or capital budgeting involves the decision of allocation of

capital or commitment of funds to long-term assets that would yield benefits in
the future. Two important aspects of the investment decision are:
(a) the evaluation of the prospective profitability of new investments, and
(b) the measurement of a cut-off rate against that the prospective return of new
investments could be compared. Future benefits of investments are difficult to
measure and cannot be predicted with certainty. Because of the uncertain future,
investment decisions involve risk. Investment proposals should, therefore, be
evaluated in terms of both expected return and risk. Besides the decision for
investment managers do see where to commit funds when an asset becomes less
productive or non-profitable.

There is a broad agreement that the correct cut-off rate is the required rate of
return or the opportunity cost of capital. However, there are problems in
computing the opportunity cost of capital in practice from the available data and
information. A decision maker should be aware of capital in practice from the
available data and information. A decision maker should be aware of these
problems.

Financing Decision

Financing decision is the second important function to be performed by the

financial manager. Broadly, her or she must decide when, where and how to
acquire funds to meet the firm’s investment needs. The central issue before him
or her is to determine the proportion of equity and debt. The mix of debt and
equity is known as the firm’s capital structure. The financial manager must strive
to obtain the best financing mix or the optimum capital structure for his or her
firm. The firm’s capital structure is considered to be optimum when the market
value of shares is maximized. The use of debt affects the return and risk of
shareholders; it may increase the return on equity funds but it always increases
risk. A proper balance will have to be struck between return and risk. When the
shareholders’ return is maximized with minimum risk, the market value per share
will be maximized and the firm’s capital structure would be considered optimum.
Once the financial manager is able to determine the best combination of debt and
equity, he or she must raise the appropriate amount through the best available
sources. In practice, a firm considers many other factors such as control, flexibility
loan convenience, legal aspects etc. in deciding its capital structure.

Dividend Decision

Dividend decision is the third major financial decision. The financial manager must
decide whether the firm should distribute all profits, or retain them, or distribute
a portion and retain the balance. Like the debt policy, the dividend policy should
be determined in terms of its impact on the shareholders’ value. The optimum
dividend policy is one that maximizes the market value of the firm’s shares. Thus
if shareholders are not indifferent to the firm’s dividend policy, the financial
manager must determine the optimum dividend – payout ratio. The payout ratio is
equal to the percentage of dividends to earnings available to shareholders. The
financial manager should also consider the questions of dividend stability, bonus
shares and cash dividends in practice. Most profitable companies pay cash
dividends regularly. Periodically, additional shares, called bonus share (or stock
dividend), are also issued to the existing shareholders in addition to the cash
dividend.

Liquidity Decision

Current assets management that affects a firm’s liquidity is yet another important
finances function, in addition to the management of long-term assets. Current assets
should be managed efficiently for safeguarding the firm against the dangers of
illiquidity and insolvency. Investment in current assets affects the firm’s profitability.
Liquidity and risk. A conflict exists between profitability and liquidity while managing
current assets. If the firm does not invest sufficient funds in current assets, it may
become illiquid. But it would lose profitability, as idle current assets would not earn
anything. Thus, a proper trade-off must be achieved between profitability and
liquidity. In order to ensure that neither insufficient nor unnecessary funds are
invested in current assets, the financial manager should develop sound techniques of
managing current assets. He or she should estimate firm’s needs for current assets and
make sure that funds would be made available when needed.
It would thus be clear that financial decisions directly concern the firm’s decision to
acquire or dispose off assets and require commitment or recommitment of funds on a
continuous basis. It is in this context that finance functions are said to influence
production, marketing and other functions of the firm. This, in consequence, finance
functions may affect the size, growth, profitability and risk of the firm, and
ultimately, the value of the firm. To quote Ezra Solomon
The function of financial management is to review and control decisions to commit or
recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial
management is directly concerned with production, marketing and other functions,
within an enterprise whenever decisions are about the acquisition or distribution of
assets.
Various financial functions are intimately connected with each other. For instance,
decision pertaining to the proportion in which fixed assets and current assets are
mixed determines the risk complexion of the firm. Costs of various methods of
financing are affected by this risk. Likewise, dividend decisions influence financing
decisions and are themselves influenced by investment decisions.

In view of this, finance manager is expected to call upon the expertise of other
functional managers of the firm particularly in regard to investment of funds.
Decisions pertaining to kinds of fixed assets to be acquired for the firm, level of
inventories to be kept in hand, type of customers to be granted credit facilities,
terms of credit should be made after consulting production and marketing
executives.
However, in the management of income finance manager has to act on his own.
The determination of dividend policies is almost exclusively a finance function. A
finance manager has a final say in decisions on dividends than in asset
management decisions.

Financial management is looked on as cutting across functional even disciplinary

boundaries. It is in such an environment that finance manager works as a part of
total management. In principle, a finance manager is held responsible to handle all
such problem: that involve money matters. But in actual practice, as noted above,
he has to call on the expertise of those in other functional areas to discharge his
responsibilities effectively.

Q.2 What are the factors that affect the financial plan of a company?

Ans. 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 a new department or any
undertaking that affects the company’s 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.

A businessman an businesswoman having a meeting image by sumos from Fotolia.com

A businessman an businesswoman having a meeting image by sumos from Fotolia.com

Organizational planning is affected by many factors.

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• Priorities

In most companies, the priority is generating revenue, and this priority can sometimes interfere
with the planning process of any project. For example, if you are in the process 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 planning process 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 project, 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 to make 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 the marketplace.
Forecasting sales revenues, materials costs, personnel costs and overhead costs 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 pull off the plan and if
the plan will help to strengthen the company’s standing within the industry. For example, if your
forecasting for the cost of goods has changed due to a sudden increase in material costs, then that
can affect elements of your product roll-out plan, 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 line will fail. The reallocation of company resources, the acceptable
financial losses and the potential public relations problems that a failed product can cause all
need to be part of the organizational planning process from the beginning

Q.3 Show the relationship between required rate of return and coupon rate on the value of
a bond.

Ans. It is important for prospective bond buyers to know how to determine the price of a bond
because it will indicate the yield received should the bond be purchased. In this section, we will
run through some bond price calculations for various types of bond instruments.

Bonds can be priced at a premium, discount, or at par. If the bond’s price is higher than its par
value, it will sell at a premium because its interest rate is higher than current prevailing rates. If
the bond’s price is lower than its par value, the bond will sell at a discount because its interest
rate is lower than current prevailing interest rates. When you calculate the price of a bond, you
are calculating the maximum price you would want to pay for the bond, given the bond’s coupon
rate in comparison to the average rate most investors are currently receiving in the bond market.
Required yield or required rate of return is the interest rate that a security needs to offer in order
to encourage investors to purchase it. Usually the required yield on a bond is equal to or greater
than the current prevailing interest rates.

Fundamentally, however, the price of a bond is the sum of the present values of all expected
coupon payments plus the present value of the par value at maturity. Calculating bond price is
simple: all we are doing is discounting the known future cash flows. Remember that to
calculate present value (PV) – which is based on the assumption that each payment is re-invested
at some interest rate once it is received–we have to know the interest rate that would earn us a
known future value. For bond pricing, this interest rate is the required yield. (If the concepts of
present and future value are new to you or you are unfamiliar with the calculations, refer to
Understanding the Time Value of Money.)

Here is the formula for calculating a bond’s price, which uses the basic present value (PV)
formula:

C = coupon payment
n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value

The succession of coupon payments to be received in the future is referred to as an ordinary

annuity, which is a series of fixed payments at set intervals over a fixed period of time. (Coupons
on a straight bond are paid at ordinary annuity.) The first payment of an ordinary annuity occurs
one interval from the time at which the debt security is acquired. The calculation assumes this
time is the present.

You may have guessed that the bond pricing formula shown above may be tedious
to calculate, as it requires adding the present value of each future coupon
payment. Because these payments are paid at an ordinary annuity, however, we
can use the shorter PV-of-ordinary-annuity formula that is mathematically
equivalent to the summation of all the PVs of future cash flows. This PV-of-ordinary-
annuity formula replaces the need to add all the present values of the future
coupon. The following diagram illustrates how present value is calculated for an
ordinary annuity:

Each full moneybag on the top right represents the fixed coupon payments (future value)
received in periods one, two and three. Notice how the present value decreases for those coupon
payments that are further into the future the present value of the second coupon payment is worth
less than the first coupon and the third coupon is worth the lowest amount today. The farther into
the future a payment is to be received, the less it is worth today – is the fundamental concept for
which the PV-of-ordinary-annuity formula accounts. It calculates the sum of the present values
of all future cash flows, but unlike the bond-pricing formula we saw earlier, it doesn’t
require that we add the value of each coupon payment. (For more on calculating the time value
of annuities, see Anything but Ordinary: Calculating the Present and Future Value of Annuities
and Understanding the Time Value of Money. )

By incorporating the annuity model into the bond pricing formula, which requires us
to also include the present value of the par value received at maturity, we arrive at
the following formula:

Let’s go through a basic example to find the price of a plain vanilla bond.

Example 1: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a
coupon rate of 10%, and a required yield of 12%. In our example we’ll assume that coupon
payments are made semi-annually to bond holders and that the next coupon payment is expected
in six months. Here are the steps we have to take to calculate the price:

1. Determine the Number of Coupon Payments: Because two coupon payments will be made
each year for ten years, we will have a total of 20 coupon payments.

2. Determine the Value of Each Coupon Payment: Because the coupon payments are semi-
annual, divide the coupon rate in half. The coupon rate is the percentage off the bond’s par value.
As a result, each semi-annual coupon payment will be $50 ($1,000 X 0.05).

3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield of 12% must be
divided by two because the number of periods used in the calculation has doubled. If we left the
required yield at 12%, our bond price would be very low and inaccurate. Therefore, the required
semi-annual yield is 6% (0.12/2).

4. Plug the Amounts Into the Formula:

From the above calculation, we have determined that the bond is selling at a discount; the bond
price is less than its par value because the required yield of the bond is greater than the coupon
rate. The bond must sell at a discount to attract investors, who could find higher interest
elsewhere in the prevailing rates. In other words, because investors can make a larger return in
the market, they need an extra incentive to invest in the bonds.

Accounting for Different Payment Frequencies

In the example above coupons were paid semi-annually, so we divided the interest rate and
coupon payments in half to represent the two payments per year. You may be now wondering
whether there is a formula that does not require steps two and three outlined above, which are
required if the coupon payments occur more than once a year. A simple modification of the
above formula will allow you to adjust interest rates and coupon payments to calculate a bond
price for any payment frequency:

Notice that the only modification to the original formula is the addition of “F”, which represents
the frequency of coupon payments, or the number of times a year the coupon is paid. Therefore,
for bonds paying annual coupons, F would have a value of one. Should a bond pay quarterly
payments, F would equal four, and if the bond paid semi-annual coupons, F would be two.

Q.4 Discuss the implication of financial leverage for a firm.

Ans. The financial leverage implies the employment of source of funds, involving fixed return
so as to cause more than a proportionate change in earnings per share (EPS) due to change in
operating profits. Like the operating leverage, financial leverage can be positive when operating
profits are increasing and can be negative in the situation of decrease in such profits. In view of
these, financial leverage will affect the financial risk of the firm. An important analytical tool for
financial leverage is the indifference point at which the EPS/market price is the same for
different financial plans under consideration.

The objective of this study was to provide additional evidence on the relationship between
financial leverage and the market value of common stock. Numerous empirical studies have been
done in this area, and, concurrently, many theories have been developed to explain the
relationship between financial leverage and the market value of common stock. Because of the
methodological weaknesses of past studies, however, no conclusions can be drawn as to the
validity of the theories. Theories on financial leverage may be classified into three categories:
irrelevance theorem, rising from value indefinitely with increase in financial leverage, and
optimal financial leverage. Empirical implications of these categories along with the
consequences of serious confounding effects are analyzed. The implications are then compared
with evidence from actual events involving financial leverage changes, and distinguished from
each other as finely as possible, using simple and multiple regression analyses, normal Z-test,
and a simulation technique. The evidence shows that changes in the market value of common
stock are positively related to changes in financial leverage for some firms and negatively related
for other firms. This evidence is consistent with the existence of an optimal financial leverage for
each firm, assuming that financial leverages of firms with a positive relationship are below the
optimum and those of firms with a negative relationship are above the optimum. The results of
the study do not depend upon the definition of the market portfolio, the definition of the event
period, or the choice of financial leverage measure. Betas estimated from equally weighted
market portfolios were generally higher than those estimated from value weighted market
portfolios during 1981-1982. However, the results of the study were the same for both portfolios.
Abnormal returns were computed for seven and two day event periods, and the results were the
same for both periods. Seven different definitions of financial leverage were tested, and the
results were the same for all measures.