OVERVIEW OF FINANCIAL MANAGEMENT

Presented By: Hyder Ali Khawaja Lecturer (Finance) Sukkur IBA

ROAD MAP
Financial Management Need for Finance FM Decisions Capital Structure Capital Budgeting Working Capital Management Distribution Decisions

FINANCIAL MANAGEMENT

Financial management is that managerial activity which is concerned with the planning and controlling of the firm's financial resources.

Making financing and investment decisions to achieve organizational goals.

WHY BUSINESS NEED FINANCE

WORKING CAPITAL
Salaries Payment to supplier Utilities
Short term Promotional activity
Miscellaneous expenses Unexpected events

WHY BUSINESS NEED FINANCE

FIXED CAPITAL
Start up Replacement current assets Long term advertisement Long term investment

Expansion and production Social projects

Acquisition & mergers

THE BALANCE-SHEET MODEL OF THE FIRM

Total Value of Assets: Investment Total Firm Value to Investors Financing Current Liabilities

Current Assets Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible Shareholders Equity

THE BALANCE-SHEET MODEL OF THE FIRM

The Capital Budgeting Decision
(Investment Decision) Current Assets Long-Term Debt Current Liabilities

Fixed Assets 1 Tangible 2 Intangible

What longterm investments should the firm engage in?

Shareholders Equity

THE BALANCE-SHEET MODEL OF THE FIRM

The Capital Structure Decision
(Financing Decision) Current Assets Long-Term Debt Current Liabilities

Fixed Assets 1 Tangible 2 Intangible

How can the firm raise the money for the required investments?
Shareholders Equity

THE BALANCE-SHEET MODEL OF THE FIRM

(Financial Decision) Current Assets Net Working Capital

The Net Working Capital Investment Decision

Current Liabilities

Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

How much short-term cash flow does a company need to pay its bills?

Shareholders Equity

FINANCIAL MARKETS

Investors
Firms
Stocks and Bonds Money Ali money securities Faisal

Primary Market

Secondary Market

CORPORATE GOVERNANCE
SEPARATION OF OWNERSHIP AND CONTROL

Board of Directors Debtholders Shareholders Management

Assets

Debt Equity

OBJECTIVE

OF FIRM

To maximize the Shareholders Wealth

Firm Value Share Price

Why?
It is easily observable constantly updated It is a real measure of stockholder wealth, since stockholders can sell their stock and receive the price now.

FACTORS AFFECTING THE VALUE OF THE FIRM/ SHARE PRICE

SIZE OF CASH FLOW TIMING OF CASH FLOW ELEMENT OF RISK

ROLE OF FINANCIAL MANAGER

Maximize stock value by:

Forecasting and planning Investment and financing decisions

Coordination and control
Transactions in the financial markets

Managing risk

CONCEPTS IN FINANCIAL MANAGEMENT

A rupee today worth more than rupee tomorrow Time value of money Dont Compare Apples with Oranges Net present value A safe rupee worth more than a risky one. Risk and return Dont put all eggs in one basket Portfolio management & diversification Insure eggs, some might broken

Hedge & Risk management

FUNCTIONS OF FM
Planning

Decision making Financing Investment Dividend policy Controlling

FINANCIAL MANAGEMENT DECISIONS

Fruit
Net Earnings Goods & Services
Working Capital Management

Operating Activities

Investing Activities

Reinvested

Investment in Producing Assets

Capital Budgeting

Debt Payment Financing Activities Distribution

Decisions

Dividends

Debt Financing Equity Financing

Branches Trunk & Capital Structure Roots

FINANCIAL MANAGEMENT DECISIONS

Capital Structure
Capital Budgeting Working Capital Management Distribution Decisions

CAPITAL STRUCTURE

THE TARGET CAPITAL STRUCTURE

Capital Structure: The combination of debt and equity used to finance a firm Target Capital Structure: The ideal mix of debt, preferred stock, and common equity with which the firm plans to finance its investments

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CAPITAL STRUCTURE
The value of the firm can be thought of as a pie. The goal of the manager is to increase the size of the pie.
25% Debt 70% 50%30% Debt Equity

50% Equity 75% The Capital Structure decision can be viewed as how best to slice up a the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters.

IMPORTANCE OF CAPITAL STRUCTURE

Helps in achieving the objective of wealth maximizing

Capital Structure & Cost of Capital Capital Structure & Share Price Capital Structure & Firms Value

FACTORS INFLUENCE CAPITAL STRUCTURE DECISIONS:

Business risk
(Operation risk sales etc)

Tax positions
Financial flexibility
(Can generate funds whenever needed regardless market conditions)

Managerial conservatism or aggressiveness

FACTORS INFLUENCE CAPITAL STRUCTURE DECISIONS:

Business risk depends on;

Demand variability Sales price variability Input cost variability Ability to adjust output prices for changes in input costs Ability to develop new products in a timely, cost-effective manner Foreign risk exposure (Forex)

FACTORS INFLUENCE CAPITAL STRUCTURE DECISIONS:

How to measure Business Risk?
Operating Leverage Financial Risk An increase in stockholders risk, over and above the firms basic business risk, resulting from the use of financial leverage. How to measure Financial Risk Financial Leverage

THE EFFECT OF CAPITAL STRUCTURE ON STOCK PRICES AND THE COST OF CAPITAL

The optimal capital structure maximizes the price of a firms stock.

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OPTIMAL CAPITAL STRUCTURE

Debt-Equity combination where weighted average cost of capital is minimum.

STOCK PRICE AND COST OF CAPITAL ESTIMATES WITH DIFFERENT DEBT/ASSETS RATIOS
Debt/ kd Expected Estimated ks = [kRF + Estimated Resulting Assets EPS Beta Price P/E Ratio (kM kRF)s] 0% Rs2.40 1.50 12.0% Rs20.00 8.33 10 8.0% 2.56 1.55 12.2 20.98 8.20 20 8.3 2.75 1.65 12.6 21.83 7.94 30 9.0 2.97 1.80 13.2 22.50 7.58 40 10.0 3.20 2.00 14.0 22.86 7.14 50 12.0 3.36 2.30 15.2 22.11 6.58 60 15.0 3.30 2.70 16.8 19.64 5.95 WACC 12.00% 11.46 11.08 10.86 10.80 11.20 12.12

All earnings paid out as dividends, so EPS = DPS. Assume that kRF = 6% and kM = 10%. Tax rate = 40%. WACC = wdkd(1 - T) + wsks = (D/A) kd(1 - T) + (1 - D/A)ks
28 At D/A = 40%, WACC = 0.4[(10%)(1-.4)] + 0.6(14%) = 10.80%

RELATIONSHIP BETWEEN CAPITAL STRUCTURE AND EPS

Expected EPS (Rs)
3.5 3 2.5 2 1.5 1 0.5 0 0 10 20 30 40 50 60

Maximum EPS = Rs3.36

Debt/Assets (%)
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RELATIONSHIP BETWEEN CAPITAL STRUCTURE AND COST OF CAPITAL

Cost of Capital (%)
20

Cost of Equity, ks
15

10

WACC
5

Minimum = 10.8%
0 0 10 20 30 40 50 60

Debt/Assets (%)

RELATIONSHIP BETWEEN CAPITAL STRUCTURE AND STOCK PRICE

Stock Price (Rs)
24 23 22

Maximum = $22.86

21 20

19 18 0 10 20 30 40 50 60

Debt/Assets (%)

CAPITAL STRUCTURE & FIRMS VALUE

Value of a Firm

Present Value of Cash Flows to the Firm, discounted back at the cost of capital.

If the cash ows to the rm are held constant, and the cost of capital is minimized, the value of the rm will be maximized.

CAPITAL STRUCTURE THEORIES AND THEIR PREDICTIONS

Trade-Off Theory
Pecking Order Theory
Market Timing Theory Signaling Theory

DETERMINANTS OF LEVERAGE

SPSS ATM GRID

DETERMINANTS OF LEVERAGE
Size of Firm Profitability Supply side factors Stock Market Conditions
Assets Nature Taxes Macro Economic Conditions

Growth Risk Industry Conditions Debt Market Conditions

CAPITAL BUDGETING

BUDGET
A plan expressed in money. It is prepared and approved prior to the budget period and may show income, expenditure and the capital to be employed.

CLASSIFICATION OF BUDGETS
According to Time
Long term budget Short term budget Current budget

According to Function
Sales budget Production budget Cost of Production budget Purchase budget Personnel budget R & D budget Capital Expenditure budget Cash budget Master budget

According to Flexibility
Fixed budget Flexible budget

CAPITAL BUDGETING

Capital budgeting is the making of long-run planning decisions for investments in projects which maximize firms value.

CAPITAL BUDGETING PROCESS

Identify Objective Screening Stage Information Acquisition Stage
Estimate Cash Flows Identify risks

Evaluation Stage
Use Criteria

Selection Stage Financing Stage Implementation and control stage

CATEGORIES OF PROJECTS
Replacement: needed to continue current operations Replacement: cost reduction

Expansion of existing products or markets

Expansion into new products or markets

Safety and/or environmental projects

Mergers & Acquisitions

Other projects Office building Parking lots etc

TYPES OF PROJECTS

Independent
Mutually Exclusive

DECISION CRITERIA : TECHNIQUES OF EVALUATION

Evaluation Criteria

Traditional (Non Discounting)

Time adjusted (Discounting)

DECISION CRITERIA : TECHNIQUES OF EVALUATION

Payback Period

Traditional (Non Discounting)

Accounting Rate of Return

DECISION CRITERIA : TECHNIQUES OF EVALUATION

NPV

Profitability Index

IRR

Time adjusted (Discounting)

Discounted Payback

MIRR

ECONOMIC LIFE VS PHYSICAL LIFE

Physical Life

Overall life of a project

Economic Life

Life till which a project is beneficial (NPV is positive) Example: Total Life = 3 years
YEAR 0 1 2 3 CASH FLOW (100) 50 60 30

ECONOMIC LIFE VS PHYSICAL LIFE

YEAR 0 1 2 CASH FLOW (100) 50 60

NPV = -10

30

Sell Project at end of 2nd year at salvage value of 30

YEAR CASH FLOW

0
1 2

(100)
50 60 + 30

NPV = 15

Physical Life Economic Life

3 years 2 years

RISKS IN CAPITAL BUDGETING

Stand-alone risk Corporate risk Market risk

MEASURING STAND-ALONE RISK

Sensitivity Analysis
Scenario Analysis

Monte Carlo Simulation

MEASURING STAND-ALONE RISK

Sensitivity Analysis
Sensitivity analysis measures the percentage change in NPV that results from a given percentage change in an input, other variables held at their expected values. Key inputs Equipment cost Required working capital Unit sales Sales price Variable cost per unit Fixed operating costs Tax rate WACC

MEASURING STAND-ALONE RISK

Scenario Analysis
A risk analysis technique in which bad and good sets of financial circumstances are compared with a most likely, or base-case, situation.
Base-Case Scenario
An analysis in which all of the input variables are set at their most likely values.

Worst-Case Scenario
An analysis in which all of the input variables are set at their worst reasonably forecasted values.

Best-Case Scenario
An analysis in which all of the input variables are set at their best reasonably forecasted values.

MEASURING STAND-ALONE RISK

Scenario Analysis

Example
CASE WORST BASE BSET CASE WORST BASE BSET PROBABILITY 0.25 0.50 0.25 PROBABILITY 0.25 0.50 0.25 UNIT SOLD 70,000 100,000 130,000 NPV (20) 10 30

MEASURING STAND-ALONE RISK

Scenario Analysis

Example
CASE WORST BASE BSET Measure Expected NPV Standard Deviation CV 0.25 (-20)+0.5(10)+0.25(30) PROBABILITY 0.25 0.50 0.25 NPV (20) 10 30 Result 7.5 17.85 2.38

MEASURING STAND-ALONE RISK

Scenario Analysis Example Given that The firms average projects have coefficients of variation ranging from 1.25 to 1.75. Would this project be of high, average, or low risk?
CV Below Average Between Average Risk Low Average

Above Average
CV 2.38

High
High Risk

MEASURING STAND-ALONE RISK

Monte Carlo Simulation
A risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indexes. Uses both sensitivities and probability together

REAL OPTIONS
Opportunities to respond to changing circumstances. Also called management options

Gives managers a chance to influence outcome of a project.

TYPES OF REAL OPTIONS

GROWTH (EXPANSION) OPTIONS

ABANDONMENT/SHUTDOWN OPTIONS

INVESTMENT TIMING OPTIONS

FLEXIBILITY OPTIONS

VALUATION OF REAL OPTIONS

Judgment NPV Decision Tree Black Sholes Model

Financial Engineering

WORKING CAPITAL MANAGEMENT

WORKING CAPITAL MANAGEMENT

Short term Financial Management Management of current assets & current liabilities Working Capital Management Decisions

Short Term Financing Short Term Investment

WORKING CAPITAL MANAGEMENT

Working Capital
Net Working Capital Net Operating Working Capital

COMPONENTS OF WORKING CAPITAL

Permanent Temporary

PERMANENT CURRENT ASSETS

The amount of current assets required to meet a firms long-term minimum needs.

AMOUNT

Permanent current assets

TIME

TEMPORARY WORKING CAPITAL

The amount of current assets that varies with seasonal requirements.
Temporary current assets

DOLLAR AMOUNT

Permanent current assets

TIME

IMPORTANCE OF WORKING CAPITAL MANAGEMENT

Trade off between Liquidity & Profitability

Profitability Current Assets Less Liquidity High

Fixed Assets

High

Less

EXAMPLE: LIQUIDITY VS PROFITABILITY

Assume Firm has

Fixed Assets of 1000 Current Liabilities of 500 Profit of 50

There are three conditions

Condition A B C Current Assets 1000 750 500

EXAMPLE: LIQUIDITY VS PROFITABILITY

CA FA
1000 1000 1000

TA
2000 1750 1500

CL
500 500 500

CR
2 1.5 1

ROI
25.00% 28.57% 33.33%

A B C

1000 750 500

EXAMPLE: LIQUIDITY VS PROFITABILITY

Liquidity
Current Ratio
2.5 2 2 1.5 1.5 1 1 0.5 0 A A B B C C 1 0.5 0 1 1.5 1.5 2 2 2.5

Current Ratio

B
Current Ratio

EXAMPLE: LIQUIDITY VS PROFITABILITY

Profitability
Return on Investment Return on Investment
A B C 33.33% 28.57% 25.00% 25.00% 28.57% Return on Investment

33.33%

EXAMPLE: LIQUIDITY VS PROFITABILITY

Liquidity vs Profitability
Liquidity vs Profitability
2.5 2 Axis Title
A

1.5
1 0.5 0 25.00% 2 28.57% 1.5

Current Ratio

33.33% 1

IMPORTANCE OF WORKING CAPITAL MANAGEMENT

Operating Cycle Cash Conversion Cycle Working Capital and Firms Value

CASH CONVERSION CYCLE

The

cash conversion model focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.

Inventory Receivables Payables CCC = conversion + collection deferral . period period period

SHORT TERM INVESTMENT DECISION

Cash Management

Receivable Management Inventory Management

WCM: FINANCING STRATEGIES

Short Term Financing versus Long Term Financing

Cost Short Term Long Term Low High

Risk High Low

Return High Low

WCM: FINANCING STRATEGIES

Aggressive Moderate

Conservative

WCM: FINANCING STRATEGIES

Aggressive
Short Term Financing Low liquidity ----- Low NWC
Current Liabilities 90 10 Fixed Assets Long term liabilities & Equity

Current Assets 100

NWC = 10 CR = 1.11

WCM: FINANCING STRATEGIES

Conservative
Long Term Financing High liquidity ----- High NWC
CL 20 80 Long term liabilities & Equity

Current Assets 100

NWC = 80 CR = 5

Fixed Assets

WCM: FINANCING STRATEGIES

Moderate
Both Short Term & Long Financing Moderate liquidity ----- Moderate NWC
Current Assets 100
Current Liabilities 50

50 Long term liabilities & Equity

Fixed Assets

NWC = 50 CR = 2

WCM: FINANCING STRATEGIES

o

Comparison
Risk Cost Low In-between High Return High In-between Low

Aggressive Moderate Conservative

High In-between Low

SOURCES OF SHORT TERM FINANCING Spontaneous Loans Securities

SPONTANEOUS
Trade credit

Account Payable Notes Payable

Installment credit

Accrued expense

Salaries payable Taxes payable Utilities payable

Advance/Unearned revenue/Deferred revenue

LOANS
Secured Inventory Account receivables Hedging Factoring Unsecured Overdraft (OD)/ Line of credit Lump sum

SHORT TERM SECURITIES

T-bills
Commercial papers
Certificate of deposit (CD)
Bankers Acceptance
Repurchase agreement

DIVIDEND DISTRIBUTION DECISIONS

WHAT IS DISTRIBUTION POLICY?

The distribution policy defines:

The level of cash distributions to shareholders The form of the distribution (dividend vs. stock repurchase) The stability of the distribution

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Free Cash Flow: Distributions to Shareholders

Sales revenues
Operating costs and taxes

Required investments in operating capital

Free cash flow (FCF)

Uses

Sources

Interest payments (after tax)

Principal repayments

Dividends

Stock repurchases

Purchase of short-term investments

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THE MECHANICS OF DIVIDEND PAYMENTS

Declaration Date Holder of Record Date Ex-dividend Date Payment Date

TYPES OF DIVIDENDS
Cash Dividend

Stock Dividend

Stock Repurchase Distribute cash to shareholders by firm buying stock

THE MECHANICS OF DIVIDEND PAYMENTS

Declaration Date
Date on which the Board of Directors meet and declare the dividend.

Date of Record
Date on which the shareholders register is closed after the trading day and all those who are listed will receive the dividend.

Ex dividend Date
Date that the value of the firms common shares will reflect the dividend payment (i.e. fall in value) ex means without.

Date of Payment
Date the cheques for the dividend are mailed out to the shareholders.

THE MECHANICS OF DIVIDEND PAYMENTS

2 business days prior to the Date of Record

Declaration Date

Date of Record

Date of Payment

The Board Meets and passes the motion to create the dividend

Ex Dividend Date is determined by the Date of Record. The market value of the shares drops by the value of the dividend per share on market openingcompared to the previous days close.

DO INVESTORS PREFER HIGH OR LOW PAYOUTS?

There are three dividend theories:

Dividends are irrelevant Investors dont care about payout. Dividend preference, or bird-in-the-hand Investors prefer a high payout. Tax effect

Investors prefer a low payout. Low payouts mean higher capital gains. Capital gains are taxed at a lower effective rate than dividends.
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THE CLIENTELE EFFECT

Clientele Effects
suggest that every firm should stick to the same dividend policy no matter what is the nature of it. Different types of investors with different preference pattern can then select the right firm that suits him the best.

RESIDUAL DIVIDEND POLICY

Find the retained earnings needed for the capital budget. Pay out any leftover earnings (the residual) as dividends. This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

USING THE RESIDUAL MODEL TO CALCULATE DIVIDENDS PAID

Net Dividends = income

[( )( )]
Target equity ratio Total capital budget

RESIDUAL DIVIDEND POLICY

Advantages
Minimizes new stock issues and flotation costs.

Disadvantages
Results in variable dividends, sends conflicting signals, increases risk, and doesnt appeal to any specific clientele.

Conclusion
Consider residual policy when setting target payout, but dont follow it rigidly.

REVIEW
Financial Management Need for Finance FM Decisions Capital Structure Capital Budgeting Working Capital Management Distribution Decisions

Thanks