Financial management book local-author rejinpaul PDF

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Preface Financial Management is an essential part of the economic and non economic activities which leads to decide the efficient procurement and utilization of finance with profitable manner. In the olden days the subject Financial Management was a part of accountancy with the traditional approaches. Now a days it has been enlarged with innovative and multi dimensional functions in the field of business with the effect of industrialization, Financial Management has become a vital part of the business concern and they are concentrating more in the field of Financial Management. Financial Management also developed as corporate finance, business finance, financial economics, financial mathematics and financial engineering. Understanding the basic concept about the financial management becomes an essential part for the students of economics, commerce and management. This book provides detailed information about the finance and finance related area with simple language and the concepts are explained with easy examples. This book is also prepared based on the B.Com., B.B.A., B.B.M., M.Com., and M.B.A. syllabus of various universities for the benefits of the students.

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Contents Preface

CHAPTER - 1 INTRODUCTION TO FINANCIAL MANAGEMENT Introduction Meaning of Finance Definition of Finance Definition of Business Finance Types of Finance Definition of Financial Management Scope of Financial Management Objectives of Financial Management • Profit maximization • Favourable arguments for profit maximization • Unfavorable arguments for profit maximization • Drawbacks of profit maximization • Wealth maximization • Favourable arguments for wealth maximization • Unfavourable arguments for wealth maximization Approaches to Financial Management • Traditional approach Functions of Finance Manager Importance of Financial Management • Financial planning • Acquisition of funds • Proper use of funds • Financial decision • Improve profitability

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1–10 1 1 1 2 2 3 4 5 5 6 6 6 6 7 7 7 8 8 9 9 9 10 10 10

Contents

• Increase the value of the firm • Promoting savings Model Questions CHAPTER - 2 FINANCIAL STATEMENT ANALYSIS Introduction Meaning and Definition • Income statement • Position statement • Statement of changes in owners equity • Statement of changes in financial position Types of Financial Statement Analysis Techniques of Financial Statement Analysis • Comparative statement analysis • Comparative balance-sheet analysis • Comparative profit and loss account analysis • Trend analysis • Common size analysis Funds Flow Statement Cash Flow Statement • Difference between funds flow and cash flow statement Ratio Analysis • Liquidity ratio • Activity ratio • Solvency ratio • Profitability ratio Model Questions CHAPTER - 3 SOURCES OF FINANCING Introduction • Long-term financial requirements or Fixed capital requirement • Short-term financial requirements or Working capital requirement Sources of Finance Security Finance • Characters of security finance • Types of security finance • Ownership securities Equity Shares • Features of equity shares • Advantages of equity shares • Disadvantages of equity shares Preference Shares • Irredeemable preference shares

10 10 10 11–24 11 11 12 12 12 12 13 14 15 15 16 17 17 18 19 19 20 21 21 22 22 24 25–39 25 25 25 26 28 28 28 28 28 28 29 30 30 31

Contents

• Participating preference shares • Non-participating preference shares • Convertible preference shares • Non-convertible preference shares • Features of preference shares • Advantages of preference shares • Disadvantages of preference shares Deferred Shares No Par Shares Creditorship securities • Debentures • Types of debentures • Features of debentures • Advantages of debenture • Disadvantages of debenture Internal Finance • Depreciation funds • Retained earnings • Advantages of retained earnings • Disadvantages of retained earnings Loan Financing • Financial institutions • Commercial banks • Short-term loans • Development banks Model Questions CHAPTER - 4 CAPITALIZATION Introduction Meaning of Capital • Fixed capital • Definition of fixed capital • Character of fixed capital • Working capital Capitalization • Meaning of capitalization • Definition of capitalization Types of Capitalization • Over capitalization • Causes of over capitalization • Effects of over capitalization • Remedies for over capitalization • Under capitalization • Causes of under capitalization

31 31 31 31 31 31 32 32 32 33 33 33 34 34 34 35 35 35 36 36 37 37 37 38 38 38 41–45 41 41 41 41 42 42 42 42 43 43 43 43 44 44 44 44

Contents

• • • •

Effects of under capitalization Remedies of under capitalization Watered capitalization Causes of watered capital

CHAPTER - 5 CAPITAL STRUCTURE Introduction • Meaning of capital structure • Definition of capital structure Financial Structure Optimum Capital Structure • Objectives of capital structure • Forms of capital structure Factors Determining Capital Structure • Leverage • Cost of capital Capital Structure Theories • Traditional approach • Assumptions • Comments • Net Income (NI) approach • Net Operating Income (NOI) approach • Modigliani and Miller approach Model Questions CHAPTER - 6 COST OF CAPITAL Introduction 65 • Meaning of cost of capital • Definitions • Assumption of cost of capital Classification of Cost of Capital • Explicit and implicit cost • Average and marginal cost • Historical and future cost • Specific and combine cost Importance of Cost of Capital • Importance to capital budgeting decision • Importance to structure decision • Importance to evolution of financial performance • Importance to other financial decisions Computation of Cost of Capital • Measurement of cost of capital • Cost of equity

45 45 45 45 47–64 47 47 47 48 49 49 49 50 50 50 50 51 51 53 53 55 58 64 65–82 65 65 66 66 66 67 67 67 67 67 67 68 68 68 68 68

Contents

• Dividend price approach • Dividend price plus growth approach • Earning price approach • Realized yield approach • Cost of debt • Debt issued at par • Debt issued at premium or discount • Cost of perpetual debt and redeemable debt • Cost of preference share capital • Cost of retained earnings • Measurement of overall cost of capital Model Questions CHAPTER - 7 LEVERAGE Introduction • Meaning of leverage • Definition of leverage • Types of leverage Operating Leverage • Degree of operating leverage • Uses of operating leverage Financial Leverage • Degree of financial leverage • Alternative definition of financial leverage • Uses of financial leverage Distinguish Between Operating Leverage and Financial Leverage EBIT - EPS Break Even Chart for Three Different Financing Alternatives Combined Leverage • Degree of combined leverage Working Capital Leverage Model Questions CHAPTER - 8 DIVIDEND DECISION Introduction • Meaning of dividend Types of Dividend/Form of Dividend • Cash dividend • Stock dividend • Bond dividend • Property dividend Dividend Decision Irrelevance of Dividend

68 69 70 71 72 72 72 73 74 76 77 80 83–98 83 83 83 83 84 84 85 86 86 87 87 89 89 90 90 93 96 99–117 99 99 99 100 100 100 100 100 101

Contents

Modigliani and Miller’s Approach Relevance of Dividend • Walter’s model • Gordon’s model Factors Determining Dividend Policy • Profitable position of the firm • Uncertainty of future income • Legal constrains • Liquidity position • Sources of finance • Growth rate of the firm • Tax policy • Capital market conditions Types of Dividend Policy • Regular dividend policy • Stable dividend policy • Irregular dividend policy • No dividend policy Model Questions CHAPTER - 9 CAPITAL BUDGETING Introduction • Definitions • Need and importance of capital budgeting Capital Budgeting Process Kinds of Capital Budgeting Decisions Methods of Capital Budgeting of Evaluation • Pay-back period • Un even cash inflows • Post pay-back profitability method • Accounting rate of return or Average rate of return • Net present value • Internal rate of return • Excess present value index • Capital rationing Risk and Uncertainly in Capital Budgeting • Risk adjusted cut off rate • Certainly equivalent method • Sensitivity technique • Probability technique • Standard deviation method • Co-efficient of variation method • Decision tree analysis

101 107 107 111 115 115 115 115 115 115 115 115 115 116 116 116 116 116 116 119–147 119 119 120 120 122 122 122 124 124 126 128 131 135 135 136 136 137 138 139 140 142 142

Contents

• Construction of decision tree Model Questions CHAPTER - 10 WORKING CAPITAL Introduction Meaning of Working Capital • Definitions Concept of Working Capital • Gross working capital • Net working capital • Component of working capital Types of Working Capital • Permanent working capital • Temporary working capital • Semi variable working capital Needs of Working Capital • Working capital position/Balanced working capital position Factors Determining Working Capital Requirements Computation (or Estimation) of Working Capital Working Capital Management Policy Sources of Working Capital • Determining the finance mix — Hedging approach — Conservative approach — Aggressive approach Working Capital and Banking Committee Model Questions CHAPTER - 11 WORKING CAPITAL MANAGEMENT Introduction • Meaning • Definition Inventory Management Introduction • Meaning • Kinds of inventories • Objectives of inventory management • Techniques of inventory management • Stock level • Minimum level • Re-order level • Maximum level • Danger level

142 144 149–163 149 149 150 150 151 151 151 152 152 153 153 154 154 155 156 159 160 161 161 162 162 163 163 165–197 165 165 165 165 166 166 166 166 167 167 168 168 168 168

Contents

• Average stock level • Lead time • Safety stock • Economic order quantity (EOQ) Techniques Based on the Classification of Inventories • A-B-C analysis • Aging schedule of inventories • VED analysis • HML analysis Techniques on the Basis of Records • Valuation of inventories Cash Management • Motives for holding cash • Cash management techniques • Speedy cash collections — Prompt payment by customers — Early conversion of payments into cash — Concentration banking — Lock box system • Slowing disbursement • Cash management models Receivable Management • Collection cost • Capital cost • Administrative cost • Default cost • Factors considering the receivable size Model Questions CHAPTER - 12 SPECIAL FINANCING Lease Financing • Definition of leasing • Elements of leasing • Term of lease • Lease rental • Type of leasing • Advantages of leasing • Leasing finance institutions in India • Leasing by development institutions • Leasing by specialized institutions • Private sector leasing company • Private sector financial company Venture Capital

168 168 169 169 171 171 171 172 172 172 172 173 173 176 176 176 176 176 176 177 177 179 179 179 179 179 179 194 199–224 199 199 200 200 200 200 202 203 203 203 204 204 204

Contents

• Introduction • Meaning of venture capital • Definition of venture capital • Features of venture capital • Venture capital in India Factoring • Myths on factoring • History of the early factoring in Roman • Factoring in United States • Factoring in India • Modus of operations • Why factoring? • Mechanics of factoring • Types of factoring Foreign Direct Investment • FDI in India • Through private placements or preferential allotments • A comparative study between India and China • Foreign Institutional Investors (FIIS) • SEBI and FIIs Merchant Banking • Introduction • Meaning • Merchant banking in India • Classification of merchant banking • Functions of merchant banking • Merchant banking organizations Credit Rating • Introduction • Meaning of credit rating • Objectives of credit rating • Credit rating in India • Operational performance of credit rating business in India • Basis for credit rating • Credit Rating Information Service of India Limited (CRISIL) • Credit rating symbols of credit rating information service of India limited • Operational result of credit rating information service of India limited • Investment Information and Credit Rating Agency of India limited (ICRA) • Credit rating symbols of investment information and credit rating agency of India limited • Operational result of ICRA • Credit Analysis and Research Limited (CARE) • Credit rating symbols of credit analysis and research limited

204 204 204 205 205 206 206 207 207 207 208 208 209 210 210 211 211 212 212 212 214 214 214 214 214 215 215 216 216 216 216 216 217 217 217 217 218 218 218 219 219 219

Contents

• Operational result of credit analysis and research limited Mutual Funds • Introduction • Origin of mutual funds • Structure of mutual fund in India • Meaning of mutual fund • Advantages of mutual funds • Public sector mutual fund • Private sector mutual fund • Open ended mutual fund • Closed ended mutual fund • Growth generated mutual fund • Income generated mutual fund • Balanced mutual fund • Domestic mutual fund • Global mutual fund • Regional mutual fund • Sector mutual fund • Top ten mutual fund Model Questions CHAPTER - 13 FINANCIAL SYSTEM Introduction Financial System in India • Financial institutions • Banking institutions • Commercial banks • Scheduled commercial banks • Nationalised banks • State Bank of India(SBI) • Growth and structure of commercial banks in India • Private sectors banks • New banks in private sectors • Foreign banks in India • Non-banking institutions • Non-banking financial institutions Industrial Finance Corporation of India (IFCI) • Origin • Capital • Objectives • Functions • Management • Subsidies of industrial finance corporation of India • Working result

219 220 220 220 220 221 221 222 222 222 223 223 223 223 223 223 223 223 223 224 225–264 225 225 226 226 226 226 227 228 228 229 229 230 231 231 231 231 232 232 232 232 232 233

Contents

Industrial Credit and Investment Corporation of India (ICICI) • Origin • Capital • Objective • Functions • Management Subsidies of industrial credit and investment corporation of India • Working result Industrial Development Bank of India (IDBI) • Origin • Capital • Objectives • Functions • Management • Working result Industrial Reconstruction Bank of India (IRBI) • Origin • Capital • Objectives • Functions • Management • Working result State Finance Corporation (SFC) • Origin • Capital • Objectives • Functions • Management State Finance Corporation in Tamil Nadu Export Import Bank (Exim Bank) • Origin • Capital • Objectives • Functions • Management • Working result National Bank for Agricultural and Rural Development • Origin • Capital • Objectives • Functions • Management • Working result Specialized Financial Institutions

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Contents

Insurance Sector in India • Some of the private sector life insurance corporation Life Insurance Corporation of India • Role of LIC General Insurance Companies Unit Trust of India • Origin • Capital • Objectives • Functions • Management • Subsidiaries of Unit Trust of India • Schemes of Unit Trust of India • Working result of Unit Trust of India Non-banking Non-financial Institutions Financial Markets • Capital market • MIBOR and MIBID • Share market • Primary market • Secondary market • Methods of raising capital • Public issue • Right Issue • Private placement • Group A and group B shares Securities and Exchange Board of India (SEBI) • Functions • Trading procedure at stock exchanges • Recent trends in capital market Share Market Terminology • Main share price index in famous share market of the world • Name of share price indices changed • Money market • Discount and Finance House of India Ltd. (DFHI) • Commercial Paper (CP) • Money Market Mutual Funds (MMMFs) • Venture Capital Funds (VCFs) • Financial services • Fund based financial services • Fee based financial services • Non-banking Finance Companies (NBFC) Model Questions

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INTRODUCTION Business concern needs finance to meet their requirements in the economic world. Any kind of business activity depends on the finance. Hence, it is called as . Whether the business concerns are big or small, they need finance to fulfil their business activities. In the modern world, all the activities are concerned with the economic activities and very particular to through any venture or activities. The entire business activities are directly related with making profit. (According to the economics concept of factors of production, rent given to landlord, wage given to labour, interest given to capital and profit given to shareholders or proprietors), a business concern needs finance to meet all the requirements. Hence , but each term is having different meanings and unique characters. . MEANING OF FINANCE Finance may be defined as the

It includes . Finance also is referred as the provision of money at the time when it is needed. Finance function is the . The concept of finance includes . But each word is having unique meaning. Studying and understanding the concept of finance become an important part of the business concern.

DEFINITION OF FINANCE According to Khan and Jain, “Finance is the art and science of managing money”.

Financial Management

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According to Oxford dictionary, the word ‘finance’ connotes ‘management of money’. Webster’s Ninth New Collegiate Dictionary defines finance as “the Science on study of the management of funds’ and the management of fund as the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities.

DEFINITION OF BUSINESS FINANCE According to the Wheeler, “ ”. According to the Guthumann and Dougall, “Business finance can broadly be defined as the activity concerned with of the funds used in the business”. In the words of Parhter and Wert, “Business finance deals primarily with by privately owned business units operating in nonfinancial fields of industry”. is concerned w of the business concern and the business concern needs to adopt modern technology and application suitable to the global environment. According to the Encyclopedia of Social Sciences, “Corporation finance deals with the financial problems of corporate enterprises. These problems include the financial aspects of the promotion of new enterprises and their administration during early development, the accounting problems connected with the distinction between capital and income, the administrative questions created by growth and expansion, and finally, the financial adjustments required for the bolstering up or rehabilitation of a corporation which has come into financial difficulties”.

TYPES OF FINANCE Finance is one of the important and integral part of business concerns, hence, it plays a major role in every part of the business activities. It is used in all the area of the activities under the different names. Finance can be classified into

3

Introduction to Financial Management Finance

Private Finance

Individual Finance

Partnership Finance

Public Finance

Business Finance

Central Government

State Government

Semi Government

Fig. 1.1 Types of Finance

which includes the activities to meet the requirements. which concerns with as

such matters.

DEFINITION OF FINANCIAL MANAGEMENT Financial management is an integral part of overall management. It is concerned with the duties of the financial managers in the business firm. The term financial management has been defined by Solomon, “It is concerned with the efficient use of an important economi...