MONEY IS
IMPORTANT IN
THIS WORLD

Finances24.pro

Strategic financial management


  1. 1. 1 Strategic Financial Management By Binoy john varghese
  2. 2.Strategic Financial Management Strategic financial management refers to both, financial implications or aspects of various business strategies, and strategic management of finance. It is an approach to management that relates financial techniques, tools and methodologies to strategic decisions making to have a long-term futuristic perspective of financial well being of the firm to facilitate growth, sustenance and competitive edge consistently.
  3. 3.Strategic Financial Management An approach to management that applies financial techniques to strategic decision making. Definition: “the application of financial techniques to strategic decisions in order to help achieve the decision-maker's objectives” Strategy: a carefully devised plan of action to achieve a goal, or the art of developing or carrying out such a plan
  4. 4.Strategic Financial Management Strategic Financial Management refers to both, financial implications or aspects of various business strategies, and strategic management of finances.
  5. 5.Strategic Financial Decisions Strategic Financial Management Deals with: 1. Investment decisions  Long Term Investment Decisions  Short Term Investment Decision 1. Financing Decisions  Best means of financing- Debt Equity Ratio 1. Liquidity Decisions  Organization maintain adequate cash reserves or kind such that the operations run smoothly 1. Dividend Decisions  Disbursement of Dividend to Share holder and Retained Earnings 5. Profitability Decisions
  6. 6.Strategic Financial Decisions Strategic Financial Management also Deals with: 1. Valuation of the firm 2. Strategic Risk Management 3. Strategic investments analysis and capital budgeting 4. Corporate restructuring and financial aspects 5. Strategic financial evaluation 6. Strategic capital restructuring 7. Strategic international financial management 8. Strategic financial engineering and architecture 9. Strategic market expansion planning 10.Strategic compensation planning 11.Strategic innovation expenditure 12.Other business challenges
  7. 7.Investment decisions The investment decision relates to the selection of assets in which funds will be invested by a firm. The assets which can be acquired fall into two broad groups: (a) long-term assets (Capital Budgeting) (b) short-term or current assets (Working Capital Management). (a) Long Term Investment Decisions Capital Budgeting Capital budgeting is probably the most crucial financial decision of a firm. It relates to the selection of an asset or investment proposal or course of action whose benefits are likely to be available in future over the lifetime of the project. Capital Budgeting decisions Use Pay Back period, NPV, IRR, etc. for evaluation
  8. 8.Investment Decisions (b)Short Term Investment Decision Working Capital Management : Working capital management is concerned with the management of current assets. It is an important and integral part of financial management as short-term survival is a prerequisite for long-term success. Fixed Part of working capital –managed from long term funds Fluctuating Part of Working Capital –managed from short term funds
  9. 9.Financing Decisions The second major decision involved in financial management is the financing decision. The investment decision is broadly concerned with the asset-mix or the composition of the assets of a firm. The concern of the financing decision is with the financing-mix or capital structure or leverage. There are two aspects of the financing decision. First, the theory of capital structure which shows the theoretical relationship between the employment of debt and the return to the shareholders. The second aspect of the financing decision is the determination of an appropriate capital structure, given the facts of a particular case. Thus, the financing decision covers two interrelated aspects: (1) the capital structure theory, and (2) the capital structure decision.
  10. 10.Dividend Decisions Two alternatives are available in dealing with the profits of a firm. (1)They can be distributed to the shareholders in the form of dividends or (2)They can be retained in the business itself. It depends on the dividend-pay out ratio, that is, what proportion of net profits should be paid out to the share holders. It depends upon the preference of the shareholders and investment opportunities available within the firm
  11. 11.Profitability Management The source of revenue has to be pre-decided to obtain profits in future. It is closely related to investment decisions as revenue generation will be from operations, investments and divestments.
  12. 12.12 Working Capital Decision Gross working capital (GWC) GWC refers to the firm’s total investment in current assets. Current assets are the assets which can be converted into cash within an accounting year (or operating cycle) and include cash, short- term securities, debtors, (accounts receivable or book debts) bills receivable and stock (inventory).
  13. 13.13 Concepts of Working Capital Net working capital (NWC). NWC refers to the difference between current assets and current liabilities. Current liabilities (CL) are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses. NWC can be positive or negative. Positive NWC = CA > CL Negative NWC = CA < CL
  14. 14.14 Concepts of Working Capital GWC focuses on – Optimization of current investment – Financing of current assets NWC focuses on – Liquidity position of the firm – Judicious mix of short-term and long-tern financing
  15. 15.15 Operating Cycle Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. The operating cycle of a manufacturing company involves three phases: – Acquisition of resources such as raw material, labour, power and fuel etc. – Manufacture of the product which includes conversion of raw material into work-in-progress into finished goods. – Sale of the product either for cash or on credit. Credit sales create account receivable for collection.
  16. 16.Working Capital Management Receivables Management Investment in receivable • volume of credit sales • collection period Credit policy • credit standards • credit terms • collection efforts Cash Management
  17. 17.Working Capital Management Inventory Management Stocks of manufactured products and the material that make up the product. Components: • raw materials • work-in-process • finished goods • stores and spares (supplies)
  18. 18.Working Capital Management Cash Management Cash management is concerned with the managing of: – cash flows into and out of the firm, – cash flows within the firm, and – cash balances held by the firm at a point of time by financing deficit or investing surplus cash
  19. 19.Functions of Financial Manager 1. Financial Forecasting and Planning 2. Acquisition of funds 3. Investment of funds 4. Helping in Valuation Decisions 5. Maintain Proper Liquidity
  20. 20.Financial Policy Criteria describing a corporation's choices regarding its debt/equity mix, currencies of denomination, maturity structure, method of financing investment projects, and hedging decisions with a goal of maximizing the value of the firm to some set of stockholders. Hedging: A strategy designed to reduce investment risk using call options, put options, short-selling, or futures contracts. Its purpose is to reduce the volatility of a portfolio by reducing the risk of loss.
  21. 21.Strategic planning Strategic planning is an organization's process of defining its strategy, or direction, and making decisions on allocating its resources to pursue this strategy, including its capital and people. Various business analysis techniques can be used in strategic planning, including SWOT analysis (Strengths, Weaknesses, Opportunities, and Threats ), PEST analysis (Political, Economic, Social, and Technological), STEER analysis (Socio-cultural, Technological, Economic, Ecological, and Regulatory factors), and EPISTEL (Environment, Political, Informatic, Social, Technological, Economic and Legal).
  22. 22.Strategic planning Strategic planning is the formal consideration of an organization's future course. All strategic planning deals with at least one of three key questions: "What do we do?" "For whom do we do it?" "How do we excel?" In business strategic planning, some authors phrase the third question as "How can we beat or avoid competition?". (Bradford and Duncan, page 1). But this approach is more about defeating competitors than about excelling.
  23. 23.Strategic planning In many organizations, this is viewed as a process for determining where an organization is going over the next year or - more typically - 3 to 5 years (long term), although some extend their vision to 20 years. In order to determine where it is going, the organization needs to know exactly where it stands, then determine where it wants to go and how it will get there. The resulting document is called the "strategic plan." It is also true that strategic planning may be a tool for effectively plotting the direction of a company; however, strategic planning itself cannot foretell exactly how the market will evolve and what issues will surface in the coming days in order to plan your organizational strategy. Therefore, strategic innovation and tinkering with the 'strategic plan' have to be a cornerstone strategy for an organization to survive the turbulent business climate.
  24. 24.Characteristics of Strategic planning Successful Strategic planning constitutes the following features. It should: 1. Exhibit impacts in daily routine 2. Facilitate dynamic, forward and backward thinking process 3. Counters repetitive patterns of mistakes, especially human tendencies 4. Remain clear and simple 5. Ensure planning is complete only when it is properly implemented 6. Designate a core planning team with a level of autonomy 7. Constitute collective leadership and involvement of key stakeholders in decision making
  25. 25.Mission and Vision Mission: Defines the fundamental purpose of an organization or an enterprise, succinctly describing why it exists and what it does to achieve its Vision A Vision statement outlines what the organization wants to be, or how it wants the world in which it operates to be. It concentrates on the future. It is a source of inspiration. It provides clear decision- making criteria.
  26. 26.26 Finance Functions Investment or Long Term Asset Mix Decision Financing or Capital Mix Decision Dividend or Profit Allocation Decision Liquidity or Short Term Asset Mix Decision
  27. 27.Strategic Financial Planning A Financial Plan is statement of what is to be done in a future time. Most decisions have long lead times, which means they take a long time to implement. In an uncertain world, this requires that decisions be made far in advance of their implementation
  28. 28.Strategic Financial Planning It formulates the method by which financial goals are to be achieved. There are two dimensions: 1. A Time Frame – Short run is probably anything less than a year. – Long run is anything over that; usually taken to be a two- year to five-year period. 2. A Level of Aggregation – Each division and operational unit should have a plan. – As the capital-budgeting analyses of each of the firm’s divisions are added up, the firm aggregates these small projects as a big project.
  29. 29.Strategic Financial Planning Scenario Analysis Each division might be asked to prepare three different plans for the near term future: 1. A Worst Case- This plan would require making the worst possible assumptions about the companies products and the state of the economy 2. A Normal Case- This plan would require making the most likely assumptions about the company and the economy 3. A Best Case- Each divisions would be required to work out a case based on optimistic assumptions. It could involve new products and expansion.
  30. 30.Components of Financial Strategy Start-Up Costs A new business venture, even those started by existing companies, has start-up costs. An existing manufacturer looking to release a new line of product has costs that may include new fabricating equipment, new packaging and a marketing plan. Include your start-up costs in your financial strategy. Competitive Analysis Your competition affects how you make money and how you spend money. The products and marketing activities of your competition should be included in your financial strategy. An analysis of how the competition will affect revenue needs to be included in your planning.
  31. 31.Components of Financial Strategy Ongoing Costs These include labor, materials, equipment maintenance, shipping and facilities costs, such as lease and utilities. Break down your ongoing cost projections into monthly numbers to include as part of your financial strategy. Revenue In order to create an effective financial strategy, you need to forecast revenue over the length of the project. A comprehensive revenue forecast is necessary when determining how much will be available to pay your ongoing costs, and how much will remain as profit.
  32. 32.Objectives and Goals Goal: The Financial Goal of the firm should be shareholder’s wealth maximization, as reflected in the market value of the firm’s share. Firms’ primary objective is maximizing the welfare of owners, but, in operational terms, they focus on the satisfaction of its customers through the production of goods and services needed by them
  33. 33.1-33 Objectives Of Financial Management The term objective is used to in the sense of a goal or decision criteria for the three decisions involved in financial management The goal of the financial manager is to maximise the owners/shareholders wealth as reflected in share prices rather than profit/EPS maximisation because the latter ignores the timing of returns, does not directly consider cash flows and ignores risk. As key determinants of share price, both return and risk must be assessed by the financial manager when evaluating decision alternatives. The EVA is a popular measure to determine whether an investment positively contributes to the owners wealth.
  34. 34.1-34 Objectives Of Financial Management However, the wealth maximizing action of the finance managers should be consistent with the preservation of the wealth of stakeholders, that is, groups such as employees, customers, suppliers, creditors, owners and others who have a direct link to the firm.
  35. 35.35 Finance Manager’s Role • Raising of Funds • Allocation of Funds • Profit Planning • Understanding Capital Markets Financial Goals • Profit maximization (profit after tax) • Maximizing Earnings per Share • Shareholder’s Wealth Maximization
  36. 36.36 Profit Maximization Maximizing the Rupee Income of Firm – Resources are efficiently utilized – Appropriate measure of firm performance – Serves interest of society also
  37. 37.37 Objections to Profit Maximization It is Vague It Ignores the Timing of Returns It Ignores Risk Assumes Perfect Competition In new business environment profit maximization is regarded as Unrealistic Difficult Inappropriate Immoral.
  38. 38.38 Maximizing EPS Ignores timing and risk of the expected benefit Market value is not a function of EPS. Hence maximizing EPS will not result in highest price for company's shares Maximizing EPS implies that the firm should make no dividend payment so long as funds can be invested at positive rate of return—such a policy may not always work
  39. 39.39 Shareholders’ Wealth Maximization Maximizes the net present value of a course of action to shareholders. Accounts for the timing and risk of the expected benefits. Benefits are measured in terms of cash flows. Fundamental objective—maximize the market value of the firm’s shares.
  40. 40.40 Risk-return Trade-off Risk and expected return move in tandem; the greater the risk, the greater the expected return. Financial decisions of the firm are guided by the risk-return trade-off. The return and risk relationship: Return = Risk- free rate + Risk premium Risk-free rate is a compensation for time and risk premium for risk.
  41. 41.41 Managers Versus Shareholders’ Goals A company has stakeholders such as employees, debt- holders, consumers, suppliers, government and society. Managers may perceive their role as reconciling conflicting objectives of stakeholders. This stakeholders’ view of managers’ role may compromise with the objective of SWM. Managers may pursue their own personal goals at the cost of shareholders, or may play safe and create satisfactory wealth for shareholders than the maximum. Managers may avoid taking high investment and financing risks that may otherwise be needed to maximize shareholders’ wealth. Such “satisfying” behaviour of managers will frustrate the objective of SWM as a normative guide.
  42. 42.42 Financial Goals and Firm’s Mission and Objectives Firms’ primary objective is maximizing the welfare of owners, but, in operational terms, they focus on the satisfaction of its customers through the production of goods and services needed by them Firms state their vision, mission and values in broad terms Wealth maximization is more appropriately a decision criterion, rather than an objective or a goal. Goals or objectives are missions or basic purposes of a firm’s existence
  43. 43.43 Financial Goals and Firm’s Mission and Objectives The shareholders’ wealth maximization is the second-level criterion ensuring that the decision meets the minimum standard of the economic performance. In the final decision-making, the judgement of management plays the crucial role. The wealth maximization criterion would simply indicate whether an action is economically viable or not.
  44. 44.What Will the Planning Process Accomplish? Interactions The plan must make explicit the linkages between investment proposals and the firm’s financing choices. Options The plan provides an opportunity for the firm to weigh its various options. Feasibility- The different plans must fit into the overall corporation objective of maximizing shareholder wealth Avoiding Surprises One of the purpose of financial planning is to avoid surprise.
  45. 45.Strategic Planning Process
  46. 46.Strategic Planning Strategic Planning relates to planning in advance for a long period of time. This facilitates predicting the future and devising a course of action well in advance. It deals with future course of action consistent with the business environment changes.
  47. 47.Components of Strategic Planning 1. Vision- Organization visualizes what it would like to in future 2. Mission- Deals with distinctive purpose which an organization is striving for. It declares the main concerns or priorities and principles of the business firm. 3. Goals – They are concrete aims which enhance the motivation of organization teams which prepare themselves in specific aspects. 4. Objectives- intend to put forward in precise terms what an organization wants to achieve, where it wants to be in future, what are the tasks that needs to be achieved in short spans of time.
  48. 48.Process of Strategic Planning 1.Visualizing ideal future 2.Identifying critical success factors 3.Analyzing the present status of the company both internal and external 4.Identifying core areas and core competencies and opportunities available in the environment 5.Focusing on core areas and devising strategy accordingly 6.Designing of long-range plan 7.Implementing plans and transition management 8.Reviewing and redesigning and updating and checking discrepancies 9.Achieving desired outcomes
  49. 49.Benefits of Strategic Planning 1. Development and articulation of the vision into mission 2. Standardization and innovation in the dimensions get included for the analysis for decision making 3. More acceptance throughout the organization and from stakeholders 4. Results into a more tolerant, enduring and dynamic organization 5. Opportunities in external environment can be tapped 6. Identifies competitive position and enables competitive advantage through growth and sustenance
  50. 50.Benefits of Strategic Planning 7. Cross functional approach integrates the systems for implementation 8. Flow of vision and its orientation to all levels and departments in an organization 9. Well-directed inputs to reduce wastage are encouraged 10. Facilities prioritization and utilization of resources 11.Empowerment leads to commitment and contribution of ideas at all levels 12. The broad view of strategic level is transferred to narrower levels of the organization
  51. 51.Financial Planning Model: The Ingredients 1. Sales forecast 2. Pro forma statements 3. Asset requirements 4. Financial requirements 5. Plug 6. Economic assumptions
  52. 52.3-52 1. Sales Forecast  All financial plans require a sales forecast.  Perfect foreknowledge is impossible since sales depend on the uncertain future state of the economy.  Businesses that specialize in macroeconomic and industry projects can be help in estimating sales.
  53. 53.3-53 2. Pro Forma Statements  The financial plan will have a forecast balance sheet, a forecast income statement, and a forecast sources-and- uses-of-cash statement.  These are called pro forma statements or pro formas.
  54. 54.3-54 3. Asset Requirements  The financial plan will describe projected capital spending.  In addition it will the discuss the proposed uses of net working capital.
  55. 55.3-55 4. Financial Requirements  The plan will include a section on financing arrangements.  Dividend policy and capital structure policy should be addressed.  If new funds are to be raised, the plan should consider what kinds of securities must be sold and what methods of issuance are most appropriate.
  56. 56.3-56 5. Plug  Compatibility across various growth targets will usually require adjustment in a third variable.  Suppose a financial planner assumes that sales, costs, and net income will rise at g1. Further, suppose that the planner desires assets and liabilities to grow at a different rate, g2. These two rates may be incompatible unless a third variable is adjusted. For example, compatibility may only be reached if outstanding stock grows at a third rate, g3.  Compatibility across various growth targets will usually require adjustment in a third variable.  Suppose a financial planner assumes that sales, costs, and net income will rise at g1. Further, suppose that the planner desires assets and liabilities to grow at a different rate, g2. These two rates may be incompatible unless a third variable is adjusted. For example, compatibility may only be reached if outstanding stock grows at a third rate, g3.
  57. 57.3-57 6. Economic Assumptions The plan must explicitly state the economic environment in which the firm expects to reside over the life of the plan. Interest rate forecasts are part of the plan. The plan must explicitly state the economic environment in which the firm expects to reside over the life of the plan. Interest rate forecasts are part of the plan.
  58. 58.Matt H. Evans, matt@exinfm.com Strategic Planning Model
  59. 59.9S Model of SFM Nine S Model combines the quantitative and qualitative skills of a strategist. 1.Sanctity 2.Selectivity 3.System 4.Strategic Cost Management 5.Sensitivity 6.Sustainability 7.Superiority 8.Structural Flexibility
  60. 60.9S Model of SFM 1. Sanctity refers to the ‘ethical economics’ of business. This approach offers a long-term, sustainable ‘brand-equity’ to the enterprise which ultimately reduces every cost at every stage of a product life cycle. 2. Selectivity refers to the most appropriate business choices based on an enterprise's core competence. SFM should concentrate on building up a most flexible core competence together with strategic cost mangement.
  61. 61.9S Model of SFM 3. System- emphasizes the need for a supportive mechanism to make ‘SFM’ a continued success. It refers to the technological, accounting, information and operational systems of an enterprise. 4. Strategic Cost Management- is the micro-level strategic analysis of various cost-structure and cost implications. Some of costing methods are; Activity Based Costing (or Objective Based Costing), Life Cycle Costing, Notional Cost Benefit Analysis, Cost analysis for establishing the validity of a certain value-chain of an enterprise, etc.
  62. 62.9S Model of SFM 5.Sensitivity- It is to know the strategic use of every piece of information. It convert technical data into commercial data. Sensitivity depends on the capacity to transform ‘x’ information into ‘y’ in minimum possible amount of cost and time. 6. Sustainability- of performance is a matter of long-term strategic planning. Strategic plan requires a very careful combination of ‘business strategy ‘ and ‘business funding strategy’. It also means ‘managing new competitors’ with extra cost on sustenance’.
  63. 63.9S Model of SFM 7. Superiority- refers to the position of ‘Leadership’ that an enterprise must attain in the market. SFM should aim at maintaining both positions in the same market and little paradoxical. 8. Structural Flexibility- It is the sum total of the qualitative and quantitative adaptability and adjustability of an organization. Sunk cost, Committed cost, Engineered cost, Capacity Costa, Burden costs and corrective cost could be huge if structural flexibility is absent.
  64. 64.9S Model of SFM 9. Soul Searching- It is based on continuous bench marking and requires a tremendous amount of financial alertness, innovation and total exposure to new variables and parameters. It also refers to establishing new heights of achievement and newer core-competences. The 9 references of SFM ultimately aim for, ‘Wealth Maximization through the accelerating Effect’.
  65. 65.Strategic planning Strategic planning is an organization's process of defining its strategy, or direction, and making decisions on allocating its resources to pursue this strategy, including its capital and people.
  66. 66.Strategic planning Various business analysis techniques can be used in strategic planning, including SWOT analysis (Strengths, Weaknesses, Opportunities, and Threats ), PEST analysis (Political, Economic, Social, and Technological), STEER analysis (Socio- cultural, Technological, Economic, Ecological, and Regulatory factors), and EPISTEL (Environment, Political, Informatic, Social, Technological, Economic and Legal).
  67. 67.Strategic planning Strategic planning is the formal consideration of an organization's future course. All strategic planning deals with at least one of three key questions: "What do we do?" "For whom do we do it?" "How do we excel?" In business strategic planning, some authors phrase the third question as "How can we beat or avoid competition?". (Bradford and Duncan, page 1). But this approach is more about defeating competitors than about excelling.
  68. 68.Strategic planning In many organizations, this is viewed as a process for determining where an organization is going over the next year or - more typically - 3 to 5 years (long term), although some extend their vision to 20 years. In order to determine where it is going, the organization needs to know exactly where it stands, then determine where it wants to go and how it will get there. The resulting document is called the "strategic plan." It is also true that strategic planning may be a tool for effectively plotting the direction of a company; however, strategic planning itself cannot foretell exactly how the market will evolve and what issues will surface in the coming days in order to plan your organizational strategy. Therefore, strategic innovation and tinkering with the 'strategic plan' have to be a cornerstone strategy for an organization to survive the turbulent business climate.
  69. 69.Characteristics of Strategic planning Successful Strategic planning constitutes the following features. It should: 1. Exhibit impacts in daily routine 2. Facilitate dynamic, forward and backward thinking process 3. Counters repetitive patterns of mistakes, especially human tendencies 4. Remain clear and simple 5. Ensure planning is complete only when it is properly implemented 6. Designate a core planning team with a level of autonomy 7. Constitute collective leadership and involvement of key stakeholders in decision making
  70. 70.Vision Goals Components of Strategic planning or Strategic Intent Mission Objectives
  71. 71.Components of Strategic Planning 1. Vision- Organization visualizes what it would like to in future 2. Mission- Deals with distinctive purpose which an organization is striving for. It declares the main concerns or priorities and principles of the business firm. 3. Goals – They are concrete aims which enhance the motivation of organization teams which prepare themselves in specific aspects. 4. Objectives- intend to put forward in precise terms what an organization wants to achieve, where it wants to be in future, what are the tasks that needs to be achieved in short spans of time.
  72. 72.Vision A Vision statement outlines what the organization wants to be, or how it wants the world in which it operates to be. It concentrates on the future. It is a source of inspiration. It provides clear decision-making criteria. Every organization visualizes what it would like to be in future. Vision describes a wishful long-term desire of the company with out mentioning the steps or plans to be used in order to set the target.
  73. 73.Mission Mission: Defines the fundamental purpose of an organization or an enterprise, describing why it exists and what it does to achieve its Vision. Mission deals with a distinctive Purpose which a organization is striving for. A well defined mission statement declares the main concerns or priorities and principles of the business firm
  74. 74.Objectives Objectives intend to put forward in precise terms what an organization wants to achieve where it wants to be in future, what are the tasks that needs to be achieved in short spans of time to achieve the future objectives and goals.
  75. 75.Goals Goals are the concrete aims or targets which enhance the motivation of the organizational teams which prepare themselves in specific aspects. Goals provide the benefit of breaking down or fragmenting the broader mission into more concert and clear tasks that are understandable, and responsibilities are allocated to individuals and teams in the organization.
  76. 76.Financial Objectives and Goals Goal: The Financial Goal of the firm should be shareholder’s wealth maximization, as reflected in the market value of the firm’s share. Firms’ primary objective is maximizing the welfare of owners, but, in operational terms, they focus on the satisfaction of its customers through the production of goods and services needed by them
  77. 77.1-77 Objectives Of Financial Management The term objective is used to in the sense of a goal or decision criteria for the three decisions involved in financial management The goal of the financial manager is to maximise the owners/shareholders wealth as reflected in share prices rather than profit/EPS maximisation because the latter ignores the timing of returns, does not directly consider cash flows and ignores risk. As key determinants of share price, both return and risk must be assessed by the financial manager when evaluating decision alternatives. The EVA is a popular measure to determine whether an investment positively contributes to the owners wealth.
  78. 78.1-78 Objectives Of Financial Management However, the wealth maximizing action of the finance managers should be consistent with the preservation of the wealth of stakeholders, that is, groups such as employees, customers, suppliers, creditors, owners and others who have a direct link to the firm.
  79. 79.79 Finance Manager’s Role • Raising of Funds • Allocation of Funds • Profit Planning • Understanding Capital Markets Financial Goals • Profit maximization (profit after tax) • Maximizing Earnings per Share • Shareholder’s Wealth Maximization
  80. 80.Strategic Financial Planning A Financial Plan is statement of what is to be done in a future time. Most decisions have long lead times, which means they take a long

    time to implement. In an uncertain world, this requires that decisions be made far in advance of their implementation

  81. 81.Strategic Financial Planning It formulates the method by which financial goals are to be achieved. There are two dimensions: 1. A Time Frame – Short run is probably anything less than a year. – Long run is anything over that; usually taken to be a two- year to five-year period. 2. A Level of Aggregation – Each division and operational unit should have a plan. – As the capital-budgeting analyses of each of the firm’s divisions are added up, the firm aggregates these small projects as a big project.
  82. 82.Strategic Financial Planning Scenario Analysis Each division might be asked to prepare three different plans for the near term future: 1. A Worst Case- This plan would require making the worst possible assumptions about the companies products and the state of the economy 2. A Normal Case- This plan would require making the most likely assumptions about the company and the economy 3. A Best Case- Each divisions would be required to work out a case based on optimistic assumptions. It could involve new products and expansion.
  83. 83.Components of Financial Strategy Start-Up Costs A new business venture, even those started by existing companies, has start-up costs. An existing manufacturer looking to release a new line of product has costs that may include new fabricating equipment, new packaging and a marketing plan. Include your start-up costs in your financial strategy. Competitive Analysis Your competition affects how you make money and how you spend money. The products and marketing activities of your competition should be included in your financial strategy. An analysis of how the competition will affect revenue needs to be included in your planning.
  84. 84.Components of Financial Strategy Ongoing Costs These include labor, materials, equipment maintenance, shipping and facilities costs, such as lease and utilities. Break down your ongoing cost projections into monthly numbers to include as part of your financial strategy. Revenue In order to create an effective financial strategy, you need to forecast revenue over the length of the project. A comprehensive revenue forecast is necessary when determining how much will be available to pay your ongoing costs, and how much will remain as profit.
  85. 85.85 Objections to Profit Maximization It is Vague It Ignores the Timing of Returns It Ignores Risk Assumes Perfect Competition In new business environment profit maximization is regarded as Unrealistic Difficult Inappropriate Immoral.
  86. 86.86 Maximizing EPS Ignores timing and risk of the expected benefit Market value is not a function of EPS. Hence maximizing EPS will not result in highest price for company's shares Maximizing EPS implies that the firm should make no dividend payment so long as funds can be invested at positive rate of return—such a policy may not always work
  87. 87.87 Shareholders’ Wealth Maximization Maximizes the net present value of a course of action to shareholders. Accounts for the timing and risk of the expected benefits. Benefits are measured in terms of cash flows. Fundamental objective—maximize the market value of the firm’s shares.
  88. 88.88 Risk-return Trade-off Risk and expected return move in tandem; the greater the risk, the greater the expected return. Financial decisions of the firm are guided by the risk-return trade-off. The return and risk relationship: Return = Risk- free rate + Risk premium Risk-free rate is a compensation for time and risk premium for risk.
  89. 89.89 Managers Versus Shareholders’ Goals A company has stakeholders such as employees, debt- holders, consumers, suppliers, government and society. Managers may perceive their role as reconciling conflicting objectives of stakeholders. This stakeholders’ view of managers’ role may compromise with the objective of SWM. Managers may pursue their own personal goals at the cost of shareholders, or may play safe and create satisfactory wealth for shareholders than the maximum. Managers may avoid taking high investment and financing risks that may otherwise be needed to maximize shareholders’ wealth. Such “satisfying” behaviour of managers will frustrate the objective of SWM as a normative guide.
  90. 90.90 Financial Goals and Firm’s Mission and Objectives Firms’ primary objective is maximizing the welfare of owners, but, in operational terms, they focus on the satisfaction of its customers through the production of goods and services needed by them Firms state their vision, mission and values in broad terms Wealth maximization is more appropriately a decision criterion, rather than an objective or a goal. Goals or objectives are missions or basic purposes of a firm’s existence
  91. 91.91 Financial Goals and Firm’s Mission and Objectives The shareholders’ wealth maximization is the second-level criterion ensuring that the decision meets the minimum standard of the economic performance. In the final decision-making, the judgement of management plays the crucial role. The wealth maximization criterion would simply indicate whether an action is economically viable or not.
  92. 92.What Will the Planning Process Accomplish? Interactions The plan must make explicit the linkages between investment proposals and the firm’s financing choices. Options The plan provides an opportunity for the firm to weigh its various options. Feasibility- The different plans must fit into the overall corporation objective of maximizing shareholder wealth Avoiding Surprises One of the purpose of financial planning is to avoid surprise.
  93. 93.Costs and Benefits Financial executives do financial cost benefit analysis. IRR is a method of cost analysis in certain cases and Economic Rate of Return (ERR) should replace the IRR for adequate and rational appraisal of the same project in both the economy. Indicative Cost –Benefit-Analysis may be useful for highly subjective decisions or judgments. The indicative or relative significance of various variables deciding the ultimate outcome of the decision making process can be used for approximate cost benefit analysis.
  94. 94.Costs and Benefits Ongoing business processes require a quick ‘incremental Cost-Benefit analysis’ for quick conclusions. As long as incremental profit exceeds incremental costs, the project is worth while. Sustainable Net incremental Benefit is very often a strategic decision. It also require a lot of strategic analysis based on a long- tem appraisal of the uncertainty involved.
  95. 95.Costs and Benefits The long term project will have to be assessed with an average Cost Benefit Analysis (CBA) for the project’s life cycle. CBA with strategic perspective is of vital significance. Multi-product or multi-locational enterprises always makes use of CBA in totality. LIFE CYCLE COASTING (LCC) is commonly used of the ‘life-cycle strategy formulations of a project.
  96. 96.LIFE CYCLE COASTING (LCC) LCC involve the analysis of the following cost: 1.Cost of Launching 2.Cost of early corrections 3.Cost of take of 4.Cost of consolidation 5.Cost of leadership 6.Cost of Sustainance 7.Cost of Revival 8. Cost of withdrawal from market
  97. 97.97 RISK AND UNCERTAINTY There are two types of expectations individuals may have about the future- – Certainty, and – uncertainty Risk describes a situation where there is not just one possible outcome, but an array of potential returns. Also there are various probabilities for each of the probable returns. Risk refers to a set of unique outcomes for a given event which can be assigned probabilities while uncertainty refers to the outcomes of a given event which are too unsecure to be assigned probabilities.
  98. 98.12 - 98 Risk and Uncertainty Risk refers to the variability in the actual returns vis-à-vis the estimated returns, in terms of cash flows. Risk is an integral part of investment decision. The uncertainty related with the returns from an investment brings risk into an investment. The possibility of variation of actual return from the expected return is known as risk.
  99. 99.12 - 99 Definition of Risk Risk may be defined as “ the chance of future loss that can be foreseen” Risk is the potential for variability in return. Risk involved in capital budgeting can be measured in absolute as well as relative terms. The absolute measures of risk include sensitivity analysis, simulation and standard deviation. The coefficient of variation is a relative measure of risk.
  100. 100.100 Nature of Risk Risk exists because of the inability of the decision-maker to make perfect forecasts. In formal terms, the risk associated with an investment may be defined as the variability that is likely to occur in the future returns from the investment. Three broad categories of the events influencing the investment forecasts: – General economic conditions – Industry factors – Company factors
  101. 101.101 Types of Risk Risk 1. Business Risk a) Internal Business Risk b) External Business Risk 2. Financial Risk Unsystematic Risk 1. Interest Rate Risk 2. Market Risk 3. Purchasing Power Risk 4. Exchange Rate Risk Systematic Risk
  102. 102.12 - 102 Types of Risk It is classified into mainly two types. 1. Systematic Risk 2. Unsystematic Risk Systematic Risk is the risk which is directly related with overall movement in general market or economy. This type of risk covers factors which are external to a particular company and are uncontrollable by the company. Unsystematic Risk refers to variability in returns caused by unique factors relating to that firm or industry like management failure, labor strikes, and shortage of raw material. There are two source of unsystematic or unique risk –business risk and financial risk.
  103. 103.12 - 103 Unsystematic Risk 1. Business Risk 2. Financial Risk 1. Business Risk is the variability in operating income due operating conditions of the company. This can be divided into two types a. Internal Business Risk Factors affecting Internal Business Risk are: Fluctuation in Sale Research and development Personnel management Fixed cost Single product b. External Business Risk Result of operating conditions imposed on the firm circumstances beyond its control. Social and regulatory factors Political Risk Business cycle
  104. 104.12 - 104 Unsystematic Risk 2. Financial Risk It refers to the variability in return due to capital structure. The use of debt with owned funds to increase the return of shareholders is known as financial leverage. If the earnings are low, it may lead to bankruptcy to equity shareholders. Financial risk considers the difference between EBIT and EBT Business risk causes the variation between revenue and EBIT. Financial risk can be avoided by management by reducing borrowed funds
  105. 105.12 - 105 Risk and Uncertainty Risk refers to situation in which the decision maker knows the possible consequences of an investment decision whereas Uncertainty involves a situation about which the likelihood of possible outcome is not known. Risk is the consequence of making wrong decision and due to this, the decision that is made is uncertain. The bigger the risk, the greater the uncertainty.
  106. 106.12 - 106 Types of Uncertainty Uncertainty can be classified into the following categories. 1.Market Uncertainty- caused by factors which are external to the economy. 2.Technical Uncertainty- caused by technical factors like size of production or change in technology 3.Competitive Uncertainty- due to action of competitors 4.Technological Uncertainty- non availability of technology 5.Political Uncertainty- Due to Unstable political system
  107. 107.12 - 107 Source of Uncertainty 1.Information incomplete 2.Reliability of source of Information 3.Variability- Parameters which change over time 4.Linguistic imprecision- People using imprecise terms and expression in communication Causes or Reasons of Risk and Uncertainty 1. Nature of investment 2. Maturity period 3. Amount of investment 4. Bias in data and its assessment 5. Misinterpretation of data 6. Non-availability of managerial talents 7. Method of investment 8. Nature of Business 9. Terms of lending 10. Wrong timing of investment 11. Nature of calamities (disasters) 12. Wrong investment decision 13. Creditworthiness of issuer 14. Obsolescence 15. Salvage ability of investment
  108. 108.12 - 108 Investment Decision Under Risk and Uncertainty Types of Investment Decision 1.Certainty (No Risk)-The estimated returns are equal to the actual return 2.Uncertainty- An uncertain situation in one when probabilities of occurrence of a particular event are not known. In the case of uncertainty, future loss cannot be foreseen. So, it cannot be planned in advance by management 3.Risk- A risky situation is one in which the probabilities of a particular event’s occurrence are known. In the case of risk, chance of future loss can be foreseen due to past experiences.
  109. 109.12 - 109 TECHNIQUES OF INVESTMENT DECISIONS Investment decision techniques refer to the choice by several decision makers of possible outcomes and probabilities of their occurrence under risk and uncertainty. An investment decision always involve a trade-off between risk and return. Assessing risk and incorporating the same in the final decision is an integral part of financial analysis.
  110. 110.12 - 110 TECHNIQUES OF INVESTMENT DECISIONS The main techniques of decision making under the conditions of risk and uncertainty: 1.Risk-adjusted discount rate 2.Certainty equivalent method or approach 3.Statistical Methods a) Standard deviation method b) Coefficient of variation method c) Sensitivity analysis d) Simulation method e) Probability and expected value method f) Decision Tree analysis
  111. 111.12 - 111 Risk Adjusted Discount Rate In this approach a risk premium is added to the risk free discount rate. Risk adjusted discount rate is than used to calculate net present value in the normal manner. Drawbacks of risk-adjusted discount rate method : Risk-adjusted discount rate method relies on accurate assessment of the riskiness of a project. Risk perception and judgment are subjective and susceptible to personal bias.
  112. 112.112 Risk-Adjusted Discount Rate Risk-adjusted discount rate, will allow for both time preference and risk preference and will be a sum of the risk-free rate and the risk-premium rate reflecting the investor’s attitude towards risk. Under CAPM, the risk-premium is the difference between the market rate of return and the risk-free rate multiplied by the beta of the project. =0 NCF NPV = (1 ) n t t t k+ ∑ f rk = k + k
  113. 113.12 - 113 Risk Adjusted Discount Rate (RADR) A project is required to invest Rs. 1,10,000 and is expected to generate cash flows after tax over its economic life of 5 years of Rs. 20,000, Rs. 30,000, Rs. 35000, Rs. 55,000 and Rs. 10,000. Risk free interest rate is 7%, and risk premium 3%. Calculate NPV using RADR method. RADR=Risk free rate + risk premium=7+3=10% Years CFAT Discount Factor (10%) PV 1 20000 0.909 18181.82 2 30000 0.826 24793.39 3 35000 0.751 26296.02 4 55000 0.683 37565.74 5 10000 0.621 6209.21 Total Present Value of Cash Inflow 113046.18 110000.00 3046.18 Cash Out Flow NPV
  114. 114.114 Evaluation of Risk-adjusted Discount Rate The following are the advantages of risk-adjusted discount rate method: – It is simple and can be easily understood. – It has a great deal of intuitive appeal for risk-averse businessman. – It incorporates an attitude (risk-aversion) towards uncertainty. This approach, however, suffers from the following limitations: – There is no easy way of deriving a risk-adjusted discount rate. As discussed earlier, CAPM provides for a basis of calculating the risk-adjusted discount rate. Its use has yet to pick up in practice. – It does not make any risk adjustment in the numerator for the cash flows that are forecast over the future years. – It is based on the assumption that investors are risk-averse. Though it is generally true, there exists a category of risk seekers who do not demand premium for assuming risks; they are willing to pay a premium to take risks.
  115. 115.115 Certainty Equivalent Certainty-equivalent is a common procedure for dealing with risk in capital budgeting to reduce the forecast the cash flows to some conservative levels. There is a certainty-equivalent cash flow for all projects. Certainty-equivalent approach may be expressed as: Where NCF= the forecasts of net cash flow with out risk- adjustment α= the risk adjustment factor or certainty equivalent coefficient k- risk free rate assumed to be constant for all period =0 NCF NPV = (1 )f n t t t t k α + ∑
  116. 116.116 Financial Management, Ninth Edition © I M Pandey Certainty-equivalent coefficient α assumes a value between 0 and 1 If the investor feels that only 80% of expected cash flow is certain, the Certainty-equivalent coefficient will be .80 Certainty-equivalent coefficient can be determined as a relationship between the certain cash flows and risky cash flows. That is If expected cash flow is 80,000 and certain cash flow is 60,000 the Certainty-equivalent coefficient α= 60,000/80,000=0.75 * NCF Certain net cash flow = NCF Risky net cash flow t t t α = Certainty Equivalent
  117. 117.117 Reduce the forecasts of cash flows to some conservative levels. The certainty—equivalent coefficient assumes a value between 0 and 1, and varies inversely with risk. Decision-maker subjectively or objectively establishes the coefficients. The certainty—equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows. =0 NCF NPV = (1 )f n t t t t k α + ∑ * NCF Certain net cash flow = NCF Risky net cash flow t t t α = Certainty Equivalent
  118. 118.118 Certainty Equivalent Sky Way Ltd. is considering an investment proposal which requires 20 lakhs. The expected cash inflow and certainty coefficients are given below: Risk Free interest rate is 6%. Determine NPV of proposal Year Cash Inflow Certainty Coefficient 1 600000 0.90 2 300000 0.85 3 700000 0.80 4 800000 0.75 5 900000 0.65
  119. 119.119 Certainty Equivalent (NPV) Sky Way Ltd. is considering an investment proposal which requires 20 lakhs. The expected cash inflow and certainty coefficients are given below: Risk Free interest rate is 6%. Determine NPV of proposal Year Cash Inflow Certainty Coefficient Certain Cash In Flow Discount Factor (6%) Present Value 1 600000 0.90 540000 0.94 509433.96 2 300000 0.85 255000 0.89 226949.09 3 700000 0.80 560000 0.84 470186.80 4 800000 0.75 600000 0.79 475256.20 5 900000 0.65 585000 0.75 437146.03 2118972.08 2000000.00 118972.08 Present Value of Cash Inflow Present Value of Cash Outflow Net Present Value
  120. 120.120 Certainty Equivalent (IRR) A company is considering an investment proposal whose cost is Rs. 10000 and its economic life is 4 years. Expected cash flow and certainty factor is given. Determine IRR. Year Cash Inflow Certainty Coefficient 1 6667 0.90 2 2500 0.80 3 2000 0.50 4 12500 0.40
  121. 121.121 Certainty Equivalent (IRR) (10841-10000) 841 IRR=12+ ------------------- x 2= 12 + ----- x 2 (11274-10841) 432.92 =12+3.886=15.886% Year Cash Inflow Certainty Coefficient Certain Cash In Flow D.F (10%) P V D.F (12%) P V 1 6667 0.90 6000 0.909 5454.82 0.893 5357.41 2 2500 0.80 2000 0.826 1652.89 0.797 1594.39 3 2000 0.50 1000 0.751 751.31 0.712 711.78 4 12500 0.40 5000 0.683 3415.07 0.636 3177.59 11274.09 10841.17Present Value of Cash Inflow
  122. 122.122 Evaluation of Certainty—Equivalent This method suffers from many dangers in a large enterprise: – First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. – Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast or to make it ultra- conservative. – Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments.
  123. 123.123 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Risk-adjusted Discount Rate Vs. Certainty– Equivalent The certainty—equivalent approach recognises risk in capital budgeting analysis by adjusting estimated cash flows and employs risk-free rate to discount the adjusted cash flows. On the other hand, the risk- adjusted discount rate adjusts for risk by adjusting the discount rate. It has been suggested that the certainty —equivalent approach is theoretically a superior technique. The risk-adjusted discount rate approach will yield the same result as the certainty—equivalent approach if the risk-free rate is constant and the risk-adjusted discount rate is the same for all future periods.
  124. 124.© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 124 Statistical Methods Statistical techniques are analytical tools for handling risky investments. This enable the decision-maker to make decisions under risk or uncertainty. The concept of probability is fundamental to the use of the risk analysis techniques. Probability may be described as a measure of someone’s opinion about the likelihood that an event will occur . Most commonly used method is to use high, low and best guess estimates
  125. 125.12 - 125 Measurement of Risk Statistical Methods a) Standard deviation method b) Coefficient of variation method c) Sensitivity analysis d) Simulation method e) Probability and expected value method f) Decision Tree analysis
  126. 126.© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 126 Measurement of Risk Risk involved in capital budgeting can be measured in absolute as well as relative terms. The absolute measures of risk include Sensitivity analysis, Simulation, and standard deviation. The coefficient of variation is a relative measure of risk.
  127. 127.© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 127 Sensitivity Analysis Sensitivity analysis provides information as to how sensitive the various estimated project parameters, namely selling price, cash flows, cost of capital, unit sold, and project’s economic life about estimation errors. Sensitivity analysis is essentially a ‘what if’ analysis. For example what if labor costs are 5% lower? What if raw material double its price?, etc. By carrying out a series of calculations it is possible to build up a picture of the nature of the risks facing the project and their impact on project profitability.
  128. 128.© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 128 Sensitivity Analysis Advantageous of Sensitivity analysis: Information for decision making To direct search – sensitivity analysis points to some variables being more crucial than others To make contingency plans –managers can make contingency plans if the key parameters differ significantly from the estimates Drawbacks of Sensitivity analysis: The absence of any formal assignment of probabilities to the variations of the parameters is a potential limitation of sensitivity analysis Another criticism of sensitivity analysis is that each variable is changed in isolation while all other factors remain constant. In practice factors change simultaneously
  129. 129.© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 129 Sensitivity Analysis Sensitivity analysis provide information about cash flows normally made under three assumptions: 1) The most pessimistic – the worst 2) The most likely – the expected 3) The most optimistic- the best the outcomes associated with the project
  130. 130.12 - 130 Example 1 From the under mentioned facts, compute the net present values (NPVs) of the two projects for each of the possible cash flows, using sensitivity analysis. Particulars Project X Project Y (’000) (’000) Initial cash outlays (t = 0) Rs 40 Rs 40 Cash inflow estimates (t = 1 – 15) Worst 6 0 Most-likely 8 8 Best 10 16 Required rate of return 0.10 0.10 Economic life (years) 15 15 Solution The NPV of each project, assuming a 10 per cent required rate of return, can be calculated for each of the possible cash flows. Table A-4 indicates that the present value interest factor annuity (PVIFA) of Re 1 for 15 years at 10 per cent discount is 7.606. Multiplying each possible cash flow by Present Value Interest Factor Annuity (PVIFA), we get, (Table 1):
  131. 131.© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 131 Table 1: Determination of NPV Project X Project Y Expected cash inflows PV NPV PV NPV Worst Most likely Best Rs 45,636 60,848 76,060 Rs 5,636 20,848 36,060 Nil Rs 60, 848 1,21,696 (Rs 40,000) 20,848 81,696 Table 1 demonstrates that sensitivity analysis can produce some very useful information about projects that appear equally desirable on the basis of the most likely estimates of their cash flows. Project X is less risky than Project Y. The actual selection of the project (assuming that the projects are mutually exclusive) will depend on the decision maker’s attitude towards risk. If the decision maker is conservative, he will select Project X as there is no possibility of suffering losses. On the other hand, if he is willing to take risks, he will choose Project Y as it has the possibility of paying a very high return as compared to project X. Sensitivity analysis, in spite of being crude, does provide the decision maker with more than one estimate of the project’s outcome and, thus, an insight into the variability of the returns.
  132. 132.© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 132 Assigning Probability It has been shown above that sensitivity analysis provides more than one estimate of the future return of a project. It is, therefore, superior to single- figure forecast as it gives a more precise idea regarding the variability of the returns. But it has a limitation in that it does not disclose the chances of occurrence of these variations. To remedy this shortcoming of sensitivity analysis so as to provide a more accurate forecast, the probability of the occurring variations should also be given. Probability assignment to expected cash flows, therefore, would provide a more precise measure of the variability of cash flows. The concept of probability is helpful as it indicates the percentage chance of occurrence of each possible cash flow. For instance, if some expected cash flow has 0.6 probability of occurrence, it means that the given cash flow is likely to be obtained in 6 out of 10 times (i.e. 60 per cent). Likewise, if a cash flow has a probability of 1, it is certain to occur (as in the case of purchase–lease capital budgeting decision that is, the chances of its occurrence are 100 per cent). With zero probability, the cash flow estimate will never materialise. Thus, probability of obtaining particular cash flow estimates would be between zero and one.
  133. 133.12 - 133 The procedure for assigning probabilities and determining the expected value is illustrated in Table 2 by using the NPVs for projects X and Y of Example 1. TABLE 2 Calculation of Expected Values Possible NPV Probability of the NPV occurrence NPV (×) Probability Project X Rs 5,636 0.25 Rs 1,409 20,848 0.50 10,424 36,060 0.25 9,015 1.00 Expected NPV 20,848 Project Y (40,000) 0.25 (10,000) 20,848 0.50 10,424 81,696 0.25 20,424 1.00 Expected NPV 20,848 The mechanism for calculating the expected monetary value and the NPV of these estimates is further illustrated in Example 2.
  134. 134.© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 134 Example 2 The following information is available regarding the expected cash flows generated, and their probability for company X. What is the expected return on the project? Assuming 10 per cent as the discount rate, find out the present values of the expected monetary values. Year 1 Year 2 Year 3 Cash flows Probability Cash flows Probability Cash flows Probability Rs 3,000 6,000 8,000 0.25 0.50 0.25 Rs 3,000 6,000 8,000 0.50 0.25 0.25 Rs 3,000 6,000 8,000 0.25 0.25 0.50 Solution TABLE 3 (i) Calculation of Expected Monetary Values Year 1 Year 2 Year 3 Cash flows Proba bility Monetar y values Cash flows Probab ility values Monetar y Cash flows Proba bility values Monet ary Rs 3,000 6,000 8,000 Total 0.25 0.50 0.25 Rs 750 3,000 2,000 5,750 Rs 3,000 6,000 8,000 0.50 0.25 0.25 Rs 1,500 1,500 2,000 5,000 Rs 3,000 6,000 8,000 0.25 0.25 0.50 Rs 750 1,500 4,000 6,250
  135. 135.© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 135 (ii) Calculation of Present Values Year 1 Rs 5,750 × 0.909 = Rs 5,226.75 Year 2 5,000 × 0.826 4,130.00 Year 3 6,250 × 0.751 4,693.75 Total 14,050.50
  136. 136.© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 136 Sensitivity analysis Sensitivity analysis can also be used to ascertain how change in key variables (say, sales volume, sales price, variable costs, operating fixed costs, cost of capital and so on) affect the expected outcome (measured in terms of NPV) of the proposed investment project. For the purpose of analysis, only one variable is considered, holding the effect of other variables constant, at a point of time.
  137. 137.Example 6.1 Acmart plc has developed a new product line called Marts. The likely demand is 1,00,000 per year at a price of Rs. 1 for the 4 year period. Cash Flows of Mart Initial Investment Rs. 800,000 Cash Flow per unit Rs. Sale Price 1.00 Costs Labour Material Overhead Cash Flow Per unit 0.20 0.40 0.10 0.70 0.30 Required rate of return is 15% Solution Annual Cash Flow =.30x1,00,000=Rs. 300,000 Present Value of annual cash flows=300,000xannuity factor for 4 years @ 15% =300,000x2.855 =856,500 - Initial Investment =800,000 Net Present Value =+56,500
  138. 138.Sensitivity Analysis What if the price is only 95 ps Annual Cash flow= .25x1,00,000=Rs. 250,000 Present Value of annual cash flows=250,000x2.855 =713,750- Initial Investment =800,000 Net Present Value =-86,250 What if the price rose by 1% Annual Cash flow= .31x1,00,000=Rs. 310,000 Present Value of annual cash flows=310,000x2.855 =885,050- Initial Investment =800,000 Net Present Value =+85,050 What if the quantity demanded is 5% more Annual Cash flow= .30x1,05,000=Rs. 315,000 Present Value of annual cash flows=315,000x2.855 =899.325- Initial Investment =800,000 Net Present Value =+99,325 What if the quantity demanded is 10% less than expected Annual Cash flow= .30x 90,000=Rs. 270,000 Present Value of annual cash flows=270,000x2.855 =770,850- Initial Investment =800,000 Net Present Value =-29,150
  139. 139.Sensitivity Analysis What if discount rate is 20% more than what is originally expected ( 15*1.2=18%) Annual Cash Flow =.30x1,00,000=Rs. 300,000 Present Value of annual cash flows=300,000xannuity factor for 4 years @ 18% =300,000x2.6901 =807,030 - Initial Investment =800,000 Net Present Value =+ 7,030 What if discount rate is 20% lower than what is originally expected ( 15*.8=13.5%) Annual Cash Flow =.30x1,00,000=Rs. 300,000 Present Value of annual cash flows=300,000xannuity factor for 4 years @ 13.5% =300,000x2.9438 =883,140 - Initial Investment =800,000 Net Present Value =+ 83,140
  140. 140.Break-Even NPV The Break-Even point is where NPV is zero. If the NPV is below zero the project is rejected, if it is above zero, it is accepted
  141. 141.Scenario Analysis With Sensitivity Analysis we change one variable at a time and look at the result. Managers are often interested in situation where a number of factors change. They are interested in worst-case and best-case scenario. That is, what NPV will result if all the assumptions made initially turned out to be too optimistic? And what would be the result if, in the event, matters went extremely well on all fronts.
  142. 142.Simulation Simulation is a statistically based behavioral approach used in capital budgeting to get a feel for risk by applying predetermined probability distributions and random numbers to estimate risky outcome

    Similar articles: