Financial Management - 2 Marks

Concept of time value of money The value of money changes over a period of time. Normally, the value of money increases with time i.e. the value of one rupee in hand today is less as compared to one rupee that was available yesterday but is more than one rupee that would be available tomorrow. Thus, we speak of present value and future value. The process of converting present value to future value is known as compounding and the process of inferring the present value from the future value is known as discounting. Reasons for time value of money There are three major reasons for time value of money1. Inflationary conditions leading to price level changes of goods and services 2. Purchasing power parity leading to changes in the value of the currency of a country 3. Individuals preference for the present as against the uncertain and dynamic future; consequently, whenever one individual sacrifices something in the present, he would like to have more in the future. Annuity & Perpetuity Both represent a series of cash flows (inflows or outflows). A series of cash flows where the amounts are the same and occur at equal intervals of time for a specified period of time is known as annuity. In an ordinary annuity (deferred), payments or receipts occur at the end of each period. In an annuity due, the payments or receipts occur at the beginning of each period. If the same series of cash flows extend to an infinite time period without any specific limit, then it is known as perpetuity. Concept of Risk and classification In the case of investment in financial assets, risk is defined as the variability in the level of expected earnings. Based on the source, risk may be categorized into systematic and unsystematic risk. Systematic risk refers to the variability in the expected earnings caused by changes in macro/micro economic factors that influence the working of all business enterprises across all sectors. For example, changes in inflation, interest rates, tax rates, currency parity, government policies, etc. influence the working of all business enterprises. This is also known as market risk and nondiversifiable risk. On the other hand, unsystematic risk refers to the variability in the expected earnings caused by changes in a specific firm or a company; for instance, labor strike in a factory would influence the working of only that company to which the factory relates and not any other entity. This is also known as firm specific or company specific or diversifiable risk. Risk return relationships The general principle is that risk and return are proportionate to each other i.e. higher the risk, higher the level of expected earnings. There are two important graphical relationships in this context, namely, Characteristic Regression Line (CRL) and Securities Market Line (SML). CRL depicts the linear relationship between expected market return (X axis) and the corresponding expected return on a given stock (Y axis). The slope of this line represents the Beta factor of the stock. The Y-intercept represents the Alpha factor of the stock. While the former is an indicator of the impact of the systematic risk on the stock, the latter is a measure of the influence of

the unsystematic risk. SML depicts the linear relationship between the beta values of the various securities in the market place (X axis) and the corresponding expected returns of the respective stocks (Y axis). The slope of the line is the market risk premium (excess of expected return on the market portfolio over risk free rate of return i.e. Rm Rf) while the Y intercept is the magnitude of the risk free rate of return (Rf). Beta This is a sensitivity factor that indicates the impact of the systematic risk on the returns of a given stock or share. By definition, the beta value of the stock market as a whole is taken as +1. The beta value of any stock is defined with reference to this with the help of both sign and magnitude. For instance, if the beta value is +1.25, then, it is interpreted as follows* A + sign would mean that the change in the price of the stock is expected to be in the same direction as that of the market (indicated in terms of the change in the stock market index). In other words, the change in stock price is positively correlated with the change in stock market index. * A value of 1.25 would mean that the expected return on the stock would be 1.25 times that of the expected return on the market portfolio. CAPM Capital Asset Pricing Model is a mathematical relationship that connects the risk of a security with the expected return. It is given as Ri = Rf + (Rm Rf) Where Ri = Expected return of a security i Rf = Risk free rate of return Rm = Expected return on the market portfolio = Beta factor of the security (indicating the impact of systematic risk) Yield to Maturity In the case of a redeemable bond or a deep discount bond, YTM represents the expected return for the investor if he or she decides to buy the bond at the current price and continues to hold it till the redemption price as decided by the issuer. Yield to Call In the case of long term bonds, the issuer (the company) as per the arrangement with the investor reserves the right of early redemption in case of decrease in the interest rates in the economy. This is known as Call provision. Yield to Call hence represents the expected return for the investor if he or she decides to buy the bond at the current price and continues to hold it till the redemption at the earliest period of time when the call provision can be exercised by the company. Capital Rationing A firm may face situations of deciding amongst competing capital investment proposals. Though there may be many competing proposals that are financially acceptable, the total financial capital available for investment is scarce. In such situations, the firm is forced to distribute the capital in the most economically profitable manner to ensure maximum value to the owners. This is known as capital rationing.

Degree of Operating Leverage and Degree of Financial Leverage Degree of Operating Leverage measures the rate of change in the operating profit (earnings before interest and tax) to the rate of change in the sales value of a firm at a given level of activity. With increase in sales turnover, DOL tends to decrease indicating that the impact of operating risk decreases. Degree of Financial Leverage measures the rate of change in the earnings per share to the rate of change in the operating profit (EBIT), at a given level of activity. With increase in EBIT, DFL tends to decrease indicating that the impact of financial risk decreases. The product of DOL and DFL is known as degree of total or composite or combined leverage and measures the rate of change in EPS to the rate of change in Sales at a given level of activity. Capital Structuring The process by which a firm decides on the mix of owners funds and borrowed funds in the long term capital is known as capital structuring. EBIT-EPS indifference point For a given capital structure, with changes in EBIT (operating profit), EPS would change. For competing capital structures, there may be a level of EBIT at which EPS would be the same. Such a level of EBIT is known as EBIT-EPS indifference point. Signaling Hypothesis. Change in the amount of a dividend sends a signal to investors. An increase in dividends tells investors the company expects continued growth; a reduction in dividends tells investors that the company is facing or is going to face cash flow issues. Clientele Effect Some investors prefer no dividends and others prefer large dividends. invest in companies which have the dividend policy they prefer.

Investors

Bonus share (or) Stock dividend A company issues additional shares to existing equity shareholders by way of capitalization of profits in lieu of cash dividends (hence known as stock dividends) Share split Also known as stock split, this represents an increase in the number of equity shares outstanding by reducing the face value of the stock; for example, a 2-for-1 stock split would mean that the face value per share is reduced by one half Buy back of shares Whenever the management of a company feels that there are not enough opportunities for reinvestment of profits resulting in growth in revenues, it may decide to repurchase the equity shares from the existing shareholders subject to regulatory requirements.

Technical insolvency A company that follows aggressive working capital policy focuses on maintaining low level of current assets, thus ensuring minimum net working capital requirement and hence less financing costs for working capital financing and improved profitability. However a low current ratio or liquidity position would mean that the company may not be able to meet unforeseen short term obligations as it does not have much of healthy cash flows in the short term. Such a situation is known as technical insolvency Temporary vs permanent working capital It is often found that as and when the business operations of a enterprise stabilize over a period of time, irrespective of fluctuations in demand for the output, the enterprise has requirement for investment in core current assets (inventory, receivables and cash balance) to meet the scheduled level of activity. Additionally, as and when the demand increases beyond an appreciable level either due to seasonality or otherwise, the investment in net current assets stands increased. Accordingly, the net working capital requirement does not remain constant throughout the year but is found to be composed of a minimum requirement for the entire period known as permanent working capital and the other component that fluctuates with reference to a given period known as temporary working capital. Trade off between liquidity vs profitability Working capital management decision is all about the trade off between liquidity and profitability. There are certain firms whose management is keen on maintaining high level of current assets, at times even more than what is required for the planned level of activity. In such cases, the liquidity position of the firm i.e. ability to meet short term obligations is high though as a result of increased cost of financing the working capital, the profitability is low. These firms are said to follow a conservative approach to working capital. On the other hand, there are some firms whose management is keen on saving interest costs on financing working capital by reducing the net working capital requirement; this is done by ensuring very minimal level of current assets. Consequently the liquidation position is not healthy though profitability stands enhanced. Such firms are said to follow an aggressive working capital management policy Trading of Debt vs Equity Net working capital is all about balancing current assets against current liabilities. Some firms believe in ensuring prompt payment of all its short term obligations like dues to trade creditors, settlement of all outstanding expenses and provisions on stated time irrespective of changes in its current assets positions or fluctuations in demand for the output. Such firms maintain high level of current assets funded by own funds. They would like to maintain low level of current liabilities. Such a situation is known as trading on equity. As against this, some other firms may try to stretch the payables and squeeze all that is possible from creditors to ensure that own investment in net working capital is minimized. Such a situation is known as trading on debt. Factoring The selling of receivables to a financial institution known as factor, usually without recourse (i.e. in case of the debtor failing to pay the amount due, the factor bears the risk of bad debt and it does not revert to the seller)

Commercial Paper Short-term, unsecured promissory notes, generally issued by large companies (highly reputed) (mostly to fund working capital requirements) Perpetual Bond A bond (debt instrument) with no stated maturity or redemption or repayment period; it carries periodic interest to the investor; normally such bonds are listed in the secondary market so that whenever an investor wants he or she may liquidate the investment and convert the same into cash Intrinsic value of shares The maximum value which an investor is willing to pay for buying a share of a company, given the expected benefits over the holding period and the expected return given the risks of the investment; this represents the real worth of the share considering all relevant factors that would influence the benefits arising from the investment Ex-post vs Ex-ante return Ex-post indicates historical or realized return i.e. return calculated over a holding period in the past; Ex-ante indicates expected or return during a period in the future Rule of 72 and 69 Both these are thumb rules to compute the doubling period of an investment; Rule of 72 is given by doubling period = 72 / (rate of interest) while Rule of 69 is given by doubling perod = 0.35 + 69/(rate of interest) Effective rate vs Nominal rate Whenever the compounding frequency i.e. the period for which interest is calculated per year is more than one, effective annual rate is higher than the nominal rate; by definition, effective annual rate = (1+r/m)m 1 where r = nominal rate of interest and m = number of times interest is computed every year (compounding frequency) Holding period and Annualized return The return from an investment is usually given by (Surplus from investment/Cost of investment) expressed in percentage terms. If the period of holding the investment i.e. time period between buying and selling is exactly one year, then the return is expressed on % p.a. basis. If the holding period is not equal to a year, then the return computed for the holding period must be adjusted to arrive at the annualized return.

Other important terms ABC Method of inventory control The method that controls expensive inventory items more closely than less expensive items Agency Costs Costs associated with monitoring management to ensure that it behaves in ways consistent with the firms contractual agreements with creditors and shareholders. Agency theory Theory relating to the behavior of Principals (owners) and their agents (Say, managers); Deals with the conflicts of interest that arises when agents execute their function; for instance, the managers of a firm are in real terms not only responsible for maximizing the wealth of owners but are also equally responsible for safe guarding the interests of the employees, customers and suppliers. In doing so, they may face a situation wherein they face a dilemma arising out of their action influencing all these groups in different ways, some of which may be favorable while the rest may be adverse. Ageing Schedule The process of classifying accounts receivable by their age outstanding as of a given date Arbitrage A situation involving mispricing of assets i.e. one asset having two different prices at the same point of time, in two different markets, creating a situation of exploiting the same by buying low and selling high simultaneously to make profits. Convertible bond A bond that is convertible into a specified number of equity shares at the option of the bond holder at a specified point of time (on or before the redemption) Cost of capital The required rate of return on the various types of financing; the overall cost of capital is the weighted average of the individual required rates of returns (costs) and is known as Weighted Average Cost of Capital (WACC) Covenant A restriction on a borrower imposed by a lender; for example, the lender may restrict the borrowing company from distributing profits as dividends beyond a particular level till all the loans have been settled. Dilution The decrease in the Earnings per share as well as proportional claim on assets of equity shareholders as a result of issue of additional equity shares Economic Order Quantity The quantity of inventory to be ordered each time so that the total costs (sum total of ordering costs and carrying costs) is minimized for a given period

Financial Leverage The influence on the profits to the equity shareholder as a result of the firm using loans carrying fixed financing costs; Also known as gearing. Floatation costs The costs associated with issuing securities (shares or bonds) such as underwriting, legal expenses, listing expenses, printing and promotional expenses, etc. Gross Working Capital The firms investment in current assets (such as cash and marketable securities, receivables and inventory) IPO Initial Public Offering indicating the first time issue of equity shares by a company to the public Lead time The length of time between the placement of an order for an inventory item and when the item is received in inventory Mutually exclusive projects Two or more projects are said to be mutually exclusive if acceptance of one precludes (excludes) the acceptance of one or more alternative projects Net Working Capital The firms investment in net current assets (sum total of cash and marketable securities, receivables and inventory less current liabilities such as payables and outstanding expenses) Operating Cycle The length of time from the commitment of cash for purchases until the collection of receivables resulting from the sale of goods or services Portfolio A combination of two or more securities or assets P/E ratio Price earnings ratio computed by dividing the market price per share of a firms equity share by the most recent 12 months EPS (earnings per share); it is indicative of the future growth prospects of the firm as perceived by the investors in the market; higher the P/E, higher the growth prospects and lower the risk of investment Primary market A market where new securities (shares and bonds issued by a company) are bought and sold for the first time (also known as new issue market) Record date The date, set by the board of directors when a dividend is declared, on which an investor must be a shareholder of record to be entitled to the upcoming dividend

Safety Stock Inventory stock held in reserve as a cushion against uncertain demand (or usage) and replenishment lead time Secondary Market A market for existing securities (shares and bonds already issued by a company) rather than new issues; in short, a market wherein prospective buyers and sellers trade on shares and bonds already issued Stretching accounts payable Postponing payment of the amount due to the suppliers beyond the end of the net (credit) period Warrant A relatively long term right given to the holder of such a security to purchase equity shares at a specified exercise price over a specified period of time Zero coupon bond A bond that pays no interest but is normally issued at a deep discount as compared to its face value;