Assignment No.

01
Financial Management

Question No. 1

Define financial management. What are the three major functions of financial
management? How they related?

Financial Management:

The process of managing the financial resources, including accounting and financial
reporting, budgeting, collecting accounts receivable, risk management, and insurance for
a business.

Major functions of financial management:

1. Accounting:

Typically includes: (a) planning the program within delegated limits; (b) developing,
revising, and/or adapting accounting systems; (c) executing day-to-day ledger
maintenance and related operations for the classification and other recording of financial
transactions; (d) analyzing the results and interpreting the effects of transactions upon the
financial resources of the organization; (e) applying accounting concepts to solve
problems, render advice, or to meet other needs of management; and (f) managing the
total accounting program, including supervision of subordinate accountants, accounting
technicians, voucher examiners, payroll clerks, and other similar supporting personnel.

2. Budgeting:

Typically includes: (a) the formulation -- developing instructions, calls for estimates,
preparing estimates, reviewing and consolidating estimates; (b) the presentation -- either
within the organization or at hearings (within the agency, at the budget bureau, or
subcommittee); and (c) the execution -- funds control, program adjustments, review of
reports and preparation of reports.

3. Managerial-Financial Reporting:

Typically includes not only the recurring budget, accounting, and financial reports but
also program operation evaluation and statistical reports and other work performance
type reports, both regular and one-time in nature. Managerial-financial reporting is the
process of providing appropriate data to key officials at all levels of management for the
purpose of helping to achieve the most effective program and financial management.
Stress is placed on aiding in the making of management
decisions. Normally, much of such data will be of a financial character, developed from the
accounting and the budget systems; however, frequently data will be a combination of both
financial and non-financial information and, in some cases, the data may be entirely non-
financial in nature. In its ideal form, the data are so integrated as to represent a single total data
system. Since in good managerial-financial reporting, concern is given to the development of the
systems that will provide the essential data, one of the normal responsibilities of the Financial
Manager is the development, revision and/or adaptation of the managerial-financial reporting
system.
4. Advice to Management:

Typically includes: advising from a financial point of view and serving as the technical expert on
the financial aspects of all matters.

B. Functions directly related to the management of financial resources and which may be
included:

1. Management Analysis:

Typically includes: administering, supervising, or performing study, analysis, evaluation,

development or improvement of managerial policies, practices, methods, and procedures;

2. Records or Paperwork Management:

typically includes: operating, maintaining, or administering one or more administrative control

systems, services, processes or functions such as those for forms control, the handling of
correspondence, directives control, the disposition of records;

3. Auditing:

Typically includes: the establishment and improvement of audit policies, programs, methods, and
procedures, and the achievement of a high standard of auditing; the proper timing and coverage
of audits; the disposition of technical accounting questions developed in audits, including
disposition through negotiations and conferences with affected business establishments or other
interested organizations; responsibility for all auditing and related activities in connection with
payments and cost analyses; and shaping, directing, and administering the audit activities;

4. Statistics:

Typically includes: administering or performing professional work, or providing professional

consultation in the application of statistical theories, techniques, and methods to the gathering
and/or interpretation of quantified information; or advising on, administering, supervising, or
performing work involved in collecting, editing, computing, compiling, analyzing; and
presenting statistical data, where the work requires knowledge and application of statistical
methods and procedures, and techniques, but does not require professional knowledge of the
mathematical or statistical theories, assumptions, or principles upon which they are based.
 Question No. 3

Explain the procedure of cash flow estimation for the capital budgeting decision.

Capital budgeting is a required managerial tool. One duty of a financial manager is to choose
investments with satisfactory cash flows and rates of return. Therefore, a financial manager must
be able to decide whether an investment is worth undertaking and be able to choose intelligently
between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select
projects is needed. This procedure is called capital budgeting.

In the form of either debt or equity, capital is a very limited resource. There is a limit to the
volume of credit that the banking system can create in the economy. Commercial banks and
other lending institutions have limited deposits from which they can lend money to individuals,
corporations, and governments. In addition, the Federal Reserve System requires each bank to
maintain part of its deposits as reserves. Having limited resources to lend, lending institutions
are selective in extending loans to their customers. But even if a bank were to extend unlimited
loans to a company, the management of that company would need to consider the impact that
increasing loans would have on the overall cost of financing.

In reality, any firm has limited borrowing resources that should be allocated among the best
investment alternatives. One might argue that a company can issue an almost unlimited amount
of common stock to raise capital. Increasing the number of shares of company stock, however,
will serve only to distribute the same amount of equity among a greater number of shareholders.
In other words, as the number of shares of a company increases, the company ownership of the
individual stockholder may proportionally decrease.

The argument that capital is a limited resource is true of any form of capital, whether debt or
equity (short-term or long-term, common stock) or retained earnings, accounts payable or notes
payable, and so on. Even the best-known firm in an industry or a community can increase its
borrowing up to a certain limit. Once this point has been reached, the firm will either be denied
more credit or be charged a higher interest rate, making borrowing a less desirable way to raise
capital.

Faced with limited sources of capital, management should carefully decide whether a
particular project is economically acceptable. In the case of more than one project, management
must identify the projects that will contribute most to profits and, consequently, to the value (or
wealth) of the firm. This, in essence, is the basis of capital budgeting.
 Basic Data

Expected Net Cash Flow

Year Project L Project S
0 ($100) ($100)
1 10 70
2 60 50
II. Basic Steps of Capital Budgeting 3 80 20
1. Estimate the cash flows
2. Assess the riskiness of the cash flows. III. Evaluation Techniques
3. Determine the appropriate discount rate. A. Payback period
4. Find the PV of the expected cash flows. B. Net present value (NPV)
5. Accept the project if PV of inflows > costs. C. Internal rate of return (IRR)
IRR > Hurdle Rate and/or D. Modified internal rate of return (MIRR)
payback < policy E. Profitability index

Definitions:
Independent versus mutually exclusive projects. A. PAYBACK PERIOD
Normal versus nonnormal projects. Payback period = Expected number of years required to
recover a project’s cost.

Project L
Expected Net Cash Flow
Year Project L Project S
0 ($100) ($100)
1 10 (90)
2 60 (30)
3 80 50
PaybackL = 2 + $30/$80 years If the projects are mutually exclusive, accept Project S since
= 2.4 years. NPVS > NPVL.
PaybackS = 1.6 years.
Note: NPV declines as k increases, and NPV rises as k
decreases.
Weaknesses of Payback:
C. INTERNAL RATE OF RETURN
1. Ignores the time value of money. This weakness is
eliminated with the discounted payback method. CFt
n
IRR : ∑ = $0 = NPV .
2. Ignores cash flows occurring after the payback period. t = 0 (1 + IRR ) t
B. NET PRESENT VALUE
CFt Project L:
n
NPV = ∑
t = 0 (1 + k) t 0 1 2 3
Project L:
−100.00 10 60 80
0 1 2 3 8.47 18.1%
43.02 18.1%
48.57 18.1%
−100.00
9.09 10 60 80
49.59 $ 0.06 ≈ $0
60.11
NPVL = $ 18.79
IRRL = 18.1%
IRRS = 23.6%
NPVS = $19.98
If the projects are independent, accept both because IRR > k.
If the projects are mutually exclusive, accept Project S since
If the projects are independent, accept both.
IRRS > IRRL.

Note: IRR is independent of the cost of capital.

 k NPVL NPVS
0% $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5
NPV
($)

50

40

30 Crossover Point = 8.7%

20 IRRS = 23.6%

10

0
5 10 15 20 25 k(%)

-10 IRRL = 18.1%

1. ADVANTAGES AND DISADVANTAGES OF IRR AND NPV

A number of surveys have shown that, in practice, the IRR method is more popular than the NPV
approach. The reason may be that the IRR is straightforward, but it uses cash flows and
recognizes the time value of money, like the NPV. In other words, while the IRR method is easy
and understandable, it does not have the drawbacks of the ARR and the payback period, both of
which ignore the time value of money.
The main problem with the IRR method is that it often gives unrealistic rates of return.
Suppose the cutoff rate is 11% and the IRR is calculated as 40%. Does this mean that the
management should immediately accept the project because its IRR is 40%. The answer is no!
An IRR of 40% assumes that a firm has the opportunity to reinvest future cash flows at 40%. If
past experience and the economy indicate that 40% is an unrealistic rate for future reinvestments,
an IRR of 40% is suspect. Simply speaking, an IRR of 40% is too good to be true! So unless the
calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as
a yardstick to accept or reject a project.
Another problem with the IRR method is that it may give different rates of return. Suppose
there are two discount rates (two IRRs) that make the present value equal to the initial
investment. In this case, which rate should be used for comparison with the cutoff rate? The
purpose of this question is not to resolve the cases where there are different IRRs. The purpose
is to let you know that the IRR method, despite its popularity in the business world, entails more
problems than a practitioner may think.