INTRODUCTION

Financial management involves planning for the future of a person or a business venture to
guarantee a positive cash flow. It includes the administration and maintenance of financial
assets. Besides, financial management covers the process of identifying and managing risks.
From an organizational point of view, the process of financial management is connected with
financial planning and financial control. Financial planning seeks to measure various
financial resources available and plan the size and timing of expenditures. Financial control
refers to monitoring cash flow. Inflow is the amount of money coming into a particular
company, while outflow is a record of the expenditure being made by the company.
Managing this movement of funds in relation to the budget is essential for a business.

Finance has three functions that involve three major decisions a company must make:

• The investment decision- The most important of all three decisions, capital investment
is the allocation of capital to investment proposals whose benefits are to be realized in
future (Van Horne, 2007). Investment decisions relate to products or projects, working
capital management, and mergers or acquisition of assets. These may be real assets,
such as land, buildings, plant, equipment, stocks, patents and trademarks, or financial
assets, such as shares and Government securities. (Dobbins, 2007). Financial
management in the hospitality industry deals particularly with investment decisions
which begins with the determination of total assets required for operations (Iyengar,
2008).
• The financing decision- Financing decisions mainly relate to the best mix of financing
to fund the firm's operations. It relates to capital structure, leasing decision, and
dividend policy (Van Horne, 2007).
• The dividend/share repurchase decision- This involves the amount of cash to
distribute to stockholders. There are two methods of distribution: cash dividends and
share repurchase (Van Horne, 2007).
CAPITAL STRUCTURE
The objective of a firm is to maximize its current market value, which is to maximize
shareholder wealth. Firms create wealth by making successful investment decisions which
generate positive net cash flows. The capital structure decision determines the balance of debt
and equity in the firm, and is a financing decision. Thus, if corporate managers can maximize
the market value of the firm by manipulating the debt-equity ratio, then they should do so.
The optimal capital structure policy, if there is one, is the policy which maximizes
shareholder wealth (Dobbins, 2007).

WORKING CAPITAL MANAGEMENT

Any business operation would require fixed or permanent capital and fluctuating or working
capital for successful operations. Investment in the form of land, kitchen equipments,
furniture, etc. signifies fixed capital. Investment in current assets required to support the daily
operations of the business, on the other hand, is known as the working capital of the operation
(Iyengar, 2008).
Working Capital Management is also a short term financial management; the day-to-day
financial activities that deal with current assets (inventories, debtors, short term holdings of
marketable securities, and cash) and current liabilities (short-term debt, trade creditors,
accruals, and provisions) (Chandra, 2010).

Working capital is usually defined as stock, debtors and cash. These are the firm's current
assets. Net working capital is usually defined as the difference between current assets and
current liabilities.
Cash is pushed into stock, stock is sold to the customers, and then finally debtors pay back in
cash. Section B includes creditors, raw materials and work in progress. Materials are
processed to become work in progress, which is finally converted into finished goods.
Finished goods are sold to the customers, who eventually pay back in cash. This same cash
then enters the working capital cycle to create further finished goods, new debtors and
additional cash receipts (Dobbins, 2007).

CAPITAL BUDGETING
Decisions regarding investment in projects and products fall within the field of capital
budgeting, which is the art of investing in assets which are worth more than they cost. Capital
budgeting is the process of analysing investment opportunities in long-term assets which are
expected to produce benefits for more than one year (Bennouna, Meredith & Marchant, 2010;
as cited in Peterson and Fabozzi, 2002).

Costs and budgets involved with the capital budgeting process must be measured in terms of
cash flow. An organization invests cash in the present with the intention of receiving even
more cash in the future. Costs are cash outflows, and benefits are cash inflows. Cash outflows
are a reasonable measure of costs and by the same principle, cash inflows are a realistic
parameter to gauge benefits (Iyengar, 2008).
Capital Budgeting Models:

Managers in the hospitality industries use a variety of capital budgeting models. These
models are divided into two categories:

• Non-discounted cash flow techniques:

- Accounting rate of return (ARR)- This is determined as

Post – tax profits / Book Value of investment

The higher the ARR, the better would be the project.

- Payback period- The payback period is the length of time required to recover the
initial investment. It is generally assumed that the shorter the payback period, the
better is the investment.

Payback period= Initial investment/Average cash flow

The main advantage with these methods is their simplicity. Payback period is used to
test a manager's gut reaction to a project; it gives the manager a feel as to the length of
time cash is at risk. The ARR only requires the accounting post tax profits that are
easily obtainable from the books of accounts. However, these methods do not indicate
whether a project is wealth-creating. They do not calculate the time value of money.
The payback period method does not consider cash flows after the period. For this
reason, discounted cash flow techniques are preferred.
(Dobbins, 2007 and Iyengar, 2008)

• Discounted cash flow techniques- In order to calculate the present value of the firm it
is necessary to use the technique of discounting, which takes into consideration the
time value of money, is regarded as theoretically correct, and includes at least four
different discounting models: Net Present Value (NPV), Internal Rate of Return
(IRR), Modified Internal Rate of Return (MIRR), and Profitability Index (PI)
(Bennouna, Meredith & Marchant, 2010; as cited in Brigham and Ehrhardt, 2002).
The value of money is time-dependant (Rs 100 now is worth more than Rs 100 at
some future date) and this needs to be taken into account in valuing the firm. A future
sum of money may be transformed into an equivalent present sum of money by
 applying a discount rate. Thus selection of an appropriate discount rate allows the
present values of all the firm's forecast cash flows at various future dates to be
obtained.

NET PRESENT VALUE & INTERNAL RATE OF RETURN

The Net Present Value (NPV) is the divergence between the sum of the discounted cash flows
which are expected from the investment in a project, & the amount which is originally
invested. The calculation of NPV is affected by four parameters:

• The economic life

• The cash flow pattern

• The initial outlay

• The cost of capital

Internal Rate of Return is the interest rate that equates the present value of the benefits of a
project with the present value of the costs. The calculation of IRR is affected by three
parameters:

• The economic life

• The cash flow pattern &

• The initial outlay

The cost of capital (i.e., the hurdle rate or required rate of return) does not enter into the IRR
formula. Hence, the calculation of the same may be delayed until venture selection. While
NPV and IRR are equivalent with respect to the investment decision (accept or eliminate) for
a single project, they differ from each other with respect to theoretical & procedural
perspectives.
 Perspectives NPV Method IRR Method

Theoretical Perspectives

1. Consistency with Explicit Implicit

Wealth Maximization

2. Reinvestment Rate Generally Applicable Specifically applicable

Assumption

Procedural Perspectives:

1. Information Requires all parameters for Delays the requirement for

Requirement calculation COG

2. Calculation Method Direct method Trial and Error

3. Consideration of Easy and Meaningful Difficult and sometimes

variations in COG inapplicable

4. Implementation of Flexible Inflexible and sometimes

inflation inapplicable

5. Alternating signs of Can be incorporated Sometimes no solutions or

cash flows multiple solutions

Theoretically, NPV is taken to be superior to IRR, NPV is synonymous to wealth

maximization & also makes realistic assumption with regard to rates. However, calculation of
IRR is more intense than NPV. IRR though is more convenient as well because cost of capital
need not be specified.

Academicians in general prefer NPV over IRR, yet they do not recommend calculation of the
same every time because no two methods can substitute the same unconditionally. A
systematic analysis of the survey results conducted in the last fifteen years shows that larger
firms prefer IRR more than smaller firms.

Example:
Imagine a hotel operator is considering which of two mutually exclusive potential investment
opportunities, Project A or Project B, it will promote to the owner of a hotel it manages. The
following data is available:
Years Project A Project B
0 (3000) (2000)
1 660 440
2 660 440
3 660 440
4 660 440
5 3660 2440

The company’s cost of capital is 12%. Select the best alternative.

The best method to use in selecting between mutually exclusive projects in NPV, thus the net
cash flows for each project is discounted at the rate of the cost of capital rate (12%) and the
project that yields the highest NPV is selected.
Years Project A PVIF @ 12% Project A*PVIF
0 (3000) 1 (3000)
1 660 0.8929 589.2857
2 660 0.7972 526.148
3 660 0.7118 469.775
4 660 0.6355 419.4419
5 3660 0.5674 2076.782
NPV 1081.433

Years Project B PVIF @ 12% Project B*PVIF

0 (2000) 1 (2000)
1 600 0.8929 392.8571
2 600 0.7972 350.7653
3 600 0.7118 313.1833
4 600 0.6355 279.628
5 2600 0.5674 1384.522
NPV 720.9552
Project A gives NPV that is higher than Project B, thus it is more feasible.

Case Study:
The following case study compares hotel capital budgeting practices in Australia employed
within and outside the hotel sector. It was found that net present value and internal rate of
return, which are based on discounting approaches, are used to a relatively low degree in the
hotel industry, and more than half the hotels surveyed either exclusively use the payback
method (36%) or use no financial investment appraisal method at all (17%).
“It is widely claimed that NPV and IRR, which involve the discounting of future cash flows,
are the preferred and more sophisticated investment appraisal practices (Butler, Davies,
Pike, & Sharp, 1993; Payne et al., 1999). It is therefore particularly pertinent to highlight
that these are the two practices that are used to a relatively low degree in hotels when
compared to the non-hotel sector (Mann-Whitney U, p < .01). Of the four investment
appraisal techniques reviewed, in the non-hotel sector, NPV and IRR are the two highest
ranking investment appraisal techniques. In the hotel sector, they rank second and fourth.
The fact that IRR ranks second in the non-hotel sector and last in the hotel sector appears to
be a particularly noteworthy observation. It is also noteworthy, in light of the widely claimed
weaknesses of the PB method, that this is the most popular technique among hotels. It is used
significantly more than all other techniques appraised (Wilcoxon signed ranks test; p < .01).
Despite this, the hotel sector is not using PB significantly more than the non-hotel sector. It
would appear that the non-hotel sector is placing greater emphasis on a breadth of
investment appraisal techniques.”
(Guilding and Lamminmaki, 2007)

CONCLUSION
Financial management is largely concerned with financing, dividend and investment
decisions of the firm with some overall goal in mind. Corporate finance theory has developed
around the goal of maximising the shareholder wealth or value. Financing decisions deal with
the firm’s optimal capital structure in terms of debt and equity. Dividend decisions relate to
the form in which returns generated by the firm are passed on to equity holders. Investment
decisions deal with how much funds should be invested and what assets should be invested
in. Funds are invested in both short-term and long term assets. Capital budgeting is primarily
concerned with sizable investments in long-term assets. Thus, they have a long-range impact
on the firms’ performance and are critical to the firm’s success or failure. Both NPV and IRR
are consistent with the goal of maximising a firm’s value, use cash flows and consider cash
flow timing. Finance theory asserts that NPV is the best method for evaluating capital
investment projects. But it is noted that both NPV and IRR are used in a relatively lower
degree in the hotel industry as compared to non-discounted cash flow techniques such as
payback period and accounting rate of return.

BIBLIOGRAPHY

Books

• Chandra, P. 2010. Financial Management, Theory and Practice. 7th ed. New Delhi:
Tata McGraw Hill.

• Dayananda, D. et al. 2002. Capital Budgeting: Financial Appraisal of Investment

Projects. United Kingdom: Cambridge University Press

• Iyengar, A. 2008. Hotel Finance. New Delhi: Oxford University Press

 • Van Horne, J.C. 2007. Financial Management and Policy. 12th Edn. New Delhi:
Pearson Education, Inc.

E-Journals
• Dobbins, R. 2007. Introduction to Financial Management. pp. 5-110. Emerald
Backfiles.

• Guilding, C. and Lamminmaki, D. 2007. Benchmarking Hotel Capital Budgeting

Practices To Practices Applied In Non-Hotel Companies. Journal of Hospitality &
Tourism Research. 31: 486. Published online by Sage Publications. <
http://jht.sagepub.com/content/31/4/486> Accessed on 24th Jan 2011
• Radtke, R., & Cheng, A. (1994). The Applicability & Usage of NPV & IRR In Capital
Budgeting Techniques. Emerald Backfiles 2007 , 20 (7), pp. 10-36.

Other Sources
• http://www.economywatch.com/finance/financial-management.html Accessed on 23rd
Jan 2011