CONCEPT OF FINANCIAL MANAGEMENT

What is Finance
1. SUB-SET OF ECONOMICS AND IN ESSENCE IS ALSO TERMED AS
APPLIED MICRO-ECONOMICS.

2. IMPORTANT BUSINESS ACTIVITY.

3. FUND MANAGEMENT SCIENCE.

4. FOCUSES IN WEALTH MAXIMIZATION GOAL/ENHANCING

FIRM’S VALUE.

5. FOCUSES ON FUTURE DECISION BASED ON ACCOUNTING

FINANCIAL STATEMENTS.

6. ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL

FINANCE.
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 BASIC CONCEPT OF NATIONAL INCOME AND ECONOMIC
INDICATORS
1. GDP: A measure of the final goods and services, produced by the residents of the
country with resources located in that country. GDP=(C+I+G)+(X-M) {Domestic
Economy}; 5.3% India’s GDP growth during Jan-March 2011-12, slowest in 9 years.
2. GNP: The value measured at market prices, of all final goods and services produced
by an economy in one year. GNP=(C+I+G)+(X-M)+(R+P) {Open Economy}
3. IIP: Index of Industrial production, released monthly, is a measure of capturing
production across factories in India. It records output in factories across three
categories-mining, electricity, manufacturing, IIP was flat at 0.1% in April.
4. WPI: Wholesale price Index; This is India’s most watched cost of living index.
Calculated on a monthly basis, the index gives trends in inflation rate or the rate at
which wholesale prices of goods such as vegetables, fuel, manufactured items and
food grains are changing. It rose to worrisome 7.55% in May.
5. CPI: Consumer Price Index; released monthly, gives retail prices of almost all
everyday products and services from food to footwear and movie tickets to medicine.
It is more realistic cost-of-living index because it captures shop-end prices. It rose
10.36% in May, showing government inability to cool prices.
6. Sensex: The Bombay Stock Exchange’s (BSE) benchmark 30-share index (reflects
the weighted arithmetic average of price relatives of 30 sensitive shares) is a
barometer for equity markets, perhaps the first indicator (base year for calculation of
sensex is 1978-79; value 100) about the health of the economy and investor
sentiments. The Sensex closed up 76 pts. at 17,538.67 on Thursday (5th July), a three-
month high, amid strong expectations about reformist moves in the coming weeks.

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 SUB-SET OF ECONOMICS
The fundamental Approach says Defines the environment in which the firm
operates i.e. key Macroeconomic factors
ECONOMY such as:-
1. Growth Rate of Economy,
2. Domestic savings.
3. Tax Environment.
INDUSTRY
4. Inflation rate.
5. Real interest rate.

BUSINESS Finance in essence, is applied Micro-

COMPANY Economics
FINANCE
key Microeconomic tools
principal of marginal analysis
according to which a decision should
be guided by a comparison of
1. Economics Focuses on optimization of Valued Goals.
incremental Benefits and Cost
2. Finance Focuses on Wealth Maximization
3. To Sum up, a basic knowledge of macro-economics is necessary for
understanding the environment in which company/firm operates.
4. Good grasp of micro-economic principles is helpful in sharpening the tools of
3 financial decision making
 IMPORTANT BUSINESS ACTIVITIES

Major Business Activities in a Firm is

categorized as:-

1. PRODUCTION

2. MARKETING

3. FINANCE

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 FUND MANAGEMENT SCIENCE
1. CHOICE OF FINANCIAL MARKET
2. CHOICE OF FINANCIAL INSTRUMENT---
FINANCING DECISION
3. OPTIMUM CAPITAL STRUCTURE DECISION
4. OPTIMIZATION OF COST OF CAPITAL
Financial Market

Investors Investors provide the initial cash required to The Business

• Shareholders finance the business proposal Proposal
• Lenders

The proposal generates cash to investors

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 FUND MANAGEMENT SCIENCE

FINANCE FUNCTION

FINANCING INVESTMENT LIQUIDITY

DECISION DECISION DECISION

1. Investment or Long Term Asset Mix Decision

2. Financing or Capital Mix Decision
3. Dividend or Profit Allocation Decision
4. Liquidity or Short Term Asset Mix Decision

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 FOCUSES IN WEALTH MAXIMIZATION
GOAL/ENHANCING FIRM’S VALUE -The process of value
creation
•Economic
conditions

•Political and
social VALUE
environments
SALES EBIT EAT EPS

Market CREATION
structure
Firm’s
competitive
position

Economic Risk + Operational Risk + Financial Risk

Business Risk

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 RISK-RETURN PARADOX
PROFITABILITY
Maximize sales
Survive Maximize Market Share
Capital Budgeting
Avoid financial distress and Minimize Cost Decision
bankruptcy Capital Structure Decision
Beat the competition
Maximize sales or market share
Dividend Decision
Contradictory* Working Capital
Minimize Costs
Maximize profits Management
Maintain steady earnings growth Risk Management
MINIMIZING RISK
Bankruptcy avoidance
Stability
Safety
*Pursuit of profit involves risk;
it is not possible to maximize
both safety and profit:- Need of
goal that encompasses both RISK AND
factors WEALTH RETURN TRADE
MAXIMIZATION/ OFF
ENHANCING
VALUE OF THE
FIRM (EVA)

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 FOCUSES ON FUTURE DECISION BASED ON ACCOUNTING FINANCIAL STATEMENTS

 Share Capital
 Equity
 Preference
Capital structure and
 Reserve &Surplus
Cost of Capital
 Secured Loans
 Debentures
 Loans and advances
 Unsecured Loans
Working Capital
 Current Liabilities and Provisions
financing policy
 Trade Creditors
 Provisions
 Fixed Assets (net)
 Gross block Capital Budgeting
 Less: depreciation
 Investments
Portfolio Management
 Current Assets, loans and advances
 Cash and bank
Cash Management

 Receivables Credit Management

 Inventories Inventory Management

Miscellaneous expenditure and losses
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 ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE
The Role of The Financial Manager

The Balance-Sheet Model of the Firm-Traditional Approach

The Net Working Capital Investment Decisions

Current
Liabilities
Net
Current Assets Working
Capital Long-Term Debt

Investment Decisions
Fixed Assets Financing Decisions
 “Capital
1 Tangible
Budgeting”  “Capital Structure”
2 Intangible Shareholders’
Equity

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 FOCUSES ON FUTURE DECISION BASED ON ACCOUNTING FINANCIAL STATEMENTS

 Net Sales Revenue Risk

 Cost of goods sold
 stocks
 Wages and salaries
 Other manufacturing expenses
 Gross Profit Gross Profit Margin
 Operating expenses
 Selling & Administration expenses
 Depreciation Depreciation Policy
 Operating Profit
 Non-operating surplus/deficit
 Earnings before income and tax Business Risk
 Interest
Financial Risk
 Profit before tax
Tax Planning
 Tax
 Profit after Tax Return on Equity
 Dividends
Dividend Policy
 Retained earnings

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 ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE
The Role of The Financial Manager

(2) (1)

Firm's Financial Financial

managers (4a)
operations markets

(3) (4b)

(1) Cash raised from investors

(5)
(2) Cash invested in firm
(3) Cash generated by operations
Government (4a) Cash reinvested
(4b) Cash returned to investors
12 (5) Taxes
 ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE
The Role of The Financial Manager

Contemporary Approach
 Concern on Institutional Imperatives referred as the focus which lead
to divergence between the goals of Managers and Shareholders. Instead
of merely focusing on the efficient allocation of funds among various
assets and the acquisition of funds on favorable terms.

 A fundamental change in financial management is the direct result of two

recent trends: the Globalization of Competition and the Integration of
World financial markets facilitated by Improved ability to collect and
analyze information.

 A common element, which distinguishes the recent Financial

Management tools from the earlier ones have emerged predominantly
from practice and from consultants. The modern approaches also have
developed concerning the pursuit of shareholder value.
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 ALSO REFERRED AS CORPORATE FINANCE OR MANAGERIAL FINANCE
The Role of The Financial Manager

Competencies
Business Knowledge

Effective Costing, Planning & Evaluation

Risk Management

Standards Compliance Value-

Valued-added Strategic
Advice Focus
for-
Effective Communication Money
Performance Management

Forecasting, Planning and Budgeting

Accounting/ Financial Knowledge

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 CONCEPT OF ECONOMIC VALUE ADDED
1. Traditional approaches to measuring ‘Shareholders’ Value Creation used
parameters such as earnings capitalisation, market capitalisation and present
value of estimated future cash flows.

2. Extensive equity research has now established that it is not earnings per se, but
value which is important.

3. A new measure called “Economic Value Added” (EVA) is increasingly being

applied to understand and evaluate financial performance.

4. EVA = NOPAT – COCE (Net operating profit after taxes – Cost of Capital
Employed)

NPOAT = Profits after depreciation and taxes but before interest costs. NOPAT thus
represents the total pool of profits available on an ungeared basis to provide a return
to lenders and shareholders;
COCE = Weighted average cost of capital (WACC x Average capital employed)

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 CONCEPT OF ECONOMIC VALUE ADDED
What does EVA show ?
EVA is residual income after charging the Company for the cost of capital provided
by lenders and shareholders. It represents the value added to the shareholders by
generating operating profits in excess of the cost of capital employed in the business.
When will EVA increase ?
(a) Operating profits can be made to grow without employing more capital, i.e.
greater efficiency.
(b) Additional capital is invested in projects that return more than the cost of
obtaining new capital, i.e., profitable growth.
(c) Capital is curtailed in activities that do not cover the cost of capital, i.e., liquidate
unproductive capital.
Utility of EVA
(i) EVA represents the value added to the shareholders by generating operating profits
over and above the cost of capital employed in the business. Hence it is a measure of
financial performance.

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 CONCEPT OF ECONOMIC VALUE ADDED
Utility of EVA Continued
(ii) EVA is a management tool that discloses the impact of both strategic as well as
operational decision of the management. The examples of strategic decisions are:
what investment to make, which business to exist, which financial structure is
optimal, etc. While operational decision include, whether to make in house or out
source, repair or replace equipment or, make short or long production runs, etc.

(iii) EVA can prove as an effective tool for increasing shareholders’ wealth, through
integrating EVA framework in four key areas, viz., to measuring business
performance, guiding managerial decision-making, aligning managerial incentives
with shareholder interests and improving the financial and business literacy
throughout the organisation.

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 The Foreign Exchange Market
 The foreign exchange market is the market where the
currency of one country is exchanged for the currency
of another country. Most currency transactions are
channelled through the world-wide interbank market.
Interbank market is the wholesale market in which
major banks trade with each other.

 Participants
 Speculators
 Arbitrageurs
 Traders
 Hedgers

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 Foreign Exchange Rates
 A foreign exchange rate is the price of one currency quoted in terms of
another currency.
 When the rate is quoted per unit of the domestic currency, it is referred to
as direct quote. Thus, the US$ and INR exchange rate would be written
as US$ 0.02538/INR.
 When the rate is quoted as units of domestic currency per unit of the
foreign currency, it is referred to as indirect quote.
 A cross rate is an exchange rate between the currencies of two countries
that are not quoted against each other, but are quoted against one
common currency.
 Suppose that German DM is selling for $ 0.62 and the buying rate for the
French franc (FF) is $ 0.17, what is the DM/FF cross-rate? It is:

US $ 0.62 FF FF 3.65
 
DM US $ 0.17 DM

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 Foreign Exchange Rates
 The spot exchange rate is the rate at which a currency can be bought or
sold for immediate delivery which is within two business days after the
day of the trade.
 Bid-ask spread is the difference between the bid and ask rates of a
currency.
 The forward exchange rate is the rate that is currently paid for the
delivery of a currency at some future date.
 The forward rate may be at a premium or at a discount.
 For a direct quote, the annualised forward discount or premium can be
calculated as follows:

 Spot rate – Forward rate  360

Forward premium (discount)    
 Spot rate  Days

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 International Parity Relationships
 There are the following four international parity
relationships:
 Interest rate parity (IRP)
 Purchasing power parity (PPP)
 Forward rates and future spot rates parity
 International Fisher effect (IFE).

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 Currency Appreciation and Depreciation
“We frequently hear things like “the dollar strengthened (or weakened) in financial
Markets today” or the dollar is expected to appreciate (or depreciate) relative to the
Rupee.” When we say that the dollar strengthens or appreciates, we mean that the
value of a dollar rises, so that it takes more foreign currency to buy a dollar.

What happens to the exchange rates as currencies fluctuate in value depends on how
exchange rates are quoted. Since we are quoting them as units of foreign currency
per Rupee, the exchange rate move in the same direction as the value of the Rupee: it
rises as the rupee strengthens, and it falls as the rupee weakens.

Relative PPP tells that the exchange rate will rise if the India’s inflation rate is lower
than the foreign country’s. This happens because the foreign currency depreciates in
value and therefore weakens relative to the Rupee.

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 Depreciation of Rupee against US Dollar
1. Rupee has depreciated a record low of Rs. 57.32 on June 22-2012 against US
dollar.
2. Loss of potential European export market. Due to Euro-zone debt crises.
Financial crunch and insolvency. The main countries are Greece, Ireland,
Portugal, Spain and Italy and France.
3. Export leads to foreign exchange inflow.
4. Huge oil bills due to import of crude oil.
5. FII’s turned bearish due to implementation of GAAR* retroactively.
6. The above mentioned reasons lead to scarcity of US dollar and depreciated
partially convertible rupee to a record low.
7. Gradual strengthening of Rupee started form 4th July 2012.
8. Offloading of dollars by banks and exporters.
9. The government increased foreign investment limits in government debt by $ 5
billion to $ 20 billion.
10. FII’s turned bullish due to announcement that application of GAAR will not be
retrospectively.
*General Anti Avoidance Rule aimed at preventing deals or incomes that are
structured to avoid taxes 23
 GAAR jarrs
1. What is GAAR? General Anti Avoidance Rule is aimed at preventing deals or
incomes that are structured only to avoid paying taxes.
2. Why is GAAR Required? Isn’t Tax Planning and Tax Savings Legitimate ; In
India the courts have ruled that savings of taxes through permissible instruments
of Tax planning is legitimate. But Tax Avoidance is illegal.
3. Why are Anti-Avoidance measures necessary? According to some expert in an
environment of moderate rates of tax, it is necessary that the correct tax base be
used for calculating taxes in the face of aggressive planning and use of opaque
low tax jurisdictions for residents as well as for sourcing capital.
4. Whom does GAAR Affect ? Almost anybody and everybody. Corporations may
be forced to re-structure salaries of employees if Taxmen conclude that these
were structured only to avoid Taxes. (FII’s) who invest through countries such as
Mauritius to exploit bilateral Tax Treaties will be effected after GARR comes
into force. It’s feared that once GAAR is invoked FII’s will have to pay capital
gain tax for their investment in Indian equities.
5. The committee has proposed to implement GARR on P-Notes. (Participatory
Notes are offshore derivative instruments issued by foreign broking houses to
overseas investors who wish to invest in the Indian stock market without
registering themselves with the market regulator, SEBI.
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 Critical Policies Awaiting Approval
1. India’s is suffering from stagflation of its own version; Morgen and
Stanley
2. P.M. is rated as under-achiever; Times Magazine.
3. Indian economy downgraded from stable to negative; Standard & Poors.
4. Raising FDI Limit in insurance sector from 29% to 49%.
5. Introduce the Direct Tax Code (DTC) to overhaul archaic income tax
laws.
6. Banking laws (Amendment) Bill to empower RBI to supersede banks’
boards; grant license to new private sector banks.
7. Introduce a uniform Goods and Services (GST).
8. Legislate the Pension Fund Regulatory and Development Authority
(PFRDA) Bill to ensure social security for employees.
9. Allow FDI in multi-brand retail.

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 PERPLEXING FACTS
1. PM promises in G20 summit at Los Cabos, Mexico, to provide $ 10
billlion (Appx Rs 56,000 crore) under deficit economy when the people
are subjected to growing economic burdens.
2. The three major rating agencies forced India to allow International
Capital flows by the recent reform witnessed. There is a strong
suspicions that these agencies promote agenda of international finance
capital by manipulating their ratings.
3. These agencies had earlier given AAA rating to mortgage-based debt of
companies like Enron.
4. In 2008, on the eve of the global financial meltdown, they had given a
similar rating to Lehman Brothers and the insurance giant AIG-the main
players in the Wall street collapse.
5. Reforms undertaken; opening Retail trade sector, reducing subsidy,
decontrolling fuel prices, increase foreign investment ceiling in thr
insurance sector, allowing foreign banks to take over Indian private
banks, allowing foreign investment in pension funds to go in for maeket
investment i.e., speculation
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 PERPLEXING FACTS
1. The retail sector in India conservatively contributes 11% of the GDP and
employs over 40 million people. According to the 4th Economic census,
38.2% of rural and 46.4% of urban employment is generated in this
sector.
2. Permitting multinational giants in retail will only displace these millions
into poverty and misery.
3. India to a large extent protected itself from the global financial meltdown
because it did not allowed its financial sector to be open to international
speculation.
4. After the proposed reforms, India may subject itself to international
volatility and thus, become extremely vulnerable.
5. Allowing international speculation in pension funds and the insurance
sector will ruin the lives of millions of working people.

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 THANK YOU

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