Financial management 1.0 Types of Cost: Costs may be divided in to two main categories. 1.

Direct costs: These are the costs which can be identified directly with the manufacture of a product. These are the amount spent on a particular product or service. 2. Indirect costs: These are the costs which are intended to be spent for more than one product or job. These costs can be allocated to the jobs for which they are spent in some proportion. Elements of costs: 1. Material cost 1. Direct material 2. Indirect material 2. Labour cost 1. Direct labor 2. Indirect labor 3. Expenses All the charges other than materials and labor are termed as expenses. 1. Direct expenses: The expenses which can be directly attributed to a particular job or product are known as direct expenses. Ex. Lay out costs, design and drawing, Jigs and fixtures, tools etc. 2. Indirect Expenses: The expenses which can not be directly attributed to a particular job or product are known as direct expenses. Ex. Rent of the buildings, Insurance premium, Telephone bills, conveyance etc. Expenses can also be classified as Fixed and variable expenses. Those expenses which remain relatively constant regardless of the volume of production. Ex. Taxes on land and buildings, depreciation arising out of time, Rent etc. 2. Variable expenses: Those expenses which tend to vary with the volume of production. Ex. Royalties paid, depreciation arising from use etc. Prime cost: Prime cost = Direct material cost + Direct labor cost + Variable direct Expenses It is limited in its use to manufacturing division of the firm. 1. Fixed Expenses:

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1.2

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Over heads: Over heads are the cost of indirect materials, indirect labor and indirect expenses. The over head costs can not be directly attributed to a product. They are allocated to all the jobs or products which utilize these costs according to some criteria. Over heads are also known as On costs or indirect costs.

1.3.1

Types of Over heads: 1. Factory over heads: These are pertaining to the shop floor. They include salaries of the indirect labor and supervisory staff, depreciation of buildings and machinery, indirect materials like consumables etc. 2. Administrative Over heads: They include expenses incurred in administrative office, salaries of administrative staff, directors, GM etc., legal costs, rates and taxes, postage and telephones, bank charges, audit fees, other miscellaneous expenses etc. 3. Sales Over heads: They include expenses towards selling and marketing, business development, salaries of sales personnel, packing, advertisement, after sales service, consumers service etc. 4. Distribution Over heads: Generally these are included in sales over heads. All expenses incurred towards distribution of products are classified as distribution over heads. 5. R & D Overheads: They include salaries of R&D personnel, all expenses spent towards research and development.

1.3.2

Allocation of Over heads: The over heads are apportioned to each product or job for which these are incurred. The methods of allocation are: 1. Percentage of direct labor 2. Percentage of direct material 3. Percentage rate on prime cost 4. labor hour rate 5. Machine hour rate 6. Production unit rate

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Selling Price: Prime cost = Direct material cost + Direct labor cost + Variable direct Expenses Factory cost = Prime cost + Factory over heads Administrative cost = Factory cost + Factory over heads (Cost of production) Cost of sales = Administrative cost + Sales over heads (including Distribution over heads) Selling price = Cost of sales + Profit Note: 1. Factory over heads may be given as a factor on direct labor cost 2. AOH may be given as a % of factory cost 3. SOH may be given as a % of administrative cost 4. Profit may be given as % of cost of sales

2.0

Depreciation: Depreciation is defined as the reduction in value of a machine or building arising from the passage of time, use or abuse, wear & tear or obsolescence. Depreciation is applicable for buildings, plant and machinery, vehicles which suffer natural deterioration in the course of time. Depreciation, in effect, sets aside from each years income enough money so that funds will be available to buy the new machine when the present one is worn out or becomes un-serviceable. The money so collected in respect of each asset is called the depreciation fund. Methods of depreciation: 1. Straight line method 2. Reducing balance method 3. Production based method 4. Repair provision method 5. Annuity method 6. Sinking fund method 7. Endowment policy method 8. Revaluation method 9. Sum of digits method 1. Straight line method: ADC = (C-S)/ N Where ADC = Annual depreciation charge C = Cost of the equipment S = Scrap or residual value N = Serviceable life f the equipment 2. Reducing balance method: It involves a non linear charge. A fixed % p of the un-depreciated balance every year is charged towards depreciation fund.

2.1

The un-depreciated portion at any time t is given by Ct = (1-p) t.C where t = 1 to N years Scrap value at the end of N years: S = (1-p) N.C The %p to be charged every year on the diminishing value of the equipment is given by: P = 1- (S/C) 1/N 3. Production based method: 1. per unit method: Rate of depreciation = Value of asset / No. of units of production 2. per hour method: Rate of depreciation = Value of asset / No. of production hours 4. Repair provision method: In this method repair and maintenance cost over the life of the equipment are added to the original cost and then depreciation is calculated. ADC = (C + R S) / N where R = repairs cost 5. Annuity method: It considers original cost and interest on the written down value of the asset Rate of depreciation = [C (1+i) N S] [1-(1+i)] / [1-(1+i) N] Where i = fixed rate of interest 6. Sinking fund method: It is based on the assumption of setting up of a fund called sinking fund and invest outside the business so that it is accumulated with interest to replace the asset at the proper time. Rate of depreciation = i(C S) / [(1+i) N - 1] 7. Endowment policy method: An endowment policy is taken from an insurance company. Each year the sum charged to the depreciation is paid as premium to the insurance company. At the end of the life of the asset the sum payable is equal to the original cost of the equipment. 8. Revaluation method: Each year the value of the asset is assessed. The difference of the value in the beginning of the year and the end of the year is charged towards depreciation fund. 9. Sum of the digits method: This method provides for depreciation by means of differing periodic rates. It charges at decreasing rate each year. If the life of the equipment is N years, then Depreciation charge for Year 1: [C-S] . N / (1+2+.+N) Year 2: [C-S] . (N-1) / (1+2+.+N) Year 3: [C-S] . (N-2) / (1+2+.+N) . . Year N: [C-S] . 1 / (1+2+.+N)

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Break even analysis: Break even point: At some point in operations, the total revenue obtained through the sales equals the cost of production. This volume of out put is known as Break even point. The break even point is the volume of out put at which neither a profit nor a loss is occurred. Scope of break even analysis: 1. It determines the volume of sales necessary to cover a) A reasonable return on capital employed b) Dividends ( both preference and ordinary) c) Reserves 2. To fix the sales budget 3. To compute the costs and revenues for various volumes of output 4. To find the selling price 5. To compare the various proposals of business Calculation of break even point: The total cost of a product = Fixed cost + Variable cost Fixed costs: Are those which tend to remain constant irrespective of the volume of output or production. Ex.: Staff salaries, depreciation, administrative expenses, rent, establishment charges etc. Variable costs: Are those which vary directly with the volume of output. Ex.: Direct materials, labor costs and expenses Contribution = Sales Variable costs Let F = Fixed costs in Rs. V = Variable cost per unit in Rs. P = Selling price in Rs. Q = The quantity at break even point in Nos. S = Total sales value in Rs. Pr = Profit Total cost = Fixed cost + variable cost = F + Q.V Total sales = P.Q At Break even point Total sales = Total cost P.Q = F + Q.V 1. Break even Quantity Q = F / (P-V) Nos. Break even value = Break even Quantity X Selling price = Q.P = F / (p-V) X P Break even value of sales = F / (1- V/P)

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Contribution = Sales Variable cost = S Q.V = S S.V/P = S[1-(V/P)] Contribution C = S[1-(V/P)] Sales = fixed cost + variable cost + Profit Q.P = F + Q.V + Pr Q.(P-V) = F + Pr Break even quantity Q = (F + Pr) / (P-V) Break even value of sales = Q.P = (F + Pr) .P / (P-V) = (F + Pr) / (1-V/P) Break even value of sales = (F + Pr) / (1-V/P)

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3.4 3.4.1

Break even chart: Break even chart is the graphical representation of the relationship between costs and revenue at a given time. Functions of break even chart: 1. It depicts a clear view of the position of business 2. It is an economic presentation rather than accounting concept 3. It portrays the likely profits and losses at various output levels 4. It determines the break even point 5. It portrays the margin of safety 6. It is a tool of management to take alternate decisions on costs and profits

Units of output = Angle of incidence A high angle of incidence shows that the profits are at high rate. A large angle of incidence with large margin of safety is a favorable business position.

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Techniques of capital budgeting: Capital budgeting: The investment decisions of a firm are generally known as the capital budgeting. or capital expenditure decisions. A capital budgeting decision may be defined as the firms decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years to come. Importance of investment decisions: 1. They influence the firms growth in the long run 2. They affect the risk of the firm 3. They involve commitment of large amount of funds 4. They are either irreversible or reversible at substantial loss 5. They are among the most difficult decisions to take Types of investment decisions: 1. Expansion of existing business 2. Establishment of new business 3. Replacement and modernization Another way of classification: 1. Mutually exclusive investment: These investments serve the same purpose and compete with each other. If one is undertaken, the others have to be excluded. EX.: Semiautomatic M/cs. or fully automatic M/cs. 2. Independent investment: They serve different purposes and do not compete with each other. 3. Contingent investments: The choice of investment necessitates undertaking one or more other investments. Ex.: Building a factory in remote backward area necessitates the investment on roads, houses, schools, hospitals etc. Techniques of capital budgeting: 1. Discounted Cash Flow (DCF) criteria: 2. Non-Discounted Cash Flow ( NDCF) criteria: Methods of capital discounting: 1. Under DCF: 1. Net Present value (NPV) NPV = t=1 [Ct / (1+k)t ] C0 where C0 = Initial cost C1, Ct2, C3 Ct = cash flow in the years 1, 2, 3,.. t K = Opportunity cost of capital in % N = No. of years If NPV > 0 then the proposal is acceptable.

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2. Internal rate of return (IRR) C0 = t=1 [Ct / (1+r)t ] Where r = Internal rate of return Calculate r from the above equation If r > k then the proposal is acceptable. Where k is the desired opportunity cost in % 3. Profitability Index (PI) PI = Present value of cash inflows / Initial cash outlay =
t=1

[Ct / (1+k)t ] / C0

If PI > 1 Accept the proposal < 1 Reject = 1 May accept 4. Discounted Pay Back Period Pay back period = Initial investment / Discounted cash inflow 2. Under NDCF: 1. Pay back Period Pay back period = Initial investment / Annual cash inflow = C0 / C 2. Accounting rate of Return or Return On Investment (ROI) ARR or ROI = Average income / Average investment Average income is earnings after taxes without any adjustment for interest ie EBIT (1-T) [t=1 (EBIT)t (1-T)] / N _____________________ (I0 + In )/2 where T = Tax rate I0 = Book value of the investment in the beginning In = Book value of the investment at the end of n years ARR = If ARR > the Min. rate established by the management, accept the proposal.

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Finance: It is defined as the provision of money at the time it is wanted. As a management function, it is defined as the procurement of funds and their effective utilization. Business finance can be broadly defined as the activity concerned with planning, raising, controlling and administering of funds in the business. Financial management is concerned with the managerial decisions that result in the acquisition and financing of long term and short term credits for the firm.

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Objectives of financial management: 1. Maintenance of liquid assets 2. Maximization of profitability preferably wealth of the firm 3. Ensuring a fair return to the share holders 4. Building up of reserves for the growth and expansion 5. Maximum operational efficiency 6. Ensuring financial discipline in the organization Methods of financial management: The term financial method or financial tool refers to any logical method or technique to be employed for the purpose of accomplishing two goals 1. Measuring the effectiveness of firms actions or decisions 2. Measuring the validity of the decisions regarding accepting or rejecting future projects. Methods or tools: 1. Cost of capital 2. Financial leverage or trading on equity 3. Capital budgeting appraisal methods 1. Pay back period 2. Average rate of return ( Accounting rate of return or ROI) 3. Internal rate of return 4. ABC analysis 5. Ratio analysis 6. cash flow analysis

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Time value of money: Money has a time value because 1. Individuals generally prefer current consumption 2. An investor can profitably employ a rupee received today to give him a higher value to be received the next day or after certain period. Valuation concepts: 1. Compound value concept: In this case the interest earned on the initial principal becomes a part of the principal at the end of the compounding period. A = P (1+i)N where A = Amount at the end of the period of N years P = Principal at the beginning i = rate of interest N = No. of yeas Multiple compounding: Compounded more than once in a year. A = P (1+i/m)m.n where m = No. of times per year compounding is done.

Compound value tables are available for ready calculations. 2. Present value concept: It is exactly opposite to compounding. Here we estimate the present value of future payment or installment or series of payments adjusted for the time value of money. The technique for finding the present value is termed as Discounting. Given a positive rate of interest, the present value of future rupee will always be lower. where Pv = Principal amount the investor is willing to forgo at present i = Interest rate A = Amount at the end of N years (Amount receivable after N years) N = No. of years Present value of a series of cash flow: P=
t=1

Pv = A / (1+i)N

[At / (1+i)t ]

where A1, A2, A3 At = cash flow after 1, 2, 3 .. N years

Present value tables are available for ready calculations. Money received today is worth more than that received after some time. Money received in future is of less value than what is received today.

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Financial leverage: Leverage is the firms ability to fixed cost assets or funds to magnify the return to its owners. Leverage is defined as the employment of an asset or funds for which the firm pays a fixed cost or fixed return. If assets are employed, it is called fixed operating cost. If funds are employed, it is called fixed financial cost. The fixed cost or return is the fulcrum of the lever. Types of leverages: 1. Operating leverage: It is a function of the amount of fixed costs, the contribution margin and the volume of sales. Operating leverage = Contribution / Operating profit Operating profit means Earning Before Interest and Tax ( EBIT) 2. Financial leverage: Financial leverage = OP / PBT where OP = EBIT PBT = Profit before tax

% Change in taxable income Degree of financial leverage =---------------------------------------% Change in the operating income If the firm is not required to pay fixed cost or return then there will be no leverage. Since the fixed cost or return has to be paid or incurred irrespective of the volume of sales or output, the size of such cost or return has considerable influence over the amount of profit available for the share holders. When the volume of sales changes, leverage helps in quantifying such influence. Hence leverage may be defined as relative change in profits due to a change in sales. A high degree of leverage implies that there will be large change in profits due to a relatively small change in sales and vice versa. Higher the leverage, higher is the risk and higher is the expected return. Operating leverage: It is the tendency of the operating profit to vary disproportionately with the sales. Operating leverage exists when a firm has to pay a fixed cost regardless of volume of output or sales. The firm is said to have a high degree of operating leverage if it employs a greater amount of fixed cost and a small amount of variable cost. Degree of operating leverage = % change in profit / % change in sales High degree of operating leverage is very risky. A small drop in sales can be excessively damaging to the firms effort to achieve profitability.

Financial leverage: It may be defined as the tendency of the residual net income to vary disproportionately with the operating profit. It indicates the change that takes place in the taxable income as a result of change in the operating income. It signifies the existence of fixed interest or fixed dividend bearing securities in the total capital structure of the company. Thus the use of fixed interest / fixed dividend bearing securities such as debt and preferential capital along with the owners equity in the total capital structure of the company is described as financial leverage. Financial leverage is also sometimes termed as trading on equity. The company resorts to trading on equity with the objective of giving the equity share holders a high rate of return than the general rate of earning on capital employed in the company. Financial leverage can also be defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the firms Earning per Share (EPS). Degree of financial leverage = % change in EPS / % change in EBIT Composite leverage: It is the combined leverage of both operating leverage and financial leverage. It discloses the effect of change in sales over change in taxable profit (or EPS). Composite leverage = Operating leverage X Financial leverage C. OP C == ---------- = ---OP. PBT PBT Where C = Contribution (Sales variable cost) PBT = Profit before tax but after interest Low operating leverage and high financial leverage is considered to be an ideal situation for the maximization of profits with minimum risk. 8.0 Cost of capital: It is defined as the rate of return the firm requires from investment in order to increase the value of the firm in the market place. Aspects of concept of cost: 1. It is not a cost as such. The cost of capital is really the rate of return that is required on the projects available. It is merely a hurdle rate. Of course such rate can be calculated on the basis of the actual cost of different components of capital. 2. It is the minimum rate of return that will result in at least maintaining the value of its equity shares if not increasing.

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3. It consists of Return at zero risk level, premium for business risk and premium for financial risk. K = R0 + B +F Where k = cost of capital R0 = Return at zero level B = Premium for business risk F = Premium for financial risk Importance of cost of capital: 1. For making capital budgeting decisions 2. Capital structure decisions Classification of cost of capital: 1. Explicit cost and Implicit cost: Explicit cost is the discount rate that equals the present value of the funds received by the firm net of under writing costs with the present value of expected cash outflow. It is the internal rate of return (IRR) the firm pays for financing. Implicit cost is the rate of return associated with the best investment opportunity for the firm and its share holders that will be foregone if the project presently under consideration were accepted. The explicit costs arise when the funds are raised while the implicit costs arise when they are used. 2. Future cost and historical cost: Future costs refer to the expected cost of funds to finance the project. Historical cost is the cost which has already been incurred for financing a particular project. 3. Specific cost and combined cost: The cost of each component of capital (equity shares, preferential shares, debentures, loans etc.) is known as specific cost of capital. Combined cost or composite cost of capital is inclusive of all costs of capital i.e. Equity shares, preference shares, debentures and loans. The composite cost of capital will be used as a basis for accepting or rejecting the proposal. 4. Average cost and marginal cost: Average cost is the weighted average of the costs of each component of funds employed by the firm. The weights are in proportion of the share each component of capital in the total capital structure. Marginal cost of capital is the weighted average cost of new funds raised by the firm. It is an important factor to be considered in capital budgeting and financing decisions.

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