NAME: Mrs.JULIE ANNAL
CLASS: II BBM
SUBJECT: FINANCIAL MANAGEMENT
UNIT I

Finance Functions The finance functions can be divided into three broad
categories: (1) investment decision, (2) financing decision, and (3) dividend
decision. In other words, the firm decides how much to invest in short-term
and long-term assets and how to raise the required funds.
Shareholders’ Wealth Maximisation (SWM) In making financial decisions,
the financial manager should aim at increasing the value of the shareholders’
stake in the firm. This is referred to as the principle of Shareholders’
Wealth Maximisation (SWM).
Wealth Wealth is precisely defined as net present value and it accounts for
time value of money and risk.
Agency Problem and Agency Costs Shareholders and managers have the
principal-agent relationship. In practice, there may arise a conflict between
the interests of shareholders and managers. This is referred to the agency
problem and the associated costs are called agency costs. Offering
ownership rights (in the form of stock options) to managers can mitigate
agency costs.
Time Value for Money Individual investors generally prefer possession of a
given amount of cash now, rather than the same amount at some future time.
This time preference for money may arise because of (a) uncertainty of cash flows,
(b) subjective preference for consumption, and (c) availability of investment
opportunities. The last reason is the most sensible justification for the time value
of money.
Risk Premium Interest rate demanded, over and above the risk-free rate as
compensation for time, to account for the uncertainty of cash flows.
Interest Rate or Time Preference Rate Rate which gives money its value,
and facilitates the comparison of cash flows occurring at different time periods.
Required Interest Rate A risk-premium rate is added to the risk- free time
preference rate to derive required interest rate from risky investments.
Compounding Compounding means calculating future values of cash flows at
a given interest rate at the end of a given period of time.
Future Value (F) of a Lump Sum Today (P) for n periods at i rate of interest
is given by the following formula:
Discount Rate being the rate of return that investors expect from securities of
comparable risk.
Bonds or Debentures are debt instruments or securities. In case of a
bond/debenture the stream of cash flows consists of annual interest payments
and repayment of principal. These flows are fixed and known.
The Value of the Bond can be found by capitalising cash flows at a rate of
return, which reflects their risk. The market interest rate or yield is used as the
discount rate in case of bonds (or debentures). The basic formula for the bond
value is as follows:

INT
Yield to Maturity A bond’s yield to maturity or internal rate of return can be
found by equating the present value of the bond’s cash outflows with its price in
the above equation.
Zero-Interest Bonds (called zero-coupon bonds in USA) do not have explicit
rate of interest. They are issued for a discounted price; their issue price is much
Return on a Security consists of two parts, the dividend and capital gain. The
rate of return for one period is given by the following equation:

Dividend yield Capital gain rate
Expected Rate of Return on a Security is the sum of the products of possible
rates of return and their probabilities. Thus
Dispersion When the expected rate of return (also called average rate of
return) deviate from the possible outcomes (rates of return), this is referred to
as dispersion.
Variance and Standard Deviation Dispersion can be measured by
variance and standard deviation of returns of a security. Variance (2) or
standard deviation () is a measure of the risk of returns on a security. They
can be calculated as follows:
Return on a Security consists of the dividend yield and capital gain.
Expected Rate of Return on a Security is the sum of the products of possible
rates of return and their probabilities. Thus
The expected rate of return is an average rate of return. This average rate may
deviate from the possible outcomes (rates of return).
Variance and Standard Deviation of Returns of a Security can be
calculated as follows:
Variance or standard deviation is a measure of the risk of returns on a security.
Portfolios Generally, investors in practice hold multiple securities.
Combinations of multiple securities are called portfolios.
Security’s Beta The market or systematic risk of a security is measured in
terms of its sensitivity to the market movements. This sensitivity is referred to
the security’s beta.
Beta is a ratio of the covariance of returns of a security, j, and the market
portfolio, m, to the variance of return of the market portfolio:
In practice, the following regression equation is used to estimate beta:
Rj j Rm e j
The expected return on the share of a company depends on its beta. The higher
the beta, the higher the expected return.
We can use historical data to determine a firm’s beta. The estimate of beta would
depend on the period of analysis (say, one year, three years or five years) and the
frequency of returns (e.g., daily, weekly or monthly). The analyst should be
careful in using a reasonable period and time interval.
Option is a contract that gives the holder a right, without any obligation, to buy
or sell an underlying asset at a given exercise (or strike) price on or before a
specified expiration period. The underlying asset (i.e., asset on which right is
written) could be a share or any other asset.
Call Option is a right to buy an asset. A buyer of a call option on a share will
exercise his right when the actual share price at expiration (St) is higher than
the exercise price (E), otherwise, he will forgo his right.
Put Option is a right to sell an asset. The buyer of a put option will exercise his
right if the exercise price is higher than the share price; he will not exercise his
option if the share price is equal to or greater than the exercise price.
American Option can be exercised at expiration or any time before expiration
while European options can be exercised only at expiration.
Discounted Cash Flow (DCF) Technique NPV, IRR and PI are the
discounted cash flow (DCF) criteria for appraising the worth of an investment
project.
Net Present Value (NPV) method is a process of calculating the present value
of the project’s cash flows, using the opportunity cost of capital as the discount
rate, and finding out the net present value by subtracting the initial investment
from the present value of cash flows.
Under the NPV method, the investment project is accepted if its net present
value is positive (NPV > 0). The market value of the firm’s share is expected to
increase by the project’s positive NPV. Between the mutually exclusive projects,
the one with the highest NPV will be chosen.
NPV methods account for the time value of money and are generally consistent
with the wealth maximisation objective.
Internal Rate of Return (IRR) is that discount rate at which the project’s net
present value is zero. Under the IRR rule, the project will be accepted when its
internal rate of return is higher than the opportunity cost of capital (IRR > k).
Profits vs. Cash Flows Cash flows are different from profits. Profit is not
necessarily a cash flow; it is the difference between revenue earned and expenses
incurred rather than cash received and cash paid. Also, in the calculation of
profits, an arbitrary distinction between revenue expenditure and capital
expenditure is made.
Incremental Cash Flows Cash flows should be estimated on incremental
basis. Incremental cash flows are found out by comparing alternative investment
projects. The comparison may simply be between cash flows with and without
the investment proposal under consideration when real alternatives do not exist.
The term incremental cash flows should be interpreted carefully. The concept
should be extended to include the opportunity cost of the existing facilities used
by the proposal. Sunk costs and allocated overheads are irrelevant in computing
cash flows. Similarly, a new project may cannibalise sales of the existing
products. The project’s cash flows should be adjusted for the reduction in cash
flows on account of the cannibalisation.
Components of Cash Flows Three components of cash flows can be identified:
(1) initial investment, (2) annual cash flows, and (3) terminal cash flows.
Profits vs. Cash Flows Cash flows are different from profits. Profit is not
necessarily a cash flow; it is the difference between revenue earned and expenses
incurred rather than cash received and cash paid. Also, in the calculation of
profits, an arbitrary distinction between revenue expenditure and capital
expenditure is made.
Incremental Cash Flows Cash flows should be estimated on incremental
basis. Incremental cash flows are found out by comparing alternative investment
projects. The comparison may simply be between cash flows with and without
the investment proposal under consideration when real alternatives do not exist.
The term incremental cash flows should be interpreted carefully. The concept
should be extended to include the opportunity cost of the existing facilities used
by the proposal. Sunk costs and allocated overheads are irrelevant in computing
cash flows. Similarly, a new project may cannibalise sales of the existing
products. The project’s cash flows should be adjusted for the reduction in cash
flows on account of the cannibalisation.
Components of Cash Flows Three components of cash flows can be identified:
(1) initial investment, (2) annual cash flows, and (3) terminal cash flows.
Complicated Investment Decisions A firm in practice faces complicated
investment decisions. The most common situations include choosing among
investments with different lives, deciding about the replacement of an existing
asset or timing of an investment and evaluating investments under capital
rationing. The NPV rule can be extended to handle such situations.
Annual Equivalent Values (AEVs) AEV is the NPV of an investment divided
by the annuity factor given its life and risk-free discount rate:
Annuity factor
NPV
AEV =
The choice between projects with unequal lives should be made by
comparing their real annual equivalent values (AEVs).The procedure of
comparing AEVs can be followed while replacing an existing asset by a new
asset.
Capital Rationing occurs because of either the external or internal constrain
on the supply of funds. In capital rationing situations, the firm cannot accept all
profitable projects. Therefore, the firm will aim at maximising NPV subject to
the funds constraint.
Risk arises in the investment evaluation because the forecasts of cash flows can
go wrong. Risk can be defined as variability of returns (NPV or IRR) of an
investment project.
Decision-makers in practice may handle risk in conventional ways. For
example, they may use a shorter payback period, or use conservative forecasts of
cash flows, or discount net cash flows at the risk-adjusted discount rates.
Statistical techniques are used to measure and incorporate risk in capital
budgeting. Two important statistics in this regard are the expected monetary
value and standard deviation.
Expected Monetary Value is the weighted average of returns where
probabilities of possible outcomes are used as weights.
Sensitivity Analysis It is a method of analysing change in the project’s NPV
for a given change in one variable at a time. It helps in asking “what if”
questions and calculates NPV under different assumptions.
Scenario Analysis considers a few combinations of variables and calculates
NPV for each of them. It is a usual practice to calculate NPV under normal,
optimistic or pessimistic scenario.
Unit ii
Important Aspects of Capital Budgeting Process are
Identification of investment ideas is the most critical aspect of the
investment process, and should be guided by the overall strategic
considerations of a firm. It needs appropriate managerial focus. Each
potential idea should be developed into a project.
Development A company should have systems for estimating cash flows of
projects. A multi-disciplinary team of managers should be assigned the task
of developing cash flow estimates.
Evaluation Once cash flows have been estimated, projects should be
evaluated to determine their profitability. Evaluation criteria chosen should
correctly rank the projects.
Authorisation Once the projects have been selected they should be
monitored and controlled to ensure that they are properly implemented and
estimates are realised. Proper authority should exist for capital spending.
The top management may supervise critical projects involving large sums of
money. The capital spending authority may be delegated subject to adequate
control and accountability.
Capital Structure The debt-equity mix of a firm is called its capital structure.
The capital structure decision is a significant financial decision since it affects
the shareholders’ return and risk, and consequently, the market value of shares.
Financial Structure The term financial structure, on the other hand, is used
in a broader sense, and it includes equity and all liabilities of the firm.
Financial Leverage or Trading on Equity The use of the fixed-charges
capital like debt with equity capital in the capital structure is described as
financial leverage or trading on equity.
The main reason for using financial leverage is to increase the shareholders’
return. Consider an example. Suppose you have an opportunity of earning 20 per
cent on an investment of Rs 100 for one year. If you invest your own money, your
return will be 20 per cent. On the other hand, you can borrow, say, Rs 50 at 10
per cent rate of interest from your friend and put your own money worth Rs 50.
You shall get total earnings of Rs 20, out of which you will have to pay Rs 5 as
interest to your friend. You shall be left with Rs 15 on your investment of Rs 50,
which gives you a return of 30 per cent. You have earned more at the cost of your
friend.
Capital Structure Decision of the firm can be characterised as a choice of that
combination of debt and equity, which maximises the market value of the firm.
Modigliani and Miller’s Theory According to MM’s proposition I, the firm’s
market value is not affected by capital structure; that is, any combination of debt
and equity is as good as any other. Firms borrow by offering investors various
types of securities. In M-M’s world of perfect capital market, because of same
borrowing and lending rates for all investors and no taxes, investors can borrow
at their own. Why should they pay a premium for a firm’s borrowing? M-M
accept that borrowing increases shareholders return, but, they argue, it also
increases risk. They show that increased risk exactly offsets the increased
return, thus leaving the position of shareholders unchanged. This is M–M’s
proposition II.
Interest tax shield and the value of the firm One unrealistic assumption of
M–M’s hypothesis is that, they assume no existence of taxes. When corporate
taxes are assumed, firms can increase earnings of all investors through
borrowing which results in interest tax shield. The value of interest tax shield
(PVINTS) is equal to TD:
Discount Rate We need estimate of the discount rate to determine the net
present value of a project. The discount rate depends on the project’s business
risk and financial risk. Under CAPM, the equity beta captures both the business
risk and the financial risk. Financial risk arises when the firm uses debt.
Opportunity Cost of Capital Following the M–M proposition I, the
opportunity cost of capital can be calculated as the pre-tax weighted average cost
of capital.
Asset Beta a reflects the business risk of the firm or the project. Thus, under
CAPM the firm’s or the project’s opportunity cost of capital is given by the riskfree
rate plus the product of the risk premium and the asset beta.
You can estimate the equity beta and the debt beta from the market data and
then estimate the asset beta. Assuming the debt is risk-free and the debt beta is
zero, the asset beta and the equity beta are given as follows:
V
E
a e
Walter’s Model Price per share is the sum of the present value of the infinite
stream of constant dividends and present value of the infinite stream of
capital gains.
(DIV / ) (EPS DIV)
Gordon’s Model Market value of a share is equal to the present value of an
infinite stream of dividends to be received by shareholders.
P EPS(1 b) /(k br)
Bird-in-the-hands Argument Investors are risk averters. They consider
distant dividends as less certain than near dividends. Rate at which an
investor discounts his dividend stream from a given firm increases with the
futurity of dividend stream and hence lowering share prices.
M–M Model According to M–M, under a perfect market situation, the
dividend policy of a firm is irrelevant as it does not affect the value of the firm.
They argue that the value of the firm depends on firm earnings which results
Forms of Dividends Dividends may take two forms: cash dividend and bonus
shares (stock dividend). In India, bonus shares cannot be issued in lieu of cash
dividends. They are paid with cash dividends. Bonus shares have a psychological
appeal. They do not increase the value of shares.
Target Payout Ratio Companies generally prefer to pay cash dividends. They
finance their expansion and growth by issuing new shares or borrowing. This
behaviour is based on the belief that shareholders are entitled to some return on
their investment. Most companies have long-term payment ratio targets. But
they do not apply target payout ratios to each year’s earnings. They try to
stabilize dividend payments by moving slowly towards the target payout each
year. Also, they consider past dividends and current as well as future earnings
in determining dividend payment. Investors recognize this. Any extreme changes
are read as signals of management’s expectations about the company’s
performance in future. Thus dividends have information contents.
Stable Dividend Policy Companies like to follow a stable dividend policy since
investors generally prefer such a policy for the reason of certainty. A stable
dividend policy does not mean constant dividend per share. It means reasonably
Efficient Capital Markets Capital market deal with financial assets or
securities. Securities will be fairly priced in the capital markets if they are
efficient. Capital markets are considered to be efficient if the prices of securities
reflect the available information. Depending on the extent of the information
being impounded in the security prices, capital markets may be efficient in
weak, semi-strong or strong form.
India’s Capital Market includes primary, secondary, OTC and derivatives
segments. As a consequence of the growing economy and the government’s policy
of liberalisation and deregulation, the various segments of capital market in
India have grown at phenomenal rates. The first stock exchange—the Bombay
Stock Exchange—was established in 1875. Now there are 23 stock exchanges in
India. The number of shareholders has increased to about 30–40 million. There
are about 9000 listed companies. Both the market capitalisation and volume of
trades have shown general growth, although they have fluctuated over years.
Stock exchanges in India have well-developed procedures for listing, trading,
settlement etc. The recent changes include shortening of the trading and
settlement period, rolling settlement, index-based price bands, dematerialized
UNIT III
Securities Ordinary share, preference share and debentures are three
important securities used by the firms to raise funds to finance their activities.
Ordinary Shares provide ownership rights to ordinary shareholders. They are
the legal owners of the company. As a result, they have residual claims on
income and assets of the company. They have the right to elect the board of
directors and maintain their proportionate ownership in the company, called the
pre-emptive right.
Pre-Emptive Right of the ordinary shareholders is maintained by raising new
equity funds through rights offerings. Rights issue does not affect the wealth of a
shareholder. The price of the share with rights-on gets divided into ex-rights
price and the value of a right. So what the shareholder gains in terms of the
value of right he loses in terms of the low ex-rights price. However, he will lose if
he does not exercise his rights.
Debenture or Bond is a long-term promissory note. The debenture trust deed
or indenture defines the legal relationship between the issuing company and the
debenture trustee who represents the debenture holders. Debenture holders
have a prior claim on the company’s income and assets. They will be paid before
Convertible Security is either a debenture or a preference share that can be
exchanged for a stated number of ordinary shares at the option of the investor.
Companies offer convertible securities to sweeten debt and thereby make it
attractive. It is a form of deferred equity financing, and provides low cost funds
during the early stage of investment project. The valuation of convertible
securities depends on its value as a straight, non-convertible security
(investment value) and its value if converted into ordinary shares. It generally
sells for a premium; that is, its market price exceeds the higher of its investment
or conversion value.
Warrant is an option to buy a specified number of ordinary shares at an
indicated price during a specified period. A detachable warrant is bought and
sold independent of the debenture to which it is associated. Warrants are
generally used to sweeten a debt to make it marketable and lower the interest
costs. When warrants are exercised, the firm obtains additional cash. The
market value of warrants depends primarily on the ordinary share price.
Warrants generally sell above their minimum, theoretical value. The difference
between the market price and theoretical value of warrants is the premium.
Lease is an agreement for the use of the asset for a specified rental. The owner
of the asset is called the lessor and the user the lessee. Two important categories
of leases are: operating leases and financial leases. The most compelling reason
for leasing equipment rather than buying it is the tax advantage of depreciation
that can mutually benefit both the lessee and the lessor. Other advantages
include convenience and flexibility as well as specialised services to the lessee.
In India, lease proves handy to those firms, which cannot obtain loan capital
from normal sources.
Operating Leases are short-term, cancellable leases where the risk of
obsolescence is borne by the lessor.
Financial Leases are long-term non-cancellable leases where any risk in the
use of the asset is borne by the lessee and he enjoys the returns too.
Equivalent Loan Financial lease involves fixed obligations in the form of lease
rentals. Thus it is like a debt and can be evaluated that way. Given the lease
rentals and tax shields, one can find the amount of debt which these cash flows
can service. This is equivalent loan. If equivalent loan is more than the cost of
the asset, it is not worth leasing the equipment.
Venture Capital is risk financing available in the form of equity or quasiequity.
A venture capitalist also provides management support and acts as a
partner and adviser to the entrepreneur. Thus, he is different from a banker
and an investor of the shares of an enterprise. Venture capital is available as
early stage financing, expansion financing and acquisition financing.
Venture capital activity in developed countries has been encouraged because
of a large number of tax incentives available to venture capital firms and
investors, well-developed avenues for buying and selling shares of the small
scale enterprises and favourable social climate and government policy for
encouraging entrepreneurial activities.
Venture Capital in India There are about a dozen venture capital
organisations in India, mainly started by central and state-level financial
institutions and commercial banks. A few private sector venture capital funds
have also been established. Venture capital is available in three forms in
India: equity, conditional loans and income notes. Conventional loans are also
made available by venture capital firms. Income notes are hybrid securities,
combining the features of both conventional and conditional loans. Overall, in
Balance Sheet is a statement of a firm’s assets, liabilities and equity on a
specific date.
Assets are economic resources that help generating revenues.
Liabilities are the firm’s obligations to creditors.
Equity is the investment made by owners in the firm.
Statement of Changes in Financial Position Both the balance sheet and the
profit and loss statement do not explain the changes in assets, liabilities and
owner’s equity. The statement of changes in financial position is prepared to
show these changes. Two common forms of such statement are: (a) the funds
flow statement, and (b) the cash flow statement.
Fund can be defined at least in three ways: It may mean (i) cash, (ii) working
capital (the difference between current assets and current liabilities), or
(iii) financial resources (arising from both current and non-current items).
Funds Flow Statement provides an analysis of changes in the firm’s working
capital position.
UNIT IV
Financial Ratio is a relationship between two financial variables. It helps to
ascertain the financial condition of a firm.
Ratio analysis is a process of identifying the financial strengths and
weaknesses of the firm. This may be accomplished either through a trend
analysis of the firm’s ratios over a period of time or through a comparison of the
firm’s ratios with its nearest competitors and with the industry averages. The
four most important financial dimensions, which a firm would like to analyse,
are: liquidity, leverage, activity and profitability.
Liquidity Ratios measure the firm’s ability to meet current obligations, and
are, calculated by establishing relationships between current assets and current
liabilities.
Leverage Ratios measure the proportion of outsiders’ capital in financing the
firm’s assets, and are calculated by establishing relationships between borrowed
capital and equity capital.
Activity Ratios reflect the firm’s efficiency in utilising its assets in generating
sales, and are calculated by establishing relationships between sales and assets.
Strategic Planning Company’s strategy establishes an effective and efficient
match between its resources, opportunities and risks. It provides a mechanism of
integrating goals of multiple stakeholders.
Financial Planning of a company has close links with strategic planning.
Financial plan should be developed within the overall context of the strategic
planning. It is a process of identifying a firm’s investments and financing needs,
given its growth objectives. It involves trade-off between various investment and
financing options. A financial plan may be prepared for a period of three or five
years.
Steps in Financial Planning:
Past performance Analysis of the firm’s past performance to ascertain the
relationships between financial variables, and the firm’s financial strengths
and weaknesses.
Operating characteristics Analysis of the firm’s operating
characteristics—product, market, competition, production and marketing
policies, control systems, operating risk etc. to decide about its growth
objective.
Strategic Planning Company’s strategy establishes an effective and efficient
match between its resources, opportunities and risks. It provides a mechanism of
integrating goals of multiple stakeholders.
Financial Planning of a company has close links with strategic planning.
Financial plan should be developed within the overall context of the strategic
planning. It is a process of identifying a firm’s investments and financing needs,
given its growth objectives. It involves trade-off between various investment and
financing options. A financial plan may be prepared for a period of three or five
years.
Steps in Financial Planning:
Past performance Analysis of the firm’s past performance to ascertain the
relationships between financial variables, and the firm’s financial strengths
and weaknesses.
Operating characteristics Analysis of the firm’s operating
characteristics—product, market, competition, production and marketing
policies, control systems, operating risk etc. to decide about its growth
objective.
Inventories Companies hold inventories in the form of raw materials, work-inprocess
and finished goods. Inventories represent investment of a firm’s funds.
The objective of the inventory management should be the maximisation of the
value of the firm. The firm should therefore consider: (a) costs, (b) return, and (c)
risk factors in establishing its inventory policy.
Transaction Motive to Hold Inventory for facilitating smooth production
and sales operation.
Precautionary Motive to Hold Inventory to guard against the risk of
unpredictable changes–in usage rate and delivery time.
Speculative Motive to Hold Inventory to take advantage of price
fluctuations.
Ordering Costs requisition, placing of order, transportation, receiving,
inspecting and storing and clerical and staff services. Ordering costs are fixed
per order. Therefore, they decline as the order size increases.
Carrying Costs warehousing, handling, clerical and staff services, insurance
and taxes. Carrying costs vary with inventory holding. As order size increases,
average inventory holding increases and therefore, the carrying costs increase.
Transaction Motive for Holding Cash A firm needs cash to make payments
for acquisition of resources and services for the normal conduct of business.
UNIT V
Precautionary Motive for Holding Cash A firm keeps additional funds to
meet any emergency situation.
Speculative Motive for Holding Cash Some firms may also maintain cash
for taking advantages of speculative changes in prices of input and output.
Optimum Balance of Cash A firm should hold an optimum balance of cash,
and invest any temporary excess amount in short-term (marketable) securities.
In choosing these securities, the firm must keep in mind safety, maturity and
marketability of its investment.
Management of Cash involves three things: (a) managing cash flows into and
out of the firm, (b) managing cash flows within the firm, and (c) financing deficit
or investing surplus cash and thus, controlling cash balance at a point of time. It
is an important function in practice because it is difficult to predict cash flows
and there is hardly any synchronisation between inflows and outflows.
Cash Budget Firms prepare cash budget to plan for and control cash flows.
Cash budget is generally prepared for short periods such as weekly, monthly,
Short-Term Sources of Financing Trade Credit, Deferred Income and
Accrued Expenses, and Bank Finance. Two alternative ways of raising shortterm
finances in India are: factoring and commercial paper.
Spontaneous Sources of Working Capital Finance Trade Credit and
Deferred Income and Accrued Expenses are available in the normal course of
business, and therefore, they are called spontaneous sources of working capital
finance. They do not involve any explicit costs.
Non-Spontaneous or Negotiated Sources of Working Capital Finance
Bank Finances have to be negotiated and involve explicit costs. They are called
non-spontaneous or negotiated sources of working capital finance
Trade Credit refers to the credit that a buyer obtains from the suppliers of
goods and services. Payment is required to be made within a specified period.
Suppliers sometimes offer cash discount to buyers for making prompt payment.
Buyer should calculate the cost of foregoing cash discount to decide whether or
not cash discount should be availed. The following formula can be used:
Credit period Discount period
360
100 % Discount
% Discount



Merger is the combination of two or more firms into one of the firms. Merger
could be horizontal, vertical or conglomerate. A merger results into an economic
advantage when the combined firms are worth more together than as separate
entities. Merger benefits may result from economies of scale, economies of
vertical integration, increased efficiency, tax shields or shared resources. Merger
should be undertaken when the acquiring company’s gain exceeds the cost. Cost
is the premium that the buyer (acquiring company) pays for the selling company
(Target Company) over its value as a separate entity. Discounted cash flow
technique can be used to determine the value of the target company to the
acquiring company. Merger and acquisition activities are regulated under
various laws in India. The objective of the laws as well as the stock exchange
requirements is to make merger deals transparent and protect the interest of all
shareholders.
Horizontal Merger is the combination of two or more firms in the same stage
of production/distribution/area of business.
Vertical Merger is combination of two or more firms involved in different
stages of production or distribution.
Derivatives are instruments that derive their value and payoff from another
asset, called underlying asset. Derivatives include options, forward contracts,
futures contracts and swaps. Investors, including firms, are risk averse. They
aim at reducing risk by hedging through derivatives.
Hedging helps to (i) reduce costs of financial distress, (ii) isolate the effects of
changes in external factor like interest rates and foreign exchange rates on
profitability, and (iii) allow managers to focus on improving operating efficiency
rather worrying about changes in factors on which they have no control.
Forward Contract is an agreement between two parties, called counterparties,
to buy and sell an asset at a future date at a price agreed upon today. There is
no immediate flow of cash. Cash is paid or received on the due date. Forward
contracts are obligations. They are not traded on organised exchanges.
Futures Contract is like a forward contract. But, unlike forward contracts,
futures contracts are traded on organised exchanges. Thus, they are liquid. Yet
another feature of futures contract is that they are marked to market. Prices
differences every day are settled through the exchange clearing house. The
clearinghouse pays to the buyer if the price of a futures contract increases on a
International Financial Management The guiding principle for international
financial management, like domestic financial management, is the shareholder
wealth maximisation. International financial management, however, differs
from domestic financial management, as it has to deal with multiple currencies,
interest rates, inflation rates and foreign exchange and political risks. There are
a number of ways in which an international company can finance its foreign
operations. It should strive to reduce its risk and minimise cost. It should take
advantages of government subsidies and tax asymmetries.
Foreign Exchange Rate is the price of one currency in terms of the other
currency.
Spot Rate is the current exchange rate, and is used for immediate delivery of
currency (which is two business days).
Forward Rate is the price determined today for delivery in the future.
Forward premium or discount for direct quote:
Days
360
Spot rate
Spot rate Forward rate
(discount) premium Forward 




–
Corporate Strategy A firm’s strategy establishes an effective and efficient
match between its competences and opportunities and environmental risks. It
provides a mechanism integrating the goals of its multiple consistencies.
Financial Policy In practice, financial policy of a company is closely linked
with its corporate strategy. Financial policies of the firms should be developed in
context of its corporate strategy. Within the overall framework of the firm’s
strategy, there should be consistency between financial policies—investment,
debt and dividend. For example, a firm can sustain a high-growth strategy only
when its investment projects generate high profits and it follows a policy of low
payout and high debt.
Economic Profit Growth should lead to the enhancement of the shareholder
value. This will happen when the firm is economically profitable; that is, when
the firm’s return on equity (ROE) is higher than its cost of equity (ke). Value is
created when ROE > ke; value is maintained when ROE = ke; and value id
destroyed when ROE < ke. Alternatively, ROCE can be compared with WACC.
Value is created when ROCE > WACC.
Performance of Government Companies Like the private sector companies,
the government companies also aim at profitability and value creation. But they
focus much more on non-financial and social objectives A very few government
companies make profits and declare dividend. In 2002–03, 81 companies, out of
118 profit making companies paid about 36 percent of their net profits as
dividends.
Finance Function in Government Companies The organization of finance
function of the government companies is evolving over the years, and it has
become now a specialized function with a decentralized structure in case of
multi-divisional and multi-product companies. The scope of finance function in
the government companies is as extended as in the case of the private sector
companies. It includes the funds management, budgeting, cost control, assets
management and security etc.
Investment Decisions of Government Companies The basic principle of
value creation governs the investment decisions of the government companies.
But these companies also use economic return and the social impact criteria in