Financial MGT

Financial Management
BFSc
Principles of financial management
 PRINCIPLE 1: The risk return trade off-
investors wont take additional risk unless they
expect to be compensated with additional
return.
 PRINCIPLE 2: Time Value of Money - a rupee
received today is worth more than a rupee
received a year from now.
 PRINCIPLE 3: CASH, not profits is KING - it is
cash flows not profits that are actually
received by the firm and can be reinvested
 PRINCIPLE 4: Incremental Cash Flows- It's
only what changes that counts. The
incremental cash flow is the difference
between the cash flows if the project is taken
on versus what they will be if the project is not
taken on.
 PRINCIPLE 5: The Curse of Competitive
Markets-Why it's hard to find exceptionally
profitable projects.
 PRINCIPLE 6: Efficient Capital Markets-the
markets are quick and the prices are right. An
efficient market is characterized by a large
number of profit-driven individuals who act
independently.
 PRINCIPLE 7: The Agency Problem-a problem
resulting from conflicts of interest between
the manager/agent and the stockholder.
 PRINCIPLE 8: Taxes Bias Business Decisions
 PRINCIPLE 9: All Risk is not Equal-some risk
can be diversified away, and some cannot.
 PRINCIPLE 10: Ethical Behaviour is doing the
right thing, and ethical dilemmas are
everywhere in finance.
3 R’s of credit: Returns, Repayment
Capacity and Risk bearing ability
 Returns from the investment
 This is an important measure in the credit
analysis. The banker needs to have an idea
about the extent of returns likely to be
obtained from the proposed investment. The
demand for credit can be accepted only when
the borrower will be able to generate returns
that will enable him to tide over the costs. The
main concern here is that the borrower should
be able to generate incremental income when
they go for the additional returns from the
borrowed funds.
 Repayment capacity:
 This simply means the ability of the borrower
to clear off the loan obtained for production
purposes within the time stipulated by the
bank. The loan amount may be productive
enough to generate additional income to the
borrower, but it may not be productive
enough to repay the loan. Hence, the
necessary condition here is that the loan
should not only be profitable but also have
potential for effecting repayment. Then only
the borrower has a favorable point on his side.
 Risk bearing ability
 It is the ability of the borrower to withstand
the risks that arise due to financial loss. Risk
can be quantified through statistical
techniques like coefficient of variation,
standard deviation, programming models etc.
Undiscounted Measures
 Undiscounted cash flow is the amount of cash that
has not been adjusted to account for the time value
of money. It is used to calculate the entity’s expected
cash flows, which are then used to calculate
expected losses and residual returns. It can be
simplified as the cash flows expected to be generated
or incurred by a project, which have not been
reduced to their present value. Mostly used when
interest rates are low or expected cash flows are for
short period of time.
 Discounted cash flows consider the time value of
money, while undiscounted cash flows do not.
 Discounted cash flows are more accurate than
undiscounted cash flows.
 Discounted cash flow= [Cash flow for the
1st year divided by (1+r)1] + [Cash flow for
the 2nd year divided by (1+r)2] +….[Cash
flow for the nth year divided by (1+r)n]
 r= discount rate
 N=additional years
 Ranking by
inspection
With the same investment, two projects produced
the same net value of incremental production for a
period, but one continues to earn longer than the
other. In other instances, for the same investment
total net value of incremental production may be
the same, but one project has more of the flow
earlier in the time sequence say in the second year
itself than the other in the third year. In many cases
projects can indeed be examined or rejected on the
basis of inspection. A clear-cut case may be two
alternative investments, one of which will cost
more than the return. Such a choice project
analysis must be done before selecting any
projects.
Pay Back Period
 Pay back period is the length of time from the
beginning of the project to until the net value
of the incremental production stream reaches
the total amount of the capital investment.
Two drawbacks are:
 It does not take into account the timings of
the proceeds (time value of money).
 It fails to consider earnings after pay back
period.
Project Evaluation or Capital
Budgeting or Investment evaluation
 Project evaluation is an integral part of the planning
process. At the stage of preparation of projects, it
implies examining the relative profitability of a
project vis-à-vis other projects to enable planners in
the choice of priority projects.
 Capital budgeting: The process in which a
business determines whether projects such as
building a new plant or investing in a long term
venture are worth pursuing. Oftentimes, a
prospective project’s lifetime cash inflows and
outflows are assessed in order to determine whether
the returns generated meet a sufficient target
benchmark. It is also known as “investment
appraisal”.
Why capital budgeting?
 Long term impact as capital is fixed on durable
assets for long time
 Investment in fisheries assets or equipment is on
specialized assets or equipment. Once, their utility
is over, it is difficult to convert this investment on
some other or it will be costly to convert
specialized investment to liquid assets.
 Relatively huge investment have to be made on
some of the fishery equipment.
 Investment mostly on illiquid assets. That is once
capital is committed on these purposes; we can
convert them into cash or into some other
purpose.

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Financial Management

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