Meaning of Financial Management Financial Management means planning, organizing, directing and controlling the financial activities such

as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise. Scope/Elements 1. 2. 3. Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in current assets are also a part of investment decisions called as working capital decisions. Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby. Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two: a. b. Dividend for shareholders- Dividend and the rate of it has to be decided. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise.

Objectives of Financial Management The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be1. 2. 3. 4. 5. To ensure regular and adequate supply of funds to the concern. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management 1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise. Determination of capital composition: Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties. Choice of sources of funds: For additional funds to be procured, a company has many choices likea. Issue of shares and debentures b. Loans to be taken from banks and financial institutions c. Public deposits to be drawn like in form of bonds. Choice of factor will depend on relative merits and demerits of each source and period of financing.

2.

3.

4. 5.

6.

7.

Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible. Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done in two ways: a. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus. b. Retained profits - The volume has to be decided which will depend upon expansional, innovational, diversification plans of the company. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchase of raw materials, etc. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc. EVOLUTION OF FINANCIAL MANAGEMENT The evolution of financial management may be divided into three broad phases: i) The traditional phase ii) The transitional phase iii) The modern phase. In the traditional phase the focus of financial management was on certain events which required funds e.g., major expansion, merger, reorganization etc. The traditional phase was also characterized by heavy emphasis on legal and procedural aspects as at that point of time the functioning of companies was regulated by a plethora of legislation. Another striking characteristic of the traditional phase was that, a financial management was designed and practiced from the outsiders point of view mainly those of investment bankers, lenders, regulatory agencies and other outside interests. During the transitional phase the nature of financial management was the same but more emphasis was laid on problems faced by finance managers in the areas of fund analysis planning and control. The modern phase is characterised by the application of economic theories and the application of quantitative methods of analysis. The distinctive features of the modern phase are: Changes in macro economic situation that has broadened the scope of financial management. The core focus is how on the rational matching of funds to their uses in the light of the decision criteria. The advances in mathematics and statistics have been applied to financial management specially in the areas of financial modeling, demand forecasting and risk analysis.

Goals of financial Management The traditional approach of financial management was all about profit maximization. The main objective of companies was to make profits. The traditional approach of financial management had many limitations: 1.Business may have several other objectives other than profit maximization. Companies may

have goals like: a larger market share, high sales,greater stability and so on.The traditional approach did not take into account so many of these other aspects. 2.Profit Maximization has to defined after taking into account many things like: a.Short term,mid term,and long term profits b.Profits over period of time The traditional approach ignored these important points. 3.Social Responsibility is one of the most important objectives of many firms. Big corporate make an effort towards giving back something to the society. The big companies use a certain amount of the profits for social causes. It seems that the traditional approach did not consider this point. Modern Approach is about the idea of wealth maximization. This involves increasing the Earning per share of the shareholders and to maximize the net present worth. Wealth is equal to the difference between gross present worth of some decision or course of action and the investment required to achieve the expected benefits. Gross present worth involves the capitalized value of the expected benefits. This value is discounted a some rate, this rate depends on the certainty or uncertainty factor of the expected benefits. The Wealth Maximization approach is concerned with the amount of cash flow generated by a course of action rather than the profits. Any course of action that has net present worth above zero or in other words, creates wealth should be selected. OBJECTIVES
PROFIT MAXIMIZATION Actions that increase profits/EPS should be undertaken The investment, financing and dividend policy decisions of a firm should be oriented to the maximization of profits/EPS. PROFITABILITY

WEALTH MAXIMIZATION Value Maximization or Net Present Worth Maximization Based on the concept of cash flows generated by the decision rather than accounting profits. Considers both the quantity and quality dimensions of benefits

The risk-return tradeoff:

The higher the risk of an investment, the higher the expected rate of return must be. The above statement makes sense, doesn't it? After all, none of us really likes risk and we certainly wouldn't accept extra risk unless we received something valuable in return.

Which Would You Choose? For example, let's assume that you have a chance to put $1,000 into a savings account at your local bank at a 4% interest rate. But before you do that, I tell you, "Consider this: Lend me the $1,000 instead and I will pay you the same 4% rate as the bank." Which are the two alternatives would you choose? If you're smart, I think that you would choose to put the money in the bank. After all, the bank account is federally insured and you will receive your $1,000 back even if the bank goes bankrupt. The bank also has several layers of people who have oversight responsibility: the bank's top management, the Board of Directors, and a federal regulator - all with the responsibility of making sure that you get your money back. I, on the other hand, have no one reviewing my actions - I can do whatever I like with your money. If I go bankrupt, you will have a difficult time in getting your money returned. In other words, your risk of lending the money to me is higher than putting it in the bank and, since you don't get any extra return, you choose the bank! No surprise there. However, what if I offered to pay you a 7% rate of interest? Or 10%? Or 15%? Then I might be able to persuade you to lend the money to me. In other words, even though the risk is higher, you now are able to earn a higher rate of return to compensate you for that extra risk.

FUNDAMENTAL PRINCIPLE OF FINANANCIAL MANAGEMENT

A business proposal-regardless of whether it is a new investment or acquisition of another company or a restructuring initiative-raises the value of the firm only if the present value of the future stream of net cash benefits expected from the proposal is greater than the initial cash outlay required to implement the proposal. The difference between the present value of future cash benefits and the initial outlay represents the net present value or NPV of the proposal NPV=present value of future cash benefits-initial cash outlay

FORMS OF BUSINESS ORGANIZATION

BUSINESS FORMS
1.SOLE PROPRIETORSHIPS 2. PARTNER SHIP 3.CORPORATIONS 4.HYBRIDS

1.SOLE PROPRIETORSHIPS
It is a business owned by a single individual that is entitled to all the firms profits and is responsible for all the firms debt. There is no separation between the business and the owner when it comes to debts or being sued.

Sole proprietorships are generally financed by personal loans from family and friends and business loans from banks. Advantages: o o o Easy to start No need to consult others while making decisions Taxed at the personal tax rate

Disadvantages: o o Personally liable for the business debts Ceases on the death of the proprietor

2.PARTNERSHIP
A general partnership is an association of two or more persons who come together as co-owners for the purpose of operating a business for profit. There is no separation between the partnership and the owners with respect to debts or being sued. Advantages: o o o Relatively easy to start Taxed at the personal tax rate Access to funds from multiple sources or partners

Disadvantages: Partners jointly share unlimited liability

LIMITED PARTNERSHIP In limited partnerships, there are two classes of partners: general and limited. The general partners runs the business and face unlimited liability for the firms debts, while the limited partners are only liable on the amount invested. One of the drawback of this form is that it is difficult to transfer the ownership of the general partner.

3.CORPORATION
Corporation is an artificial being, invisible, intangible, and existing only in the contemplation of the law. Corporation can individually sue and be sued, purchase, sell or own property, and its personnel are subject to criminal punishment for crimes committed in the name of the corporation.

Corporation is legally owned by its current stockholders. The Board of directors are elected by the firms shareholders. One responsibility of the board of directors is to appoint the senior management of the firm. Advantages o o o o Liability of owners limited to invested funds Life of corporation is not tied to the owner Easier to transfer ownership Easier to raise Capital

Disadvantages o o Greater regulation Double taxation of dividends

4. HYBRID ORGANIZATIONS
These organizational forms provide a cross between a partnership and a corporation. Limited liability company (LLC) combines the tax benefits of a partnership (no double taxation of earnings) and limited liability benefit of corporation (the owners liability is limited to what they invest). S-type corporation provides limited liability while allowing the business owners to be taxed as if they were a partnership that is, distributions back to the owners are not taxed twice as is the case with dividends in the standard corporate form.

FINANCIAL STATEMENTS
1. Understand the content of the 4 basic financial statements. Focus on 2. 3. Income statement Balance sheet statement Cash flow statement

Evaluate firm profitability using the income statement. Estimate a firms tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate.

Three types of financial statements are mandated by the accounting and financial regulatory authorities: 1. Income statement how much money you made last year? 2. Revenue, expense, profits over a year or quarter.

Balance sheet Whats your current financial situation?

a snap shot on a specific date of 1. Assets (value of what the firm owns), Liabilities (value of firms debts), and Shareholders equity (the money invested by the company owners)

Cash flow statement How did the cash come and go? cash received and cash spent by the firm over a period of time

What is a profit and loss statement?

The profit and loss statement is a summary of the financial performance of a business over time (monthly, quarterly or annually is most common). It reflects the past performance of the business and is the report most often used by small business owners to track how their business is performing. As the name indicates the profit and loss statement (also known as a statement of financial performance or an income statement) measures the profit or loss of a business over a specified period. A profit and loss statement summarises the income for a period and subtracts the expenses incurred for the same period to calculate the profit or loss for the business.

Are profit and loss statements compulsory?

Sole traders, partnerships and small proprietary companies are not required to prepare and lodge a profit and loss statement with their annual tax return. However, they are very useful in helping you to objectively determine the financial performance of your business. Most accounting software packages will produce a profit and loss statement, but you may need the help of a bookkeeper or an accountant unless your business is very small. All public companies and large proprietary companies are required by law to prepare a formal financial report that complies with Australian Accounting Standards for each financial year.

Why prepare a profit and loss statement?

Producing regular profit and loss statements (at least quarterly or monthly) will enable you to:
answer the question, "How much money am I making, if any?" compare your projected performance with actual performance;

compare your performance against industry benchmarks; use past performance trends to form reasonable forecasts for the future; show your business growth and financial health over time; detect any problems regarding sales, margins and expenses within a reasonable time so adjustments may be made to recoup losses or decrease expenses; provide proof of income if you need a loan or mortgage; and calculate your income and expenses when completing and submitting your tax return.

ach component influences the determination of net profit, and are used in the two basic equations.
A profit and loss statement is based on two basic equations:
Gross profit = sales cost of goods sold Net profit = gross profit expenses

Gross profit and net profit is calculated as follows:

Revenue Less Cost of good sold (COGS) Gross Profit $ 550,000 $ 220,000 $ 330,000

Less

Expenses Net Profit (before tax)

$ 275,000 $ 55,000

The main components of a profit and loss statement are:

1. 2. 3. 4. 5. Revenue Cost of goods sold Gross profit Expenses Net profit

Revenue
Revenue (sales) is the total earned from ordinary business operations. Revenue includes sales of goods and services, interest received, dividends, rebates, and rent received. Back to top

Cost of goods sold (COGS)

Cost of goods sold (cost of sales) is the cost of merchandise sold during the period. COGS includes all the costs directly related to getting your inventory ready for sale such as:

the purchase price, import duties, non-recoverable taxes, freight inwards, freight insurance, handling, direct labour, and other costs of converting materials into finished goods.

COGS vary directly with sales and production; the more items you sell or make, the more stock or components you need to buy. Generally, COGS only applies where there is a sale of stock or inventory and is the total direct cost of getting your products into inventory and ready for sale. Items included in the COGS will differ from one type of business to another.
Retail business:
COGS includes the cost of buying stock for resale, and freight inwards.

Manufacturer:
COGS includes the cost of raw materials or parts, and the direct labour costs used to manufacture the product.

Business selling only services (e.g. accountants or consultants):

These usually do not have COGS unless they hire additional casual or contract labour to provide direct services to clients.

For example, the COGS for a bicycle retailer would include the costs of the component parts plus the labour costs used to assemble the bicycle.

COST OF GOODS SOLD IS CALCULATED AS FOLLOWS:

Opening inventory (cost of inventory at the beginning of the period) Plus Equals Inventory purchased (during the period) Total inventory available during the period $ 10,000 $ 43,500 $ 53,500

Less

Closing inventory (cost of all unsold stock) Cost of goods sold

7,000

$ 46,500

Back to top

Gross profit
Gross profit is the difference between sales and the cost of producing or purchasing products or providing services before subtracting operating expenses such as wages, rent, accounting fees, or electricity. Gross profit reflects how efficiently labour and materials are used to produce goods.
Gross profit = sales cost of goods sold

The gross profit margin is one indicator of the financial health of a business. Larger gross profit margins are better for business the higher the percentage, the more the business retains of each dollar of sales for other expenses and net profit.
Gross Profit Margin % = (Gross Profit Sales) x 100

Back to top

Expenses
Expenses (overheads, outgoings) are costs incurred for the purposes of earning income. They include items such as:
wages, rent, accounting and legal fees, electricity, depreciation, and interest paid on loans.

Back to top

Net profit
Net Profit (net income; net earning; the bottom line) is calculated by subtracting expenses from the gross profit, showing what the business has earned (or lost) in a given period of time (usually monthly, quarterly, or annually) after both the cost of goods sold and operating expenses have been taken into account.
Net Profit = Gross Profit Expenses Sole traders

For sole traders, drawings are not an expense and net profit is calculated before the owners benefits are subtracted, and is the total taxable income of the business. You pay tax on the entire net profit, regardless of how much you have taken out for your drawings.
Partners

For partners where no partnership agreement exists, net profit is allocated according to the proportion specified in the partnership agreement. Each partner pays tax on the

proportion of their interest of the total net profit, regardless of how much the partner takes out as drawings.
Companies

For companies, salaries for working directors are treated as an expense along with other employees wages. So, net profit is whats left after these salaries have been subtracted, and it is then available for distribution to shareholders as dividends.
Service businesses

For a service business, net profit will be the difference between the income of the business and its expenses, given there is no gross profit calculation. Refer to the example profit and loss statement.

Example Profit and Loss Statement

Total revenue Less Cost of Goods Sold Gross Profit $ $ $ 1,000,000 426,200 573,800 100% 42.6% 57.4%

Less

Expenses Accounting and legal fees Advertising Depreciation Electricity Insurance Interest and bank charges Postage Printing and stationary Professional memberships Rent for premises $ $ $ $ $ $ $ $ $ $ 11,700 15,000 38,000 2,700 15,200 27,300 1,500 8,700 1,800 74,300

Repairs and maintenance Training Vehicle operating costs Wages and salaries Workers compensation All other expenses Less Equals Total Expenses Net Profit (BOS)

$ $ $ $ $ $ $ $

21,100 6,900 20,000 223,500 6,500 14,100 488,300 85,500 48.8% 8.6%

BOS = Before owners salary

Balance Sheet
A balance sheet, also known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth). The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company's financial statements.

If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyse it and how to read it. How the balance sheet works The balance sheet is divided into two parts that, based on the following equation, must equal (or balance out) each other. The main formula behind balance sheets is: assets = liabilities + shareholders' equity This means that assets, or the means used to operate the company, are balanced by a company's financial obligations along with the equity investment brought into the company and its retained earnings. Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. Owners' equity, referred to as shareholders' equity in a publicly traded company, is the amount of money initially invested into the company plus any retained earnings, and it represents a source of funding for the business. It is important to note, that a balance sheet is a snapshot of the company's financial position at a single point in time. Know the types of assets

Currentassets Current assets have a life span of one year or less, meaning they can be converted easily into cash. Such assets classes are: cash and cash equivalents, accounts receivable and inventory. Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks. Cash equivalents are very safe assets that can be are readily converted into cash such as US Treasuries. Accounts receivable consists of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit, which then are held in this account until they are paid off by the clients. Lastly, inventory represents the raw materials, work-in-progress goods and the company's finished goods. Depending on the company, the exact makeup of the inventory account will differ. For example, a manufacturing firm will carry a large amount of raw materials, while a retail firm caries none. The makeup of a retailers inventory typically consists of goods purchased from manufacturers and wholesalers. Non-currentassets Non-current assets, are those assets that are not turned into cash easily, expected to be turned into cash within a year and/or have a life-span of over a year. They can refer to tangible assets such as machinery, computers, buildings and land. Non-current assets also can be intangible assets, such as goodwill, patents or copyright. While these assets are not physical in nature, they are often the resources that can make or break a company - the value of a brand name, for instance, should not be underestimated. Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life. Learn the different liabilities On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside parties. Like assets, they can be both current and long-term. Long-term liabilities are debts and other nondebt financial obligations, which are due after a period of at least one year from the date of the balance sheet. Current liabilities are the company's liabilities which will come due, or must be paid, within one year. This is comprised of both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan. Shareholders' equity Shareholders' equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder's equity account. This account represents a company's total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders' equity on the other. Read the Balance Sheet Below is an example of a balance sheet:

As you can see from the balance sheet above, it is broken into two sides. Assets are on the left side and the right side contains the company's liabilities and shareholders' equity. It also can be seen that this balance sheet is in balance where the value of the assets equals the combined value of the liabilities and shareholders' equity. Another interesting aspect of the balance sheet is how it is organized. The assets and liabilities sections of the balance sheet are organised by how current the account is. So for the asset side, the accounts are classified typically from most liquid to least liquid. For the liabilities side, the accounts are organized from short to long-term borrowings and other obligations. Analyze the balance sheet with ratios With a greater understanding of the balance sheet and how it is constructed, we can look now at some techniques used to analyze the information contained within the balance sheet. The main way this is done is through financial ratio analysis. Financial ratio analysis uses formulas to gain insight into the company and its operations. For the balance sheet, using financial ratios (like the debt-to-equity ratio) can show you a better idea of the company's financial condition along with its operational efficiency. It is important to note that some ratios will need information from more than one financial statement, such as from the balance sheet and the income statement.

The main types of ratios that use information from the balance sheet are financial strength ratios and activity ratios. Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how they are leveraged. This can give investors an idea of how financially stable the company is and how the company finances itself. Activity ratios focus mainly on current accounts to show how well the company manages its operating cycle (which include receivables, inventory and payables). These ratios can provide insight into the operational efficiency of the company. There are a wide range of individual financial ratios that investors use to learn more about a company.

CASH FLOWS

Classifying Cash Flows into Three Categories

August 2005
This month we continue our discussion of the cash flow statement. Last month we likened the cash flow statement to your bank account statement. It tells you what you actually havenot what might come in and might go out, as is accounted for on the income statement. What the cash flow statement does that your bank statement doesnt do is categorize the amounts that you collected and the amounts that you paid. Your bank account statement only lists the check numbers and deposit dates; it doesnt tell you what all of those inflows and outflows were for. Both the direct and indirect methods divide cash flows into three categories:

Operations Financing Investing

Lets talk about each of these in turn.

Operating Activities
The operations section gives us an idea of how much cash the organization generated in its day-to-day delivery of its products and services. This number can and should be compared with the operating income on the income statement. If operating income and operating cash flow are vastly different, you need to start asking some tough questions. It might mean that the organization is recording sales that will never be collected in cash. Ooh... Cash inflows from operating activities include:

Cash receipts for the sale of goods or services Cash receipts for the collection or sale of operating receivables (receivables arising from the sale of goods or services) Cash interest received Cash dividends received Other cash receipts not directly identified with financing or investing activities

Cash outflows for operating activities include:

Cash payments for trade goods purchased for resale or use in manufacturing Cash payments for notes to suppliers or trade goods Cash payments to other suppliers and to employees Cash paid for taxes, fees, and fines Interest paid to creditors Other cash payments not directly identified with financing or investing activities

Financing Activities
The financing category tells us how much cash was generated by debt or equity financing. Put another way, the financing section details the cash flows between the organization and the folks who help finance the organization through debt and equity. An interesting twist here is that interest used to repay debt is not included in the financing category; it is included in the operating category. Somewhere along the way I have probably told you that accounting is just a set of rules about how to keep records. Not everything is intuitive or sensible. You are just going to have to accept this one and move on!

Cash inflows from financing activities include: Cash proceeds from the sale of stock Cash receipts from borrowing

Cash receipts from contributions and investment income that donors restricted for endowments or for buying, improving, or constructing long-term assets

Cash outflows from financing activities include: Cash disbursed to repay principal on long and short-term debt Cash paid to reacquire common and preferred equity instruments Dividends paid to common and preferred stockholders

Investing Activities
The last category is investing. And, as you might expect, this section of the cash flow statement details how much cash the entity made and used in making investments in other entities, such as the purchase of stocks or bonds of another entity. What you may not expect is that this category includes the purchase and sale of productive assets, such as manufacturing equipment. This is, per the professions view, an investment in the companys future and should not be classified under either operations or financing. Cash inflows from investing activities are:

Collections of principal on debt instruments of other entities Cash proceeds from the sale of equity investments Cash received from the sale of productive assets

Cash outflows from investing activities are:

Cash paid to acquire debt instruments of other entities Cash payments to buy equity interest in other entities Disbursements made to purchase productive assets

TAXES
A tax is a financial charge or other levy imposed upon a tax payer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many administrative. Taxes consist of direct or indirect taxes and may be paid in money or as its labour equivalent.\ Direct tax: Tax on individuals directly Tax burden can be shifted to other people

Time Value of Money Introduction Time Value of Money (TVM) is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities. TVM is based on the concept that a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance, you can invest your dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the year. You can say that the future value of the dollar is $1.06 given a 6% interest rate and a one-year period. It follows that the present value of the $1.06 you expect to receive in one year is only $1. A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date. You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods, Payments, Present Value, and Future Value. Each of these factors is very briefly defined in the right-hand column below. The left column has references to more detailed explanations, formulas, and examples.

Interest Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the amount borrowed per period of time, usually one year. The prevailing market rate is composed of: 1. 2. The Real Rate of Interest that compensates lenders for postponing their own spending during the term of the loan. An Inflation Premium to offset the possibility that inflation may erode the value of the money during the term of the loan. A unit of money (dollar, peso, etc) will purchase progressively fewer goods and services during a period of inflation, so the lender must increase the interest rate to compensate for that loss.. Various Risk Premiums to compensate the lender for risky loans such as those that are unsecured, made to borrowers with questionable credit ratings, or illiquid loans that the lender may not be able to readily resell.

3.

The first two components of the interest rate listed above, the real rate of interest and an inflation premium, collectively are referred to as the nominal risk-free rate. In the USA, the nominal risk-free rate can be approximated by the rate of US Treasury bills since they are generally considered to have a very small risk. Simple Interest Simple interest is calculated on the original principal only. Accumulated interest from prior periods is not used in calculations for the following periods. Simple interest is normally used for a single period of less than a year, such as 30 or 60 days.

Simple Interest = p * i * n

where: p = principal (original amount borrowed or loaned) i = interest rate for one period n = number of periods Example: You borrow $10,000 for 3 years at 5% simple annual interest. interest = p * i * n = 10,000 * .05 * 3 = 1,500 Example 2: You borrow $10,000 for 60 days at 5% simple interest per year (assume a 365 day year). interest = p * i * n = 10,000 * .05 * (60/365) = 82.1917

Compound Interest Compound interest is calculated each period on the original principal and all interest accumulated during past periods. Although the interest may be stated as a yearly rate, the compounding periods can be yearly, semiannually, quarterly, or even continuously. You can think of compound interest as a series of back-to-back simple interest contracts. The interest earned in each period is added to the principal of the previous period to become the principal for the next period. For example, you borrow $10,000 for three years at 5% annual interest compounded annually: interest year 1 = p * i * n = 10,000 * .05 * 1 = 500 interest year 2 = (p2 = p1 + i1) * i * n = (10,000 + 500) * .05 * 1 = 525 interest year 3 = (p3 = p2 + i2) * i * n = (10,500 + 525) *.05 * 1 = 551.25 Total interest earned over the three years = 500 + 525 + 551.25 = 1,576.25. Compare this to 1,500 earned over the same number of years using simple interest. The power of compounding can have an astonishing effect on the accumulation of wealth. This table shows the results of making a one-time investment of $10,000 for 30 years using 12% simple interest, and 12% interest compounded yearly and quarterly.

Type of Interest Simple Compounded Yearly Compounded Quarterly

Principal Plus Interest Earned 46,000.00 299,599.22 347,109.87

You can solve a variety of compounding problems including leases, loans, mortgages, and annuities by using the present value, future value, present value of an annuity, and future value of an annuity formulas.

Number of Periods The variable n in Time Value of Money formulas represents the number of periods. It is intentionally not stated in years since each interval must correspond to a compounding period for a single amount or a payment period for an annuity. The interest rate and number of periods must both be adjusted to reflect the number of compounding periods per year before using them in TVM formulas. For example, if you borrow $1,000 for 2 years at 12% interest compounded quarterly, you must divide the interest rate by 4 to obtain rate of interest per period (i = 3%). You must multiply the number of years by 4 to obtain the total number of periods ( n = 8). You can determine the number of periods required for an initial investment to grow to a specified amount with this formula:

number of periods = natural log [(FV * i) / (PV * i)] / natural log (1 + i)

where: PV = present value, the amount you invested FV = future value, the amount your investment will grow to i = interest per period Example: You put $10,000 into a savings account at a 9.05% annual interest rate compounded annually. How long will it take to double your investment? LN [(20,000 * .0905) / (10,000 * .0905)] / LN (1 .0905) = LN (2) / LN (1.0905) =.69314 / . 08663 = 8 years

Present Value Present Value Of A Single Amount Present Value is an amount today that is equivalent to a future payment, or series of payments, that has been discounted by an appropriate interest rate. Since money has time value, the present value of a promised future amount is worth less the longer you have to wait to receive it. The difference between the two depends on the number of compounding periods involved and the interest (discount) rate. The relationship between the present value and future value can be expressed as:

PV = FV [ 1 / (1 + i)n ]

Where: PV = Present Value FV = Future Value i = Interest Rate Per Period n = Number of Compounding Periods

Example: You want to buy a house 5 years from now for $150,000. Assuming a 6% interest rate compounded annually, how much should you invest today to yield $150,000 in 5 years? FV = 150,000 i =.06 n=5 PV = 150,000 [ 1 / (1 + .06)5 ] = 150,000 (1 / 1.3382255776) = 112,088.73 End of Year Principal Interest Total 1 2 3 4 5

112,088.73 118,814.05 125,942.89 133,499.46 141,509.43 6,725.32 7,128.84 7556.57 8,009.97 8,490.57

118,814.05 125,942.89 133,499.46 141,509.43 150,000.00

Example 2: You find another financial institution that offers an interest rate of 6% compounded semiannually. How much less can you deposit today to yield $150,000 in five years?

Interest is compounded twice per year so you must divide the annual interest rate by two to obtain a rate per period of 3%. Since there are two compounding periods per year, you must multiply the number of years by two to obtain the total number of periods. FV = 150,000 i = .06 / 2 = .03 n = 5 * 2 = 10 PV = 150,000 [ 1 / (1 + .03)10] = 150,000 (1 / 1.343916379) = 111,614.09 Present Value of an Ordinary Annuity The Present Value of an Ordinary Annuity (PVoa) is the value of a stream of expected or promised future payments that have been discounted to a single equivalent value today. It is extremely useful for comparing two separate cash flows that differ in some way. PV-oa can also be thought of as the amount you must invest today at a specific interest rate so that when you withdraw an equal amount each period, the original principal and all accumulated interest will be completely exhausted at the end of the annuity. The Present Value of an Ordinary Annuity could be solved by calculating the present value of each payment in the series using the present value formula and then summing the results. A more direct formula is:

PVoa = PMT [(1 - (1 / (1 + i)n)) / i]

Where: PVoa = Present Value of an Ordinary Annuity PMT = Amount of each payment i = Discount Rate Per Period n = Number of Periods Example 1: What amount must you invest today at 6% compounded annually so that you can withdraw $5,000 at the end of each year for the next 5 years? PMT = 5,000 i = .06 n=5 PVoa = 5,000 [(1 - (1/(1 + .06)5)) / .06] = 5,000 (4.212364) = 21,061.82 Year Begin 1 2 3 4 5

21,061.82 17,325.53 13,365.06 9,166.96 4,716.98

Interest Withdraw End

1,263.71 -5,000

1,039.53 -5,000

801.90 -5,000

550.02 -5,000

283.02 -5,000 .00

17,325.53 13,365.06

9,166.96 4,716.98

Future Value Future Value Of A Single Amount Future Value is the amount of money that an investment made today (the present value) will grow to by some future date. Since money has time value, we naturally expect the future value to be greater than the present value. The difference between the two depends on the number of compounding periodsinvolved and the going interest rate. The relationship between the future value and present value can be expressed as:

FV = PV (1 + i)n

Where: FV = Future Value PV = Present Value i = Interest Rate Per Period n = Number of Compounding Periods Example: You can afford to put $10,000 in a savings account today that pays 6% interest compounded annually. How much will you have 5 years from now if you make no withdrawals? PV = 10,000 i = .06 n=5 FV = 10,000 (1 + .06)5 = 10,000 (1.3382255776) = 13,382.26 End of Year Principal 1 2 3 4 5

10,000.00 10,600.00 11,236.00 11,910.16 12,624.77

Interest Total

600.00

636.00

674.16

714.61

757.49

10,600.00 11,236.00 11,910.16 12,624.77 13,382.26

Example 2: Another financial institution offers to pay 6% compounded semiannually. How much will your $10,000 grow to in five years at this rate? Interest is compounded twice per year so you must divide the annual interest rate by two to obtain a rate per period of 3%. Since there are two compounding periods per year, you must multiply the number of years by two to obtain the total number of periods. PV = 10,000 i = .06 / 2 = .03 n = 5 * 2 = 10 FV = 10,000 (1 + .03)10 = 10,000 (1.343916379) = 13,439.16

Future Value of Annuities An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period.for an annuity due. Future Value of an Ordinary Annuity The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of expected or promised future payments will grow to after a given number of periods at a specific compounded interest. The Future Value of an Ordinary Annuity could be solved by calculating the future value of each individual payment in the series using the future value formula and then summing the results. A more direct formula is:

FVoa = PMT [((1 + i)n - 1) / i]

Where: FVoa = Future Value of an Ordinary Annuity PMT = Amount of each payment i = Interest Rate Per Period n = Number of Periods Example: What amount will accumulate if we deposit $5,000 at the end of each year for the next 5 years? Assume an interest of 6% compounded annually.

PV = 5,000 i = .06 n=5 FVoa = 5,000 [ (1.3382255776 - 1) /.06 ] = 5,000 (5.637092) = 28,185.46 Year Begin Interest Deposit End 1 0 0 5,000.00 2 3 4 5

5,000.00 10,300.00 15,918.00 21,873.08 300.00 5,000.00 618.00 5,000.00 955.08 5,000.00 1,312.38 5,000.00

5,000.00 10,300.00 15,918.00 21,873.08 28,185.46

MERGERS AND ACQUISITIONS

Mergers and acquisitions are the most popular means of corporate restructuring or business combinations in comparison to amalgamation, takeovers, spin-offs, leverage buy-outs, buy-back of shares, capital reorganization, sale of business units and assets etc. Corporate restructuring refers to the changes in ownership, business mix, assets mix and alliances with a motive to increase the value of shareholders. To achieve the objective of wealth maximization, a company should continuously evaluate its portfolio of business, capital mix, ownership and assets arrangements to find out opportunities for increasing the wealth of shareholders. There is a great deal of confusion and disagreement regarding the precise meaning of terms relating to the business combinations, i.e. mergers, acquisition, take-over, amalgamation and consolidation. For example, absorption of Tata Fertilisers Ltd. (TFL) by Tata Chemical Limited (TCL). Consolidation is a combination of two or more companies into a new company. In this form of merger, all companies are legally 3 dissolved and new company is created for example Hindustan Computers Ltd., Hindustan Instruments Limited, Indian Software Company Limited and Indian Reprographics Ltd. Lost their existence and create a new entity HCL Limited.

TYPES OF MERGERS
Mergers may be classified into the following three types- (i) horizontal, (ii) vertical and (iii) conglomerate. HORIZONTAL MERGER Horizontal merger takes place when two or more corporate firms dealing in similar lines of activities combine together. For example, merger of two publishers or two luggage manufacturing companies. Elimination or reduction in competition, putting an end to price cutting, economies of scale in production, research and development, marketing and management are the often cited motives underlying such mergers. VERTICAL MERGER

Vertical merger is a combination of two or more firms involved in different stages of production or distribution. For example, joining of a spinning company and weaving company. Vertical merger may be forward or backward merger. When a company combines with the supplier of material, it is called backward merger and when it combines with the customer, it is known as forward merger. The main advantages of such mergers are lower buying cost of materials, lower distribution costs, assured supplies and market, increasing or creating barriers to entry for competitors etc. CONGLOMERATE MERGER Conglomerate merger is a combination in which a firm in one industry combines with a firm from an unrelated industry. A typical example is merging of different businesses like manufacturing of cement products, fertilizers products, electronic products, insurance investment and advertising agencies. Voltas Ltd. is an example of a conglomerate company. Diversification of risk constitutes the rationale for such mergers. ADVANTAGES OF MERGER AND ACQUISITION The major advantages of merger/acquisitions are mentioned below: Economies of Scale: The operating cost advantage in terms of economies of scale is considered to be the primary objective of mergers. These economies arise because of more intensive utilisation of production capacities, distribution networks, engineering services, research and development facilities, data processing system etc. Economies of scale are the most prominent in the case of horizontal mergers. In vertical merger, the principal sources of benefits are improved coordination of activities, lower inventory levels. Synergy: It results from complementary activities. For examples, one firm may have financial resources while the other has profitable investment opportunities. In the same manner, one firm may have a strong research and development facilities. The merged concern in all these cases will be more effective than the individual firms combined value of merged firms is likely to be greater than the sum of the individual entities. Strategic benefits: If a company has decided to enter or expand in a particular industry through acquisition of a firm engaged in that industry, rather than dependence on internal expansion, may offer several strategic advantages: (i) it can prevent a competitor from establishing a similar position in that industry; (ii) it offers a special timing advantages, (iii) it may entail less risk and even less cost. Tax benefits: Under certain conditions, tax benefits may turn out to be the underlying motive for a merger. Suppose when a firm with accumulated losses and unabsorbed depreciation mergers with a profitmaking firm, tax benefits are utilised better. Because its accumulated losses/unabsorbed depreciation can be set off against the profits of the profit-making firm. Utilisation of surplus funds: A firm in a mature industry may generate a lot of cash but may not have opportunities for profitable investment. In such a situation, a merger with another firm involving cash compensation often represent a more effective utilisation of surplus funds. Diversification: Diversification is yet another major advantage especially in conglomerate merger. The merger between two unrelated firms would tend to reduce business risk, which, in turn reduces the cost of capital (K0) of the firms earnings which enhances the market value of the firm.

TAKEOVER The transfer of control from one ownership group to another

TYPES OF TAKEOVER

Friendly takeovers
A "friendly takeover" is an acquisition which is approved by the management. Before a bidder makes an offer for another company, it usually first informs the company's board of directors. In an ideal world, if the board feels that accepting the offer serves the shareholders better than rejecting it, it recommends the offer be accepted by the shareholders. Hostile takeovers A "hostile takeover" allows a suitor to take over a target company whose management is unwilling to agree to a merger or takeover. A takeover is considered "hostile" if the target company's board rejects the offer, but the bidder continues to pursue it, or the bidder makes the offer directly after having announced its firm intention to make an offer A "reverse takeover" is a type of takeover where a private company acquires a public company. This is usually done at the instigation of the larger, private company, the purpose being for the private company to effectively float itself while avoiding some of the expense and time involved in a conventional IPO. Pros and Cons of Takeover Pros: 1. Increase in sales/revenues (e.g. Procter & Gamble takeover of Gillette) 2. Venture into new businesses and markets 3. Profitability of target company 4. Increase market share 5. Decreased competition (from the perspective of the acquiring company) 6. Reduction of overcapacity in the industry 7. Enlarge brand portfolio (e.g. L'Oral's takeover of Body Shop) 8. Increase in economies of scale 9. Increased efficiency as a result of corporate synergies/redundancies (jobs with overlapping responsibilities can be eliminated, decreasing operating costs) Cons: 1. Goodwill, often paid in excess for the acquisition 2. Culture clashes within the two companies causes employees to be less-efficient or despondent 3. Reduced competition and choice for consumers in oligopoly markets. (Bad for consumers, although this is good for the companies involved in the takeover) 4. Likelihood of job cuts 5. Cultural integration/conflict with new management 6. Hidden liabilities of target entity 7. The monetary cost to the company 8. Lack of motivation for employees in the company being bought.

PRIVATIZATION
it is the process of transferring ownership of a business, enterprise, agency, public service or public property from the public sector (a government) to the private sector, either to a business that operate for a profit or to a non-profit organization. It may also mean government outsourcing of services or functions to private firms, e.g. revenue collection, law enforcement, and prison management. There are four main methods of privatization: 1. Share issue privatization (SIP) - selling shares on the stock market 2. Asset sale privatization - selling an entire organization (or part of it) to a strategic investor, usually by auction or by using the Treuhand model 3. Voucher privatization - distributing shares of ownership to all citizens, usually for free or at a very low price. 4. Privatization from below - Start-up of new private businesses in formerly socialist countries. Choice of sale method is influenced by the capital market, political, and firm-specific factors. SIPs are more likely to be used when capital markets are less developed and there is lower income inequality. Share issues can broaden and deepen domestic capital markets, boosting liquidity and (potentially) economic growth, but if the capital markets are insufficiently developed it may be difficult to find enough buyers, and transaction costs (e.g. underpricing required) may be higher. For this reason, many governments elect for listings in the more developed and liquid markets, for example Euronext, and the London, New York and Hong Kong stock exchanges. As a result of higher political and currency risk deterring foreign investors, asset sales occur more commonly in developing countries.

Divestment
In finance and economics, divestment or divestiture is the reduction of some kind of asset for financial, ethical, or political objectives or sale of an existing business by a firm. A divestment is the opposite of an investment

CORPORATE SECURITY
It identifies and effectively mitigates or manages, at an early stage, any developments that may threaten the resilience and continued survival of a corporation. It is a corporate function that oversees and manages the close coordination of all functions within the company that are concerned with security, continuity and safety. A debenture is an unsecured loan you offer to a company. The company does not give any collateral for the debenture, but pays a higher rate of interest to its creditors. In case of bankruptcy or financial difficulties, the debenture holders are paid later than bondholders. Debentures are different from stocks and bonds, although all three are types of investment. Below are descriptions of the different types of investment options for small investors and entrepreneurs.

Debentures and Shares

When you buy shares, you become one of the owners of the company. Your fortunes rise and fall with that of the company. If the stocks of the company soar in value, your investment pays off high dividends, but if the shares

decrease in value, the investments are low paying. The higher the risk you take, the higher the rewards you get. Debentures are more secure than shares, in the sense that you are guaranteed payments with high interest rates. The company pays you interest on the money you lend it until the maturity period, after which, whatever you invested in the company is paid back to you. The interest is the profit you make from debentures. While shares are for those who like to take risks for the sake of high returns, debentures are for people who want a safe and secure income.