VFinancial management may refer to:

Managerial finance, a branch of finance that concerns itself with the managerial significance of finance techniques. Corporate finance, a type of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions
Introduction to financial management Financial Management can be defined as:

The management of the finances of a business / organisation in order to achieve financial objectives Taking a commercial business as the most common organisational structure, the key objectives of financial management would be to: Create wealth for the business Generate cash, and Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested There are three key elements to the process of financial management: (1) Financial Planning Management need to ensure that enough funding is available at the right time to meet the needs of the business. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit. In the medium and long term, funding may be required for significant additions to the productive capacity of the business or to make acquisitions. (2) Financial Control Financial control is a critically important activity to help the business ensure that the business is meeting its objectives. Financial control addresses questions such as: Are assets being used efficiently? Are the businesses assets secure? Do management act in the best interest of shareholders and in accordance with business rules? (3) Financial Decision-making The key aspects of financial decision-making relate to investment, financing and dividends: Investments must be financed in some way however there are always financing alternatives that can be considered. For example it is possible to raise finance from selling new shares, borrowing from banks or taking credit from suppliers

 A key financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via dividends. If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further.

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. 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. Dividend for shareholders- Dividend and the rate of it has to be decided. b. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise.

3.

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.

2.

3.

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.

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, maintainance 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.

The Financial Management Association International (FMA) is the global leader in developing and disseminating knowledge about financial decision making. FMA's members include academicians and practitioners worldwide. FMA serves the global finance community by: Promoting the development and understanding of high quality basic and applied research and of sound financial practices. Facilitating interaction and relationships among those who share a common interest in finance. Encouraging and supporting quality financial education. Sponsoring annual finance conferences that provide a chance to get together with colleagues, present current research and receive feedback, observe the presentations of others, and visit interesting places

15. What is Trading on Equity ? When does a company become a highly leveraged company ? 16. What kind of dividend policy will you recommend for a new and growing company ? Give reasons for your answer. 1. What is a financial leverage? Explain value of equity according to Gordan. . Distinguish between profit maximization and wealth maximization as an objective of financial management Highlight the important factors influencing dividend policy of a firm
Financial Management

The main challenge in the NAIP is that the project will be implemented by agencies spread all over India and the number of spending units will be large (about 80-85). Therefore mere collection of financial information from the various units, consolidation of the same and making them available to the management in a timely manner for decision-making will be a challenge. In order to meet this challenge, certain key tasks need to be done: -

(a)

Preparation of a accounting manual to bring uniformity in procedures and reporting. (b) Development of a web-enabled software to account for receipts and expenditures and generation of financial reports for decision making. (c) Identifying finance personnel at each spending unit (as and when the units are identified) and training them on the financial management procedures of the Project. The project would be able to adequately account for project resources and expenditures by following the procedures stated in earlier chapters. The financial part of the proposal will be submitted in the format give in Appendix 18.

Identification and Classification of Expenditure

A)
B)

Capital Expenditure Includes Cost of: All works including construction of buildings, laboratories, sheds etc., Plant and machinery, including technology, Land development including nursery, ponds/tanks etc., Goods, equipment and loose tools, furniture and fittings, computer hardware and bulk software etc. , The consortium partners are expected to provide capital expenses and relevant infrastructures.

Revenue Expenditure Covers Cost of: Consultancy, contractual services, human capacity building, workshop/ seminar etc.,

Salaries under the project, Operating and maintenance including printing, stationery, stores, consumables, telephone, local charges, electricity bills, rent & rates, internet, honorarium to resource persons, travel & conveyance costs, farm costs, seeds, fertilizers, chemicals, glassware, seedlings, feeds, water, fuel, software etc., and Institutional overheads.

Budgeting and Funds Flow System

Budgeting

Under the NAIP , the ICAR acquires the funds through DARE under its annual plan budget. These fund flow directly to the PIU. The Budget for the entire project is approved at the central level before 31 of March every year. Budgeting involves planning for the operations and forecasting the activities and related expenditure thereto to be incurred at a later stage. The budgeting exercise starts with signing of the MoU/contract and the issue of Sanction Letters. This Letter contains the physical and financial targets over the life of the project. Thus, the details mentioned on the contract/MoU, Sanction Letter, form the basis for Budgeting and its Control. Further, to distinguish the NAIP budget from the Ministry of Agriculture (MoA) budget, a separate budget head will be assigned for the NAIP. This simplifies the identification of the NAIP budget and helps in monitoring the budget utilization from time to time.
st

Budget Allocation Process

The budget compiled by the Finance wing of PIU will be submitted to the DARE/ICAR. On receipt of sanctioned budget, the PIU will re-allocate the annual budget to the agencies based on their budgetary requirements. While allocating these funds, the PIU will consider:
Re-allocation of Funds During the year, Finance and Accounts wing of the PIU will monitor the fund utilization status on a quarterly basis, based on expenditure statements received. On review, if felt that the funds allocated may not be utilized by the agency due to certain reasons, the same can be reallocated to an agency in need. Such re-allocation of funds is possible after following normal government procedures and obtaining the required sanctions from the competent authority.

Importance of the work handled by the unit. Priority of work based on the NAIP ICAR/World Bank guidelines. Funding required for completion of pending work. Allocation as per EFC. Inter linkage of expenditure with other components which are taken up. Other considerations.

Release of Funds Once the competent authority approves the research sub-project, the process of flow of funds and reporting of expenditure will start. The major Governing guidelines for the Financial Management will be the following: -

After signing the MoU/agreement, the first installment of funds for the first financial year of the project will be disbursed in the form of a mobilization advance, which will comprise 50% of the budget provided for revenue expenditure and the full budget of the capital expenditure of the first year, Subsequently, the release of funds to the implementing units will be linked both to the progress of technical programmes in terms of deliverables as reported by the PIs and CCPIs and accepted by NCs and, the progress of expenditure during the previous reporting period. The funds will be released on six-monthly intervals against the sanctioned budget provision of the financial year. The fund for capital expenditures will be disbursed in a single installment at the beginning of each financial year, In respect of components 2, 3 & 4, funds will be released directly to each spending unit of the consortium by the PIU. However, the lead agency of the consortium will have to approve the release before the PIU releases the fund. Release of funds to each consortia member will be as per the MOU between the lead agency and the other members of the consortium, which will specify the schedule of payments (initial advance and the subsequent installments) and the milestones to be achieved to qualify for each next installment. Unutilized amount will be adjusted while making the next remittance. Requisition for the second installment of funds for each year will be submitted immediately after expiry of the first half year along with the fund utilization statement in the prescribed proforma on-line through an electronically signed mail and as a hard copy too with the recommendation of the Lead Centre. The fund requisition format is given in Appendix - 19. The funds will be released directly to the implementing units from the PIU under the information to Lead Centre/CL. Since, the releases under the project will be on the basis of the sanctioned budget and keeping in view the unspent amounts, no separate financial concurrence is required for release at each stage. However, if any additional fund is to be released, proper approval of the competent authority with the concurrence of finance will be required at the PIU.

Electronic Transfer of Funds

The funds under the NAIP will be transferred electronically. In NAIP an attempt is being made to approach a national Bank having a countrywide network to handle the transfer of funds. To facilitate flow of funds, it is proposed that the PIU and all other spending units open accounts with the same bank or, for areas where the selected bank does not have any branches, with any other bank, which has a tie up with the selected bank. The PIU will send an advice to its Banker listing the various spending units and the amounts to be transferred to the account of each unit. The Banker will provide a terminal at the PIU which will give the status of the account of each spending unit on a daily/weekly basis. Bank statements will be provided by the national Bank to every spending unit for

its withdrawals on a monthly basis. Spending units will reconcile their withdrawals with their books and send it to the PIU on a monthly/quarterly basis.
Accounting System For the projects financed by the World Bank, the Project Implementing Agency is supposed to maintain a Financial Management System including adequate accounting and financial reporting, to ensure that they can provide to the Bank and the Government accurate and timely information regarding project resources and expenditures. Besides the accounting system evolved to maintain departmental accounts of the project entity as per their Departmental Accounting Procedure, the project entity will need to maintain an independent record of transactions to show the expenditure incurred under the project separately under each category of loan proceeds as laid down under the loan/credit agreement. The accounting record will show separately the value of contract approved under each component of the category and expenditure incurred periodically under the contract and the claims submitted to Government of India against such expenditure. The project agency at periodical interval will review this accounting record to monitor that the total expenditure incurred does not go beyond the approved contract value. The PIU will take necessary timely action to revise the contract value for approval much in advance whenever the total expenditure under the contract is likely to exceed in the near future. No claims should be sent to Government of India over and above the approved contract value. A financial statement of expenditure under each category contract- wise will be prepared annually for the year ending 31st March for onward submission to the World Bank. A similar statement will also accompany the audit report on the project financial account for the year as a whole. Basis of Accounting System

The Accounting System to be followed by each of the project implementing agencies will be on the basis of the Accrual Accounting System i.e. the double entry system of accounting to have the uniformity in the project accounting and in no situation will the Cash Base Accounting System be followed. Accounting Centres: The main accounting centres will be following units: 1. Project Implementation Unit (PIU) 2. Consortium Lead Centres 3. Implementing Centres
The PIU is responsible to release funds to the ICAR Institutes, SAUs and NGO/Partners, etc. under the approved sub-projects, activities etc. These units in turn are required to furnish Annual Accounts, Statement of Expenditure and Audit Utilization Certificates (to be submitted by other than the ICAR Institutes) to the PIU. Also, the World Banks Articles of Agreement require the borrower to ensure that the credit/ loan proceeds are used only for the purpose set out in the loan documents including the Project Appraisal Document and that the goods and services required for the project are procured in accordance with the Banks procurement procedures. Further, the records should be kept sub-project-wise, so that various Financial Statements can be sent with respect to amount of funds received for the sub-projects from the respective source i.e. consolidation shall be done sub-project-wise at various lead institutions/ funding agencies. Each implementing centre has to maintain its Cash Book, Cheque Book/ DD Register, Valuable Register, Grant Register, Project-wise Expenditure Control Register, Asset Register, Advance Register, Objection Book, Balance Sheet etc. as in case of institution funds.

Reporting of Expenditure

It is expected that:
While incurring expenditure, the implementing agency should keep in mind that funds must be utilized strictly in accordance with the approved allocations for the sub-project as envisaged in the sanction following the WB guidelines/procedures and the term and conditions of the projects. Any over-utilization or utilization not in accordance with the sanction is not reimbursable, For effective execution and monitoring, an online Financial Management System (web based) will be developed. The expenditures of all the participating units will always be available to the PIU through this accounting software through a central server installed at the PIU, For ensuring the uniformity in the Financial Management procedure, it will be mandatory for all the partners to operate and report through the Financial Management System, the requisite training for which will be arranged by the PIU, Initially quarterly reports on fund utilization i.e. Statement of Expenditure (SoE) will be submitted by the implementing centres directly to the PIU/ ICAR, with a copy of the same to the lead centre of the consortium for its endorsement/authentication. Once the online system is put in use effectively, this arrangement will be reviewed and modified for reporting on a monthly basis, for which the PIU will inform implementing units separately, (the format of SoE is given in Appendix 20) For reporting purposes, usages of the standards formats prescribed by the WB/ PIU will be mandatory for each implementing agency, The SoEs will be consolidated at the PIU. The consolidated SoE for the project as a whole will be submitted to the World Bank for claiming re-imbursement. The SoE in respect of the ICAR institutes will also be submitted to the Principal Director of Audit (Scientific Department) for arranging audit of the NAIP, The budget utilization will be certified annually by the competent authority i.e., the head of the organization and the head of the finance of each member institution/ organization of the consortium, The PIU will develop the Financial Management Manual, which will lay down financial and accounting policies and procedures, standard reporting formats etc. This will have to be followed by all the member institutions, and Financial reporting (expenditure statements and bank reconciliation statements) from Implementing units to the PIU will be on-line. The FMR formats will be agreed and provided in the Finance Manual. The PIU will furnish consolidated FMRs on a quarterly basis, to the Bank.

Separate Bank Account

As per the WB requirement, a separate bank account is to be operated for monetary transactions under the NAIP. Each implementing agency is to open only one bank account for all the NAIP projects, and Bank statements will be provided by the nationalized Bank to every spending unit for its withdrawals on a monthly basis. Spending units will reconcile their withdrawals with their books and send it to the PIU on a monthly/quarterly basis.

Supervision Plan

The project would require intensive supervisions in the initial stages for ensuring successful implementation of the agreed financial management arrangements in the implementing units. The other focus areas during the supervision will be on meeting the training needs of the projects finance personnel.

Financial Control

This includes:

Inspection at periodic intervals will be carried out by the PIU to monitor the financial management of the implementing agencies, Funds will be utilized for the bonafide/intended purpose using the prescribed norms and procedures of GOI/World Bank and will not be diverted to any other schemes/heads etc. Expenditure be kept within the approved budgetary allocation, All basic records such as cashbook, cheque register, counter foils of cheques, grant register, project-wise and sub-head-wise expenditure control register, assets register etc. will be maintained, All advances irrespective of their nature will be adjusted within the prescribed time limit but before the close of the financial year to which they pertain, All procurements will be made following World Bank guidelines/procedures, Revenue/ interest generated if any, during the project period will be refunded to the PIU and will not be utilized for meeting any expenditure (to be decided), ???? Incurring of the expenditure within the sanctioned budget will be ensured. Any expenditure in excess will be liable to be disallowed.

To be delet ed

Disbursement of Funds The total project cost is USD 250 million. Of this, the portion financed by the Bank is USD 200 million. The Bank assistance received by GoI will be passed on to the ICAR.

The funds for the project will be budgeted for in the ICARs budget, including counterpart funds, as an identifiable single-head budget item each year. GOI would open a Special Account with RBI to receive the initial deposit and thereafter reimbursements from the Bank under the project and would make the funds available to the ICAR through DARE, Ministry of Agriculture & Cooperation under the Plan Budget. The ICAR will then pass on funds to the bank account of the NAIP PMU.. DEA is yet to define the arrangements for passing on bank funds to implementing agencies

To be replace with Credit

Disbursements from the Loan would be made in the traditional system of reimbursement with full documentation and against a statement of expenditure (SoE). Consolidated quarterly/half yearly claims will be submitted by the PIU to the Bank for reimbursement. A uniform 80% disbursement rate across the different cost categories and components was agreed upon. Disbursement will be made as 80% of the allowed statements of expenditures. Funds will be disbursed against SoEs. Expenditure as shown in the SoEs will be certified by the GOI, as the Borrower, as representing the eligible project expenditure. Supporting documents for SoEs will be available for post-review by the Supervision Missions of the WB and the Auditors. These documents will be retained by the implementing agencies/ICAR for one year after receipt of the Audit Report by the WB for the fiscal year in which the last withdrawal from the Credit/Loan

account was made. The formats for the SoE and the AUC will mutually be agreed on much before the project becomes effective.

Audit Requirements and Procedures The process involves that:

As per fiduciary requirements in the World Bank funded projects, the executive agency generally is required to submit the Audit Certificates for the entire project within six months of the end of the financial year & this will applied to the NAIP also. As the NAIP will be implemented in consortia mode having multiple implementing agencies/partners, a suitable audit mechanism which may serve the purpose of timely completion/submission of AUCs to the World Bank has been devised. As per this mechanism the PIU will maintain a roster of A category CA Firms empanelled with the C&AG The accounts of the project will be audited by the C&AG in case of the ICAR and other Government institutes and Private Chartered Accountants from the roster maintained by the PIU in case of other consortia members. The SAUs will have an option of getting their accounts audited by the local fund auditor who does statutory audit of SAUs or by a Chartered Accountant Firm from the roster maintained by the PIU provided they meet the deadline of submitting the audit report to the PIU within the stipulated time. The annual project financial statements, duly audited and a compiled audit report will be submitted to the Bank within six months of the end of each financial year. Terms of reference will be drawn up in consultation with the Bank and agreed with for the C&AG and the private firm of Chartered Accountants. The PIU will compile the audit observations with the help of a selected private audit firm hired in the Northern zone and send a single report to the Bank. The annual project financial statement, duly audited, will be submitted to the Bank within six months of the end of each financial year. The following audit reports will be monitored on ARCS: Audit Report Implementing Agency PIU DEA/GOI

Compilation of Audit Observations Special Account

The consolidated Audit Utilization Certificates (AUCs) for the project expenditure as a whole for each financial year has to be submitted to the WB by 30th September of the next financial year. This certificate is to be issued by the concerned statutory auditors, The responsibility of getting the accounts audited and submission of the AUCs at the end of each financial year to the PIU by the due dates as per

the dates so fixed by the PIU keeping in view (i) above will lie with the individual implementing agencies under the overall responsibility of the Lead Centre of the consortium, Audit is conducted to see that the individual expenditures included in the SoE are fully supported by documentation retained by the implementing units, the expenditures are properly authorized and eligible under the loan/credit agreements and the expenditures are properly accounted, The observance of the WB procedure will be mandatory so as to ensure that there are no audit disallowances, and In case of an audit disallowance, the expenditure so disallowed will be transferred from the NAIP to some other source of funds of the implementing agency and the resultant balance will have to be refunded to the PIU-NAIP immediately after the conduct of audit.

Internal Audit Considering the large size of the operation and multiplicity of spending units, management oversight will be strengthened by quarterly internal audits. A quarterly internal audit will be conducted by a CA firm or Finance wing of the PIU. The World Bank recommends appointment of a reputed audit firm acceptable to the Bank under agreed TOR. Audit in each quarter will be done on a sample basis (selected sample of spending units and within that selected sample of transactions). The sample for audit in each quarter will be selected in consultation with the PIU based on factors such as amount of expenditure incurred, perceived risks etc. The internal auditor will assess the operation of the projects financial management system and will review internal control mechanisms. Issues arising in the external and internal audits would need to be promptly addressed and acted upon in a timely manner by the project authorities.
Audit by the World Bank The World Bank also conducts post-audit of the SoE-based re-imbursement on a sample basis. For this purpose the records/accounts of the implementing agencies are audited by the firm of Chartered Accountants appointed by the Bank.

Financial Governance
It is expected that:

As and when a consortium is formed, the consortium members will have to get their financial management systems assessed and certified by one of the CA firms from the roster or byu the finance wing of the PIU. Tye CA firm/ Finance wing of the PIU will certify that the financial management systems of the consortium members are compliant with the project requirements. Each implementing agency will get the audit carried out as per the schedule and by the agency notified by the PIU. The internal auditor will

assess the operation of the projects Financial Management System, including a review of internal control mechanism. This will assist the PIU to identify issues and take corrective actions in timely manner. The institutions were internal audit would be conducted, will be decided by the PIU based on magnitude of expenditure and risks perceived,
Any re-appropriation of funds from one head to other will not be normally permissible. However in exceptional cases such re-appropriation may be allowed with the approval of the competent authority (to be decided), ???? The mechanism for distribution and accounting of the royalty will be worked out separately, In case an implementing agency defaults and withdraws from the consortium in between, all the funds so received by the member will be required to be refunded to the Council, along with the highest rate of penal interest of the bank prevailing at that time, The assets acquired out of the project fund will be the property of the Council (to be decided), All the vouchers/ records/ files relating to the NAIP expenditure will have to be kept in proper condition by the partners up to 5 years after the completion of the project, Adequate financial staff to be provided from the very beginning so as to ensure that the project work does not suffer. As far as possible, the staff deputed for the work relating to maintaining of project accounts should be well versed with accrual accounting system and preferably acquainted with externally aided projects of the WB or some other agency, The staff should not be changed/transferred at frequent intervals unless and until required to be done on administrative grounds but with information to the PIU, NAIP, For assisting in the finance and accounts work of the NAIP, provision shall be made in project proposal for hiring of the skilled staff under contractual services (if required). The hiring of the staff will be through a service contractor who shall be selected by adopting the World Bank guidelines. It will be ensured by the implementing agencies that such hiring will not create any permanent liability on the part of the ICAR. In no case, the ICAR will be responsible for any such liability. The first internal audit report should be submitted to the Bank within the first 6 months of project implementation. The PIU and every spending unit should maintain throughout the project period staff in positions agreed for handling finance functions. The financial management software should be ready for implementation and staff trained within six months of the project starting incurring expenditure after effectiveness. On-line Financial Management System

To be delet ed

A Financial Management Software System will be selected, customized and rolled out across the ICAR system. Capacity building activities to prepare finance and administration staff for the new system will be designed and implemented.
A need is felt to have a financial and accounting system which could not only meet the present day accounting requirements but also to help the day to day monitoring both in terms of quantative and qualitative aspects from operational as well as management point of view. Therefore, a web-based Financial Management System having broader coverage of the ICAR/SAUs/NGOs/Private Bodies/Other Govt. Deptts./Foreign Aided Projects will be developed. For an early implementation of this FMS an off the self-software will be identified with the help of the project management consultant and will be customized according the needs of NAIP/ICAR. The FMS/MIS will be developed on a universally tested software platform like SAP/Oracle. This system will be an integration of an accounting system with a procurement management system. The system will enable to retain a full set of accounting data in standard accounting format. The FMS of the NAIP will be at first stage implemented at the PIU and consortia as a pilot project, after that it will be expanded to the ICAR Hqrs. and its institutes. The proposal in its second stage envisages the integration with the Pay Role Package, Inventory management, Research

project management, Personal information system, Library information system, M&E system, knowledge management related modules so that package broadly can be termed as the MIS of the ICAR. A sound and updated information should serves as a base for effective managerial control and timely decision making. The FMS/MIS is expected to enable a meaningful extrapolation, forecasting and projections. The primary objective of the FMS will be to assist in the processing and tracking of investments to projects, capacity building and institutional support. The MIS will be an important tool for management, M&E and reporting. Standard data management procedures and processes will be developed with the assistance of an MIS expert or consultant. The objectives of the FMS/MIS as a tool will be to:

Capture the complete project cycle from the beginning, i.e. project/sub-project submission, approval process, sanction and funding. Track the expenditure progress of sub-projects as well as the overall progress of the NAIP. Manage finances, budgets and procurement. To evaluate the project and the NAIP sub-projects on an ongoing basis as well as at midterm and after completion. Provide all necessary reports.

The FMS-MIS implementation plan finally will result in capacity building and to enhance managerial skill for finance and other officials. The ultimate aim of the entire effort is to achieve a complete robust solution through this FMS to cater the overall needs of Accounting, Financial and Administration disciplines at least for the next 8-10 years. Finally it will help in strengthening & remodeling the complete system of the ICAR, and will equip it as a learning organization to meet the challenges of 21st century. Once the software is developed, it will be mandatory for all the implementing centres to adopt the system and report through it for which adequate training will be provided by the PIU. The software will have multiple user system and will be user friendly. It will enable us to generate the following release and expenditure reports: 1. Subject Matter Division-wise. 2. Component-wise. 3. Expenditure item (head of Accounts). 4. Sub-head-wise. 5. Project-wise. 6. Implementing Centre-wise. 7. Expenditure category wise (Recurring/Non-recurring). 8. Reimbursement claims category-wise. 9. Monthly/Annual Accounts. 10. Bank Reconciliation. 11. Cash Book. 12. Ledgers. The operational manual to be developed for FMS-MIS, covering all the formats etc. will be a part of this manual. Profit maximization v/s wealth maximisation

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 corporates 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 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 capitalised 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.

Discussion Issues and Derivations

1. What is the difference between stock price maximization, firm value maximization and stockholder wealth maximization? Stock price maximization is the most restrictive of the three objective functions. It requires that managers take decisions that maximize stockholder wealth, that bondholders be fully protected from expropriation, that markets be efficient and that social costs be negligible. Stockholder wealth maximization is slightly less restrictive, since it does not require that markets be efficient. Firm value maxmization is the least restrictive, since it does not require that

bondholders be protected from expropriation. Thus, when we make the argument that an action by a firm (such as investing or financing) increases firm value, this increase in firm value will necessarily translate into increasing stockholder wealth and stock price only if the more restrictive assumptions hold. Conversely, an action that increases the stock price in a world where the less restrictive assumptions do not hold, may not necessarily increase firm value. 2. What is the objective function in corporate finance for a private firm? The objective of maximizing stock prices is a relevant objective only for firms which are publicly traded. How, then, can corporate finance principles be adapted for private firms? For firms which are not publicly traded, the objective in decision making is the maximization of firm value. The investment, financing and dividend principles we will develop in the chapters to come apply for both publicly traded firms, which focus on stock prices, and private businesses, that maximize firm value. Since firm value is not observable and has to be estimated, what private businesses will lack is the feedback, sometimes unwelcome, that publicly traded firms get when they make major decisions. 3. What is the objective function for a non-profit organization? It is much more difficult to adapt corporate finance principles to not-for-profit organizations, since their objective is often to deliver a service in the most efficient way possible, rather than to make profits. The objective therefore has to be stated in terms of cost efficiency. For instance, the objective of a public school system might be to deliver a quality education (defined in terms of a skill set that every graduate should have) at the lowest cost. This does mean, however, that the skill set has to be both specifically defined and measurable. 4. Are markets short term? There are many who believe that stock price maximization leads to a short term focus for manager - see for instance Michael Porters book on competitive strategy. The reasoning goes as follows: Stock prices are determined by traders, short term investors and analysts, all of whom hold the stock for short periods and spend their time trying to forecast next quarter's earnings. Managers who concentrate on creating long term value, rather than short term results, will be penalized by markets. Most of the empirical evidence that exists suggests that markets are much more long term than they are given credit for: (1) There are hundreds of firms, especially small and start-up firms, which do not have any current earnings and cash flows, do not expect to have any in the near future, but which are still able to raise substantial amounts of money on the basis of expectations of success in the future. If markets were in fact as short term as the critics suggest, these firms should be unable to raise funds in the first place. (2) If the evidence suggests anything, it is that markets do not value current earnings and cash flows enough and value future earnings and cash flows too much. Studies indicate that stocks with low price-earnings ratios, i.e., high current earnings, have generally been underpriced relative to stocks with high priceearnings ratios. (3) The market response to research and development and investment expenditure is not uniformly negative, as the 'short term' critics would lead you to believe.

Instead, the response is tempered, with stock prices, on average, rising on the announcement of R&D and capital expenditures. 5. What is the German/Japanese alternative to stockholder wealth maximization and does it work? In the German and Japanese systems of corporate governance, firms own stakes in other firms, and often make decisions which are in the best interests of the industrial group they belong to, rather than in their own best interests. In this system, the argument goes, firms will keep an eye on each other, rather than ceding power to the stockholders. In addition to being undemocratic - the stockholders are after all the owners of the firm, it suggests a profound suspicion of how stockholders might use the power if they get it and is heavily skewed towards maintaining the power of incumbent managers. While this approach may protect the system against the waste that is a by-product of stockholder activism and inefficient markets, it has its own disadvantages. Industrial groups are inherently more conservative than investors in allocating resources, and thus are much less likely to finance high risk and venture capital investments by upstarts who do not belong to the group. The other problem is that entire groups can be dragged down by individual firms that have run into trouble.

Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc. The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. Some other reasons include bankruptcy costs, agency costs, taxes, and information asymmetry. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm.

[edit] Capital structure in a perfect market

Consider a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made

two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created. Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all.

[edit] Capital structure in the real world

If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model.

[edit] Trade-off theory

Main article: Trade-off theory of capital structure Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E ratios between industries, but it doesn't explain differences within the same industry.

[edit] Pecking order theory

Main article: Pecking Order Theory Pecking Order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company. Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory is popularized by Myers (1984)[1] when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is

overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance..

[edit] Agency Costs

There are three types of agency costs which can help explain the relevance of capital structure.

Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders. Underinvestment problem: If debt is risky (e.g., in a growth company), the gain from the project will accrue to debtholders rather than shareholders. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value. Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.

[edit] Other

The neutral mutation hypothesisfirms fall into various habits of financing, which do not impact on value. Market timing hypothesiscapital structure is the outcome of the historical cumulative timing of the market by managers.[2] Accelerated investment effecteven in absence of agency costs, levered firms use to invest faster because of the existence of default risk.[3]

[edit] Arbitrage
Similar questions are also the concern of a variety of speculator known as a capitalstructure arbitrageur, see arbitrage. A capital-structure arbitrageur seeks opportunities created by differential pricing of various instruments issued by one corporation. Consider, for example, traditional bonds and convertible bonds. The latter are bonds that are, under contracted-for conditions, convertible into shares of equity. The stock-option component of a convertible bond has a calculable value in itself. The value of the whole instrument should be the value of the traditional bonds plus the extra value of the option feature. If the spread (the difference between the convertible and the non-convertible bonds) grows excessively, then the capital-structure arbitrageur will bet that it will converge.

Capital structure substitution theory

From Wikipedia, the free encyclopedia

Jump to: navigation, search In finance, the capital structure substitution theory (CSS) [1] describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share (EPS) are maximized. Managements have an incentive to so as shareholders and analysts value EPS growth. The theory is used to explain trends in capital structure, stock market valuation, dividend policy, the monetary transmission mechanism, and stock volatility, and provides an alternative to the ModiglianiMiller theorem that has limited descriptive validity in real markets. The CSS theory is only applicable in markets where share repurchases are allowed. Investors can use the CSS theory to identify undervalued stocks.

Contents
[hide]

1 The formula 2 Capital structure 3 Asset pricing 4 Fed model equilibrium 5 Dividend policy 6 Monetary policy 7 Beta 8 Assumptions 9 See also 10 References

[edit] The formula

The CSS theory assumes that company managements can freely change the capital structure of the company substituting bonds for stock or vice versa on a day-to-day basis and in small denominations without paying transaction costs. Companies can decide to buy back one single share for the current market price P and finance this by issuing one extra corporate bond with face value P or do the reverse. In mathematical terms these substitutions are defined as

CSS equilibrium conditions: (1) companies fulfilling the equilibrium condition are found on B-B", (2) companies cannot issue debt with interest rates below 'Aaa' rated bonds on line A-A", (3) high valued companies with E/P<R*[1-T] are not expected to hold long term debt, pay no dividends and are found on line A-B.

where D is the corporate debt and n the number of shares of company x at time t. The negative sign indicates that a reduction of the number of shares n leads to a larger debt D and vice versa. The earnings-per-share change when one share with price P is repurchased and one bond with face value P is issued: 1. The earnings that were allocated to the one share that was repurchased are redistributed over the remaining outstanding shares, causing an increase in earnings per share of: E / n 2. The earnings are reduced by the additional interest payments on the extra bond. As interest payments are tax-deductible the real reduction in earnings is obtained by multiplying with the tax shield. The additional interest payments thus reduce the EPS by: Combining these two effects, the marginal change in EPS as function of the total number of outstanding shares becomes:

where

E is the earnings-per-share R is the nominal interest rate on corporate bonds T is the corporate tax rate

EPS is maximized when substituting one more share for one bond or vice versa leads to no marginal change in EPS or:

This equilibrium condition is the central result of the CCS theory, linking stock prices to interest rates on corporate bonds.

[edit] Capital structure

The two main capital structure theories as taught in corporate finance textbooks are the Pecking order theory and the Trade-off theory. The two theories make some contradicting predictions and for example Fama and French conclude[2]: "In sum, we identify one scar on the tradeoff model (the negative relation between leverage and profitability), one deep wound on the pecking order (the large equity issues of small low-leverage growth firms)...". The capital structure substitution theory has the potential to close these gaps. It predicts a negative relation between leverage and valuation (=reverse of earnings yield) which in turn can be linked to profitability. But it also predicts that high valued small growth firms will avoid the use of debt as especially for these companies the cost of borrowing (Rx,t) is higher than for large companies, which in turn has a negative effect on their EPS. This is consistent with the finding that "firms with higher current stock prices (relative to their past stock prices, book values or earnings) are more likely to issue equity rather than debt and repurchase debt rather than equity".[3]

[edit] Asset pricing

The equilibrium condition can be easily rearranged to an asset pricing formula:

The CSS theory suggests that company share prices are not set by shareholders but by bondholders. As a result of active repurchasing or issuing of shares by company managements, equilibrium pricing is no longer a result of balancing shareholder demand and supply. In a way the CCS theory turns asset pricing upside-down, with bondholders setting share prices and shareholders determining company leverage. The asset pricing formula only applies to debt-holding companies.

[edit] Fed model equilibrium

In the US, a positive relationship between the average earnings yield of the S&P 500 index and government bond yields has been present over the last several decades. This relationship has become popular as the Fed model and states in its strongest form an equality between the one year forward looking E/P ratio or earnings yield and the 10-year government bond yield. The CSS equilibrium condition suggests that the Fed model is misspecified: the S&P 500 earnings yield is not in equilibrium with the government bond yield but with the average after-tax interest rate on corporate bonds. The CSS theory suggests that the Fed equilibrium was only observable after 1982, the year in which the United States Securities and Exchange Commission allowed open-market repurchases of shares.

[edit] Dividend policy

From the CSS equilibrium condition it can be derived that debt-free companies should prefer repurchases whereas companies with a debt-equity ratio larger than

should prefer dividends as a means to distribute cash to shareholders, where

D is the companys total long term debt Eq is the companys total equity TC is the tax rate on capital gains TD is the tax rate on dividends

Low valued, high leveraged companies with limited investment opportunities and a high profitability use dividends as the preferred means to distribute cash to shareholders.[4]

[edit] Monetary policy

An unanticipated 25-basis-point cut in the federal funds rate target is associated with a 1% increase in broad stock indexes in the US.[5] The CSS theory suggests that the monetary policy transmission mechanism is indirect but straightforward: a change in the federal funds rate affects the corporate bond market which in turn affects asset prices through the equilibrium condition.

[edit] Beta
The CSS equilibrium condition can be used to deduct a relationship for the beta of a company x at time t:

where is the market average interest rate on corporate bonds. The CSS theory predicts that companies with a low valuation and high leverage will have a low beta. This is counter-intuitive as traditional finance theory links leverage to risk, and risk to high beta.

[edit] Assumptions

Managements of public companies manipulate capital structure such that earnings-per-share are maximized. Managements can freely change the capital structure of the company substituting bonds for stock or vice versa on a day-to-day basis and in small denominations. Shares can only be repurchased through open market buybacks. Information about share price is available on a daily basis. Companies pay a uniform corporate tax rate T.

Cost of capital
From Wikipedia, the free encyclopedia

Jump to: navigation, search The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities".[1] It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

Contents
[hide]

1 Summary 2 Cost of debt 3 Cost of equity o 3.1 Expected return o 3.2 Comments 3.2.1 Cost of retained earnings/cost of internal equity 4 Weighted average cost of capital 5 Capital structure 6 Modigliani-Miller theorem 7 References 8 Further reading

[edit] Summary
For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital. However, a rate of return larger than the cost of capital is usually required. The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modelled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous (not linked to the company's activities). The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the riskweighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments (comparable) with similar risk profiles to determine the "market" cost of equity. It is commonly equated using the CAPM formula (below), although articles such as Stulz 1995 question the validity of using a local CAPM versus an international CAPM- also considering whether markets are fully integrated or segmented (if fully integrated, there would be no need for a local CAPM).

Once cost of debt and cost of equity have been determined, their blend, the weightedaverage cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's projected cash flows.

[edit] Cost of debt

The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk free rate. The yield to maturity can be used as cost of capital.

[edit] Cost of equity

Cost of equity = Risk free rate of return + Premium expected for risk Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) Where Beta= sensitivity to movements in the relevant market:

Where: Es The expected return for a security Rf The expected risk-free return in that market (government bond yield) s The sensitivity to market risk for the security RM The historical return of the stock market/ equity market (RM-Rf) The risk premium of market assets over risk free assets. The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds.

[edit] Expected return

The expected return (or required rate of return for investors) can be calculated with the "dividend capitalization model", which is

[edit] Comments
The models state that investors will expect a return that is the risk-free return plus the security's sensitivity to market risk times the market risk premium. The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5%. The equity market real capital gain return has been about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average have been 1.6% per year over the period 1910-2005. [1] The dividends have increased the total "real" return on average equity to the double, about 3.2%. The sensitivity to market risk () is unique for each firm and depends on everything from management to its business and capital structure. This value cannot be known "ex ante" (beforehand), but can be estimated from ex post (past) returns and past experience with similar firms.

[edit] Cost of retained earnings/cost of internal equity

Note that retained earnings are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.

[edit] Weighted average cost of capital

Main article: Weighted average cost of capital The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital. The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as the company's market capitalization) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet.To calculate the firms weighted cost of capital, we must first calculate the costs of the

individual financing sources: Cost of Debt, Cost of Preference Capital and Cost of Equity Capital. Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital. [2]

[edit] Capital structure

Main article: Capital structure Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity (this is only true for profitable firms, tax breaks are available only to profitable firms). At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Management must identify the "optimal mix" of financing the capital structure where the cost of capital is minimized so that the firm's value can be maximized. The Thomson Financial league tables show that global debt issuance exceeds equity issuance with a 90 to 10 margin.weighted average cost of capital

[edit] Modigliani-Miller theorem

Main article: Modigliani-Miller theorem If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that, under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same.

[ Discounted cash flow

From Wikipedia, the free encyclopedia

Jump to: navigation, search This article needs additional citations for verification. Please help improve this article by adding reliable references. Unsourced material may be challenged and removed. (January 2010)

Excel spreadsheet uses Free cash flows to estimate stock's Fair Value and measure the sensibility of WACC and Perpetual growth In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question. Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite process taking cash flows and a price and inferring a discount rate, is called the yield. Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.

Contents
[hide]

1 Discount rate 2 History 3 Mathematics o 3.1 Discrete cash flows o 3.2 Continuous cash flows 4 Example DCF 5 Methods of appraisal of a company or project 6 Shortcomings 7 See also 8 References 9 External links 10 Further reading

[edit] Discount rate

Main article: Discounting The most widely used method of discounting is exponential discounting, which values future cash flows as "how much money would have to be invested currently, at a given rate of return, to yield the cash flow in future." Other methods of discounting, such as hyperbolic discounting, are studied in academia and said to reflect intuitive decisionmaking, but are not generally used in industry. The discount rate used is generally the appropriate Weighted average cost of capital (WACC), that reflects the risk of the cashflows. The discount rate reflects two things: 1. The time value of money (risk-free rate) according to the theory of time preference, investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay. 2. A risk premium reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all. An alternative to including the risk in the discount rate is to use the risk free rate, but multiply the future cash flows by the estimated probability that they will occur (the success rate). This method, widely used in drug development, is referred to as rNPV (risk-adjusted NPV), and similar methods are used to incorporate credit risk in the probability model of CDS valuation. Oxera (2011) [1] reviews the selection of a discount rate suitable for the assessment of new and emerging energy technologies.

[edit] History
Discounted cash flow calculations have been used in some form since money was first lent at interest in ancient times. As a method of asset valuation it has often been opposed to accounting book value, which is based on the amount paid for the asset. Following the stock market crash of 1929, discounted cash flow analysis gained popularity as a valuation method for stocks. Irving Fisher in his 1930 book "The Theory of Interest" and John Burr Williams's 1938 text 'The Theory of Investment Value' first formally expressed the DCF method in modern economic terms.

[edit] Mathematics
[edit] Discrete cash flows
The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.

Thus the discounted present value (for one cash flow in one future period) is expressed as:

where

DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt; FV is the nominal value of a cash flow amount in a future period; i is the interest rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full; d is the discount rate, which is i/(1+i), i.e. the interest rate expressed as a deduction at the beginning of the year instead of an addition at the end of the year; n is the time in years before the future cash flow occurs.

Where multiple cash flows in multiple time periods are discounted, it is necessary to sum them as follows:

for each future cash flow (FV) at any time period (t) in years from the present time, summed over all time periods. The sum can then be used as a net present value figure. If the amount to be paid at time 0 (now) for all the future cash flows is known, then that

amount can be substituted for DPV and the equation can be solved for i, that is the internal rate of return. All the above assumes that the interest rate remains constant throughout the whole period.

[edit] Continuous cash flows

For continuous cash flows, the summation in the above formula is replaced by an integration:

where FV(t) is now the rate of cash flow, and = log(1+i).

[edit] Example DCF

To show how discounted cash flow analysis is performed, consider the following simplified example.

John Doe buys a house for $100,000. Three years later, he expects to be able to sell this house for $150,000.

Simple subtraction suggests that the value of his profit on such a transaction would be $150,000 $100,000 = $50,000, or 50%. If that $50,000 is amortized over the three years, his implied annual return (known as the internal rate of return) would be about 14.5%. Looking at those figures, he might be justified in thinking that the purchase looked like a good idea. 1.1453 x 100000 = 150000 approximately. However, since three years have passed between the purchase and the sale, any cash flow from the sale must be discounted accordingly. At the time John Doe buys the house, the 3-year US Treasury Note rate is 5% per annum. Treasury Notes are generally considered to be inherently less risky than real estate, since the value of the Note is guaranteed by the US Government and there is a liquid market for the purchase and sale of T-Notes. If he hadn't put his money into buying the house, he could have invested it in the relatively safe T-Notes instead. This 5% per annum can therefore be regarded as the risk-free interest rate for the relevant period (3 years). Using the DPV formula above (FV=$150,000, i=0.05, n=3), that means that the value of $150,000 received in three years actually has a present value of $129,576 (rounded off). In other words we would need to invest $129,576 in a T-Bond now to get $150,000 in 3 years almost risk free. This is a quantitative way of showing that money in the future is not as valuable as money in the present ($150,000 in 3 years isn't worth the same as $150,000 now; it is worth $129,576 now).

Subtracting the purchase price of the house ($100,000) from the present value results in the net present value of the whole transaction, which would be $29,576 or a little more than 29% of the purchase price. Another way of looking at the deal as the excess return achieved (over the risk-free rate) is (14.5%-5.0%)/(100%+5%) or approximately 9.0% (still very respectable). But what about risk? We assume that the $150,000 is John's best estimate of the sale price that he will be able to achieve in 3 years time (after deducting all expenses, of course). There is of course a lot of uncertainty about house prices, and the outcome may end up higher or lower than this estimate. (The house John is buying is in a "good neighborhood," but market values have been rising quite a lot lately and the real estate market analysts in the media are talking about a slow-down and higher interest rates. There is a probability that John might not be able to get the full $150,000 he is expecting in three years due to a slowing of price appreciation, or that loss of liquidity in the real estate market might make it very hard for him to sell at all.) Under normal circumstances, people entering into such transactions are risk-averse, that is to say that they are prepared to accept a lower expected return for the sake of avoiding risk. See Capital asset pricing model for a further discussion of this. For the sake of the example (and this is a gross simplification), let's assume that he values this particular risk at 5% per annum (we could perform a more precise probabilistic analysis of the risk, but that is beyond the scope of this article). Therefore, allowing for this risk, his expected return is now 9.0% per annum (the arithmetic is the same as above). And the excess return over the risk-free rate is now (9.0%-5.0%)/(100% + 5%) which comes to approximately 3.8% per annum. That return rate may seem low, but it is still positive after all of our discounting, suggesting that the investment decision is probably a good one: it produces enough profit to compensate for tying up capital and incurring risk with a little extra left over. When investors and managers perform DCF analysis, the important thing is that the net present value of the decision after discounting all future cash flows at least be positive (more than zero). If it is negative, that means that the investment decision would actually lose money even if it appears to generate a nominal profit. For instance, if the expected sale price of John Doe's house in the example above was not $150,000 in three years, but $130,000 in three years or $150,000 in five years, then on the above assumptions buying the house would actually cause John to lose money in present-value terms (about $3,000 in the first case, and about $8,000 in the second). Similarly, if the house was located in an undesirable neighborhood and the Federal Reserve Bank was about to raise interest rates by five percentage points, then the risk factor would be a lot higher than 5%: it might not

be possible for him to predict a profit in discounted terms even if he thinks he could sell the house for $200,000 in three years. In this example, only one future cash flow was considered. For a decision which generates multiple cash flows in multiple time periods, all the cash flows must be discounted and then summed into a single net present value.

[edit] Methods of appraisal of a company or project

This is necessarily a simple treatment of a complex subject: more detail is beyond the scope of this article. For these valuation purposes, a number of different DCF methods are distinguished today, some of which are outlined below. The details are likely to vary depending on the capital structure of the company. However the assumptions used in the appraisal (especially the equity discount rate and the projection of the cash flows to be achieved) are likely to be at least as important as the precise model used. Both the income stream selected and the associated cost of capital model determine the valuation result obtained with each method. This is one reason these valuation methods are formally referred to as the Discounted Future Economic Income methods.

Equity-Approach o Flows to equity approach (FTE)

Discount the cash flows available to the holders of equity capital, after allowing for cost of servicing debt capital Advantages: Makes explicit allowance for the cost of debt capital Disadvantages: Requires judgement on choice of discount rate

Entity-Approach: o Adjusted present value approach (APV)

Discount the cash flows before allowing for the debt capital (but allowing for the tax relief obtained on the debt capital) Advantages: Simpler to apply if a specific project is being valued which does not have earmarked debt capital finance Disadvantages: Requires judgement on choice of discount rate; no explicit allowance for cost of debt capital, which may be much higher than a "risk-free" rate
o

Weighted average cost of capital approach (WACC)

Derive a weighted cost of the capital obtained from the various sources and use that discount rate to discount the cash flows from the project Advantages: Overcomes the requirement for debt capital finance to be earmarked to particular projects Disadvantages: Care must be exercised in the selection of the appropriate income stream. The net cash flow to total invested capital is the generally accepted choice.
o

Total cash flow approach (TCF)[clarification needed]

This distinction illustrates that the Discounted Cash Flow method can be used to determine the value of various business ownership interests. These can include equity or debt holders. Alternatively, the method can be used to value the company based on the value of total invested capital. In each case, the differences lie in the choice of the income stream and discount rate. For example, the net cash flow to total invested capital and WACC are appropriate when valuing a company based on the market value of all invested capital.[2]

[edit] Shortcomings
Commercial banks have widely used discounted cash flow as a method of valuing commercial real estate construction projects. This practice has two substantial shortcomings. 1) The discount rate assumption relies on the market for competing investments at the time of the analysis, which would likely change, perhaps dramatically, over time, and 2) straight line assumptions about income increasing over ten years are generally based upon historic increases in market rent but never factors in the cyclical nature of many real estate markets. Most loans are made during boom real estate markets and these markets usually last less than ten years. Using DCF to analyze commercial real estate during any but the early years of a boom market will lead to overvaluation of the asset. Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on[3] involves calculating the period of time likely to recoup the initial outlay.

[edit] See also

Adjusted present value

Flows to equity

Capital asset pricing model Capital budgeting Cost of capital Economic value added Enterprise value Internal rate of return Financial modeling

Free cash flow Market value added Net present value Time value of money Valuation using discounted cash flows Weighted average cost of capital

[edit] References
1.
^ Oxera (April 2011). Discount rate for low-carbon and renewable generation technologies. Oxford, United Kingdom: Oxera Consulting Ltd. http://hmccc.s3.amazonaws.com/Renewables%20Review/Oxera%20low%20carbon %20discount%20rates%20180411.pdf. 2. ^ Pratt, Shannon; Robert F. Reilly, Robert P. Schweihs (2000). Valuing a Business. McGraw-Hill Professional. McGraw Hill. ISBN 0071356150. http://books.google.com/books? id=WO6wd8O8dsUC&printsec=frontcover&dq=shannon+pratt&ei=fcfUR6qF4TCyQSrxfWABA&sig=Fpqt8pGRjbLPZJ9e_QEQGFzQ7y0#PPA913,M1. 3. ^ "Discounted Cash Flow - DCF". investopedia.com. http://www.investopedia.com/terms/d/dcf.asp. Retrieved 22 November 2010.

[edit] External links

Continuous compounding/cash flows DCF Online Calculator The Theory of Interest at the Library of Economics and Liberty. Monography about DCF (including some lectures on DCF). Foolish Use of DCF. Motley Fool. Getting Started With Discounted Cash Flows. The Street. International Good Practice: Guidance on Project Appraisal Using Discounted Cash Flow, International Federation of Accountants, June 2008, ISBN 978-1934779-39-2 Equivalence between Discounted Cash Flow (DCF) and Residual Income (RI) Working paper; Duke University - Center for Health Policy, Law and Management

[edit] Further reading

International Association of CPAs, Attorneys, and Management (IACAM) (Free DCF Valuation E-Book Guidebook) International Federation of Accountants (2007). Project Appraisal Using Discounted Cash Flow. Copeland, Thomas E.; Tim Koller, Jack Murrin (2000). Valuation: Measuring and Managing the Value of Companies. New York: John Wiley & Sons. ISBN 0471-36190-9.

Damodaran, Aswath (1996). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. New York: John Wiley & Sons. ISBN 0471-13393-0. Rosenbaum, Joshua; Joshua Pearl (2009). Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. Hoboken, NJ: John Wiley & Sons. ISBN 0-470-44220-4. James R. Hitchnera (2006). Financial Valuation: Applications and Models. USA: Wiley Finance. ISBN 0-471-76117-6. v d eCorporate finance and investment banking Senior secured debt Senior debt Second lien debt Subordinated debt Mezzanine debt Convertible debt Exchangeable debt Preferred equity Warrant Shareholder loan Common equity Pari passu Initial public offering (IPO) Secondary Market Offering (SEO) Follow-on offering Rights issue Private Equity offerings placement Spin out Equity carveout Greenshoe (Reverse) Book building Bookrunner Underwriter Mergers andTakeover acquisitionsReverse takeover Tender offer Proxy fight Poison pill

Capital structure

Transactions (terms / conditions)

Staggered Board Squeeze out Tagalong right Dragalong right Preemption right Control premium Due diligence Divestment Sell side Buy side Demerger Supermajority Pitch book Leveraged buyout Leveraged recap Financial sponsor Private equity Leverage Bond offering High-yield debt DIP financing Project finance Debt restructuring Financial modeling Free cash flow Business valuation Fairness opinion Stock valuation APV DCF Net present value (NPV) Cost of capital (Weighted average) Comparable company analysis Accretion/dilution analysis Enterprise value Tax shield Minority interest Associate company EVA MVA Terminal value Real options valuation

Valuation

List of investment banks List of finance topics Retrieved from "http://en.wikipedia.org/wiki/Discounted_cash_flow" Categories: Basic financial concepts | Real estate | Cash flow | Corporate finance

Hidden categories: Articles needing additional references from January 2010 | All articles needing additional references | All pages needing cleanup | Wikipedia articles needing clarification from February 2009

Corporate finance
From Wikipedia, the free encyclopedia

Jump to: navigation, search Corporate finance

Working capital Cash conversion cycle Return on capital Economic value added Just in time Economic order quantity Discounts and allowances Factoring (finance) Capital budgeting Capital investment decisions The investment decision The financing decision Sections Managerial finance Financial accounting Management accounting Mergers and acquisitions Balance sheet analysis Business plan Corporate action Societal components Financial market Financial market participants Corporate finance Personal finance

Public finance Banks and Banking Financial regulation Clawback This box: view talk edit

Domestic credit to private sector in 2005. Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate value[1] while managing the firm's financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms. The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers).[citation needed] The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms corporate finance and corporate financier may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses.

Contents
[hide]

1 Capital investment decisions o 1.1 The investment decision 1.1.1 Project valuation 1.1.2 Valuing flexibility 1.1.3 Quantifying uncertainty o 1.2 The financing decision o 1.3 The dividend decision 2 Working capital management o 2.1 Decision criteria o 2.2 Management of working capital 3 Relationship with other areas in finance o 3.1 Investment banking o 3.2 Financial risk management o 3.3 Personal and public finance 4 See also 5 References

[edit] Capital investment decisions

Capital investment decisions[2] are long-term corporate finance decisions relating to fixed assets and capital structure. Decisions are based on several inter-related criteria. (1) Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate in consideration of risk. (2) These projects must also be financed appropriately. (3) If no such opportunities exist, maximizing shareholder value dictates that management must return excess cash to shareholders (i.e., distribution via dividends). Capital investment decisions thus comprise an investment decision, a financing decision, and a dividend decision.

[edit] The investment decision

Main article: Capital budgeting Management must allocate limited resources between competing opportunities (projects) in a process known as capital budgeting.[3] Making this investment, or capital allocation, decision requires estimating the value of each opportunity or project, which is a function of the size, timing and predictability of future cash flows.

[edit] Project valuation

Further information: Business valuation, stock valuation, and fundamental analysis

In general,[4] each project's value will be estimated using a discounted cash flow (DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams: theory). This requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future cash flows are then discounted to determine their present value (see Time value of money). These present values are then summed, and this sum net of the initial investment outlay is the NPV. See Financial modeling. The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate - often termed, the project "hurdle rate"[5] - is critical to making an appropriate decision. The hurdle rate is the minimum acceptable return on an investmenti.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured by volatility of cash flows, and must take into account the financing mix. Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.) In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance. These are visible from the DCF and include discounted payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI. Alternatives (complements) to NPV include MVA / EVA (Joel Stern, Stern Stewart & Co) and APV (Stewart Myers). See list of valuation topics.

[edit] Valuing flexibility

Main articles: Real options analysis and decision tree In many cases, for example R&D projects, a project may open (or close) the paths of action to the company, but this reality will not typically be captured in a strict NPV approach.[6] Management will therefore (sometimes) employ tools which place an explicit value on these options. So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted, here the flexibile and staged nature of the investment is modelled, and hence "all" potential payoffs are considered. The difference between the two valuations is the "value of flexibility" inherent in the project. The two most common tools are Decision Tree Analysis (DTA)[7][8] and Real options analysis (ROA);[9] they may often be used interchangeably:

DTA values flexibility by incorporating possible events (or states) and consequent management decisions. (For example, a company would build a factory given that demand for its product exceeded a certain level during the pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by contrast, there

is no "branching" - each scenario must be modelled separately.) In the decision tree, each management decision in response to an "event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this knowledge of the events that could follow, and assuming rational decision making, management chooses the actions corresponding to the highest value path probability weighted; (3) this path is then taken as representative of project value. See Decision theory: Choice under uncertainty.

ROA is usually used when the value of a project is contingent on the value of some other asset or underlying variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low, management will abandon the mining rights, if sufficiently high, management will develop the ore body. Again, a DCF valuation would capture only one of these outcomes.) Here: (1) using financial option theory as a framework, the decision to be taken is identified as corresponding to either a call option or a put option; (2) an appropriate valuation technique is then employed - usually a variant on the Binomial options model or a bespoke simulation model, while Black Scholes type formulae are used less often; see Contingent claim valuation. (3) The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in corporate finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options was originally per Timothy Luehrman, in the late 1990s.)

[edit] Quantifying uncertainty

Further information: Sensitivity analysis, Scenario planning, and Monte Carlo methods in finance Given the uncertainty inherent in project forecasting and valuation,[8][10] analysts will wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change in that factor is then observed, and is calculated as a "slope": NPV / factor. For example, the analyst will determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and their various combinations produce a "value-surface" (or even a "value-space"), where NPV is then a function of several variables. See also Stress testing. Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (demand for the product, exchange rates, commodity prices, etc...) as well as for company-specific factors (unit costs, etc...). As an example, the analyst may specify various revenue growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case"), where all key inputs are adjusted so as to be consistent with the growth assumptions, and

calculate the NPV for each. Note that for scenario based analysis, the various combinations of inputs must be internally consistent, whereas for the sensitivity approach these need not be so. An application of this methodology is to determine an "unbiased" NPV, where management determines a (subjective) probability for each scenario the NPV for the project is then the probability-weighted average of the various scenarios. A further advancement is to construct stochastic[11] or probabilistic financial models as opposed to the traditional static and deterministic models as above.[10] For this purpose, the most common method is to use Monte Carlo simulation to analyze the projects NPV. This method was introduced to finance by David B. Hertz in 1964, although it has only recently become common: today analysts are even able to run simulations in spreadsheet based DCF models, typically using an add-in, such as Crystal Ball. Here, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". In contrast to the scenario approach above, the simulation produces several thousand random but possible outcomes, or "trials"; see Monte Carlo Simulation versus What If Scenarios. The output is then a histogram of project NPV, and the average NPV of the potential investment as well as its volatility and other sensitivities is then observed. This histogram provides information not visible from the static DCF: for example, it allows for an estimate of the probability that a project has a net present value greater than zero (or any other value). Continuing the above example: instead of assigning three discrete values to revenue growth, and to the other relevant variables, the analyst would assign an appropriate probability distribution to each variable (commonly triangular or beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions would then be "sampled" repeatedly - incorporating this correlation - so as to generate several thousand random but possible scenarios, with corresponding valuations, which are then used to generate the NPV histogram. The resultant statistics (average NPV and standard deviation of NPV) will be a more accurate mirror of the project's "randomness" than the variance observed under the scenario based approach. These are often used as estimates of the underlying "spot price" and volatility for the real option valuation as above; see Real options valuation: Valuation inputs. A more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a credit crunch) that drive variations in one or more of the DCF model inputs.

[edit] The financing decision

Main article: Capital structure Achieving the goals of corporate finance requires that any corporate investment be financed appropriately.[12] As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix can impact the valuation and long-term management. Management must therefore identify the "optimal mix" of financingthe capital structure that results in maximum value. (See Balance sheet, WACC, Fisher separation theorem; but, see also the Modigliani-Miller theorem.)

The sources of financing will, generically, comprise some combination of debt and equity financing. Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow implications independent of the project's degree of success. Equity financing is less risky with respect to cash flow commitments, but results in a dilution of share ownership, control and earnings. The cost of equity is also typically higher than the cost of debt (see CAPM and WACC), and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.[13] Management must also attempt to match the financing mix to the asset being financed as closely as possible, in terms of both timing and cash flows. One of the main theories of how firms make their financing decisions is the Pecking Order Theory, which suggests that firms avoid external financing while they have internal financing available and avoid new equity financing while they can engage in new debt financing at reasonably low interest rates. Another major theory is the Trade-Off Theory in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when making their decisions. An emerging area in finance theory is right-financing whereby investment banks and corporations can enhance investment return and company value over time by determining the right investment objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and under given market conditions. One last theory about this decision is the Market timing hypothesis which states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity.

[edit] The dividend decision

Main article: The Dividend Decision Whether to issue dividends,[14] and what amount, is calculated mainly on the basis of the company's unappropriated profit and its earning prospects for the coming year. The amount is also often calculated based on expected free cash flows i.e. cash remaining after all business expenses, and capital investment needs have been met. If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then - finance theory suggests - management must return excess cash to investors as dividends. This is the general case, however there are exceptions. For example, shareholders of a "Growth stock", expect that the company will, almost by definition, retain earnings so as to fund growth internally. In other cases, even though an opportunity is currently NPV negative, management may consider investment flexibility / potential payoffs and decide to retain cash flows; see above and Real options. Management must also decide on the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate

action. Today, it is generally accepted that dividend policy is value neutral - i.e. the value of the firm would be the same, whether it issued cash dividends or repurchased its stock (see Modigliani-Miller theorem).

[edit] Working capital management

Main article: Working capital Decisions relating to working capital and short term financing are referred to as working capital management.[15] These involve managing the relationship between a firm's shortterm assets and its short-term liabilities. As above, the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive investments. These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of Working capital management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See Economic value added (EVA).

[edit] Decision criteria

Working capital is the amount of capital which is readily available to an organization. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements (Current Liabilities). As a result, the decisions relating to working capital are always current, i.e. short term, decisions. In addition to time horizon, working capital decisions differ from capital investment decisions in terms of discounting and profitability considerations; they are also "reversible" to some extent. (Considerations as to Risk appetite and return targets remain identical, although some constraints - such as those imposed by loan covenants - may be more relevant here). Working capital management decisions are therefore not taken on the same basis as long term decisions, and working capital management applies different criteria in decision making: the main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which cash flow is probably the more important).

The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle. This represents the time difference between cash payment for raw materials and cash collection for sales. The cash conversion cycle indicates the firm's ability to convert its resources into cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.

(Another measure is gross operating cycle which is the same as net operating cycle except that it does not take into account the creditors deferral period.)

In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. As above, firm value is enhanced when, and if, the return on capital, exceeds the cost of capital. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making.

[edit] Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital.[16] These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.

Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs. Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity (EPQ). Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances. Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

[edit] Relationship with other areas in finance

[edit] Investment banking
Use of the term corporate finance varies considerably across the world. In the United States it is used, as above, to describe activities, decisions and techniques that deal with many aspects of a companys finances and capital. In the United Kingdom and Commonwealth countries, the terms corporate finance and corporate financier tend

to be associated with investment banking - i.e. with transactions in which capital is raised for the corporation.[17] These may include

Raising seed, start-up, development or expansion capital Mergers, demergers, acquisitions or the sale of private companies Mergers, demergers and takeovers of public companies, including public-toprivate deals Management buy-out, buy-in or similar of companies, divisions or subsidiaries typically backed by private equity Equity issues by companies, including the flotation of companies on a recognised stock exchange in order to raise capital for development and/or to restructure ownership Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and restructuring of businesses Financing joint ventures, project finance, infrastructure finance, public-private partnerships and privatisations Secondary equity issues, whether by means of private placing or further issues on a stock market, especially where linked to one of the transactions listed above. Raising debt and restructuring debt, especially when linked to the types of transactions listed above

[edit] Financial risk management

Main article: Financial risk management Risk management and Global Association of Risk Professionals is the process of measuring risk and then developing and implementing strategies to manage that risk. Financial risk management focuses on risks that can be managed ("hedged") using traded financial instruments (typically changes in commodity prices, interest rates, foreign exchange rates and stock prices). Financial risk management will also play an important role in cash management. This area is related to corporate finance in two ways. Firstly, firm exposure to business and market risk is a direct result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of enhancing, or preserving, firm value. All[citation needed] large corporations have risk management teams, and small firms practice informal, if not formal, risk management. There is a fundamental debate on the value of "Risk Management" and shareholder value that questions a shareholder's desire to optimize risk versus taking exposure to pure risk (a risk event that only has a negative side, such as loss of life or limb). The debate links value of risk management in a market to the cost of bankruptcy in that market. Derivatives are the instruments most[citation needed] commonly used in financial risk management. Because unique derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk management methods usually involve derivatives that trade on well-established financial markets or exchanges. These standard derivative

instruments include options, futures contracts, forward contracts, and swaps. More customized and second generation derivatives known as exotics trade over the counter aka OTC. See: Financial engineering; Financial risk; Default (finance); Credit risk; Interest rate risk; Liquidity risk; Market risk; Operational risk; Volatility risk; Settlement risk; Value at Risk;.

[edit] Personal and public finance

Corporate finance utilizes tools from almost all areas of finance. Some of the tools developed by and for corporations have broad application to entities other than corporations, for example, to partnerships, sole proprietorships, not-for-profit organizations, governments, mutual funds, and personal wealth management. But in other cases their application is very limited outside of the corporate finance arena. Because corporations deal in quantities of money much greater than individuals, the analysis has developed into a discipline of its own. It can be differentiated from personal finance and public finance.

[ Debt overhang
From Wikipedia, the free encyclopedia

Jump to: navigation, search A debt overhang problem emerges if a company has a new investment project with positive net present value (NPV), but cannot capture the investment opportunity due to an existing debt position, i.e., the face value of the existing debt is bigger than the expected payoff to debt holders. Thus, debt holders will not finance the firm. The situation emerges if existing debtholders of a company can be expected to lay claim to (part of) the profits of the new project, and this renders the NPV of the project (when undertaken by this company) negative.

Contents
[hide]

1 Overview 2 Debt overhang and the Financial Crisis of 2008 3 Structural macroeconomic debt overhang 4 See also 5 Further reading 6 References

[edit] Overview
The result of having excessive debt is that any earnings generated by new investment projects are partially appropriated by existing debt holders. A firm facing debt overhang cannot issue new junior debt because default is likely. Moreover, more debt will make the problems of debt overhang worse not better. In addition, the firm's shareholders do not want to issue new stock because this forces shareholders to bear some of the losses that would have been borne by junior creditors. Thus, the firm refuses to fund projects with a positive NPV. This problem was first discussed by (Myers, 1977). Debt overhang can affect firms or banks that have excessive amounts of debt, but are solvent, in the sense that the value of their assets exceeds the value of their liabilities. Debt overhang also prevents firms that are insolvent, with assets worth less than their liabilities from recovering from their troubles. Bankruptcy which takes the form of Chapter 11 reorganization or receivership, for banks, can cure the problems of debt overhang for insolvent institutions. Successful bankruptcy reorganizations allow organizations to reduce their debt levels and allow new private shareholders to bear enough of the gains from new investments that they will pursue new projects that have positive expected net present value. The concept of debt overhang has been applied to sovereign governments, predominantly in developing countries (Krugman, 1988). It describes a situation where the debt of a country exceeds its future capacity to pay it.[1] Debt overhang in developing countries was the motivation for the successful Jubilee 2000 campaign.

[edit] Debt overhang and the Financial Crisis of 2008

The problem of debt overhang was used as a justification by governments to inject capital into banks around the world after the collapse of Lehman Brothers in September 2008 and the subsequent falls in stock markets worldwide. Nevertheless, many governments in the financial crisis of 2008, including the United States, primarily bought newly issued preferred stock. Preferred stock is similar to debt in that it gets paid before common stock; it also pays regular dividends that are similar to interest. Thus, the capital infusions of Troubled Assets Relief Program's Capital Purchase Program (TARP CPP) in the

United States may have done little to cure debt overhang problems in the United States largest banks. Academic research suggests that if the government bought common stock or toxic assets in troubled banks that the debt overhang problem would be better corrected.[2] Nevertheless, if a bank is very insolvent, subsidies will have to be extremely large to correct the problems of debt overhang and unsecured debt and preferred stock holders may have to bear some losses.[3] Interviews with many bank executives found that many banks were not eager to increase lending after receiving TARP funds. [4] The Congressional Review Panel, created to oversee the TARP, concluded on January 9, 2009 that, "Although half the money has not yet been received by the banks, hundreds of billions of dollars have been injected into the marketplace with no demonstrable effects on lending."[5]

[edit] Structural macroeconomic debt overhang

This occurs if there is a latent output gap or underemployment in an economy, which is bridged repeatedly by credit creation, the build up of which results in a debt overhang. Conversely, you may deduce from a long term tendency to build up debt the existence of latent structural underemployment. Typically private lenders (banks) boldly venture forth: whether they lend to developing countries like in the 1970s, covered by the expected stream of high future coupons, or excessive consumption of their own folk covered by higher paper valuations of assets, it is the same basic story. In the eventual shakeout (due yet again, in the last instance, to latent underemployment), the debt overhang is preserved by substituting public debt for private debt (bailouts), andkeeps growing.

[edit] See also

Capital structure Corporate finance Credit creation

[edit] Further reading

Myers, S. (1977), "Determinants of Corporate Borrowing", Journal of Financial Economics, 5, 147-75 Krugman, Paul R., "Market-Based Debt-Reduction Schemes", (May 1, 1988). NBER Working Paper No. W2587

[edit] References
1.
^ "Debt Overhang.". Investopedia ULC. August 2007. http://www.investopedia.com/terms/d/debtoverhang.asp. Retrieved 2007-08-10. 2. ^ "Debt Overhang and Bank Bailouts". SSRN.com. February 2, 2009. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1336288. Retrieved February 2, 2009.

3.

^ "The Put Problem with Buying Toxic Assets". SSRN.com. February 14, 2009. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1343625. Retrieved February 15, 2009. 4. ^ McIntire, Mike (2009-01-17). "Bailout Is a Windfall to Banks, if Not to Borrowers.". New York Times (New York Times). http://www.nytimes.com/2009/01/18/business/18bank.html. Retrieved 2009-01-20. 5. ^ Accountability for the Troubled Asset Relief Program: The Second Report of the Congressional Oversight Panel January 9, 2009. [1] Downloaded January 20, 2009.

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Enterprise value
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Accountancy
Key concepts Accountant Accounting period Bookkeeping Cash and

accrual basis Cash flow management Chart of accounts Constant Purchasing Power Accounting Cost of goods sold Credit terms Debits and credits Double-entry system Fair value accounting FIFO & LIFO GAAP / IFRS General ledger Goodwill Historical cost Matching principle Revenue recognition Trial balance Fields of accounting Cost Financial Forensic Fund Management Mergers and Acquisitions Tax Financial statements Statement of Financial Position Statement of cash flows Statement of changes in equity Statement of comprehensive income Notes MD&A XBRL Auditing Auditor's report Financial audit GAAS / ISA Internal audit SarbanesOxley Act Accounting qualifications CA CPA CCA CGA CMA This box: view talk edit

Enterprise value (EV), Total enterprise value (TEV), or Firm value (FV) is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others. Enterprise value is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, etc. EV is more comprehensive than market capitalization (market cap), which only includes common equity.

Contents
[hide]

1 EV equation 2 Comments on basic EV equation 3 Intuitive Understanding of Enterprise Value 4 Usage 5 See also 6 External links

[edit] EV equation
Enterprise value = common equity at market value + debt at market value + minority interest at market value, if any - associate company at market value, if any + preferred equity at market value - cash and cash-equivalents.

[edit] Comments on basic EV equation

All the components are taken at marketnot bookvalues, reflecting an opportunistic nature of the EV metric. Some proponents argue that debt should be accounted for at book value. This is particularly relevant in liquidation analysis, since using absolute priority in a bankruptcy all securities senior to the equity have par claims. Generally, also, debt is less liquid than equity so that the "market price" may be significantly different from the price at which an entire debt issue could be purchased in the market. In valuing equities, this approach is more conservative. Cash is subtracted because when it is paid out as a dividend after purchase, it reduces the net cost to a potential purchaser. Therefore, the business was only worth the reduced amount to start with. The same effect is accomplished when the cash is used to pay down debt. Value of minority interest is added because it reflects the claim on assets consolidated into the firm in question. Value of associate companies is subtracted because it reflects the claim on assets consolidated into other firms. EV should also include such special components as unfunded pension liabilities, employee stock option, environmental provisions, abandonment provisions, and so on, for they also reflect claims on the company's assets. EV can be negative in certain casesfor example, when there is more cash in the company than the value of the other components of EV.

[edit] Intuitive Understanding of Enterprise Value

A simplified way to understand the EV concept is to envision purchasing an entire business. If you settle with all the security holders, you buy EV.

[edit] Usage

Because EV is a capital structure-neutral metric, it is useful when comparing companies with diverse capital structures. Price/earnings ratios, for example, will be significantly more volatile in companies that are highly leveraged. Stock market investors use EV/EBITDA to compare returns between equivalent companies on a risk-adjusted basis. They can then superimpose their own choice of debt levels. In practice, equity investors may have difficulty accurately assessing EV if they do not have access to the market quotations of the company debt. It is not sufficient to substitute the book value of the debt because a) the market interest rates may have changed, and b) the market's perception of the risk of the loan may have changed since the debt was issued. Remember, the point of EV is to neutralize the different risks, and costs of different capital structures. Buyers of controlling interests in a business use EV to compare returns between businesses, as above. They also use the EV valuation (or a debt free cash free valuation) to determine how much to pay for the whole entity (not just the equity). They may want to change the capital structure once in control.

[edit] See also

DCF, discounted cash flow method of valuation Capital structure WACC, weighted average cost of capital Triple Accounting

[edit] External links

Wikianswers: debt free cash free [hide]v d eCorporate finance and investment banking

Capital structure

Senior secured debt Senior debt Second lien debt Subordinated debt Mezzanine debt Convertible debt Exchangeable debt Preferred equity Warrant Shareholder loan Common equity Pari passu Initial public offering (IPO) Secondary Market Offering (SEO) Follow-on offering Rights issue Private Equity offerings placement Spin out Equity carveout Greenshoe (Reverse) Book building Bookrunner Underwriter Mergers andTakeover acquisitionsReverse takeover Tender offer Proxy fight Poison pill Staggered Board Squeeze out Tagalong right Dragalong right Preemption right Control premium Due diligence Divestment Sell side Buy side Demerger Super-

Transactions (terms / conditions)

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Financial modeling
From Wikipedia, the free encyclopedia

Jump to: navigation, search It has been suggested that this article or section be merged with Modeling and analysis of financial markets. (Discuss) Proposed since June 2008.

Financial modeling is the task of building an abstract representation (a model) of a financial decision making situation.[1] This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or a portfolio, of a business, a project, or any other investment. Financial modeling is a general term that means different things to different users; the reference usually relates either to accounting and corporate finance applications, or to quantitative finance applications. While there has been some debate in the industry as to the nature of financial modeling - whether it is a tradecraft, such as welding, or a science - the task of financial modeling has been gaining acceptance and rigor over the years.[2] Several scholarly books have been written on the topic, in addition to numerous scientific articles.[3]

Contents
[hide]

1 Accounting 2 Quantitative finance 3 See also 4 Selected books 5 External links

[edit] Accounting
In corporate finance, investment banking and the accounting profession (and generally in Europe [4][citation needed]), financial modelling is largely synonymous with cash flow forecasting.[5] This usually involves the preparation of detailed company specific models used for decision making purposes;[6] see Financial analyst. Applications include:

Business valuation, especially discounted cash flow, but including other valuation problems Scenario planning and management decision making ("what is"; "what if"; "what has to be done" [7]). Capital budgeting Cost of capital (i.e. WACC) calculations Financial analysis and / or Financial statement analysis Project finance.

To generalize as to the nature of these models: firstly, as they are built around financial statements, calculations and outputs are monthly, quarterly or annual; secondly, the inputs take the form of assumptions, where the analyst specifies the values that will apply in each period for external / global variables (exchange rates, tax percentage, etc) and internal / company specific variables (wages, unit costs , etc). Correspondingly, both characteristics are reflected (at least implicitly) in the mathematical form of these models: firstly, the models are in discrete time; secondly, they are deterministic. [8] For discussion of the issues that may arise, see below; for dicussion as to more sophisticated approaches sometimes employed, see Corporate finance: Quantifying uncertainty. Modellers are sometimes referred to (tongue in cheek) as "Number crunchers",[9] and are often designated as "Financial analyst". Typically, the modeller will have completed an MBA or MSF with (optional) coursework in "financial modeling". Accounting qualifications,[10] and finance certifications such as the CIIA, CEFA, CFA, [11] generally do not provide direct / explicit training in modeling. At the same time, numerous commercial training courses are offered, [12] [13] both through universities and privately.

Although purpose built software does exist, the vast proportion of the market is spreadsheet-based[citation needed] - this is largely since the models are almost always company specific. Microsoft Excel now has by far the dominant position, having overtaken Lotus 1-2-3 in the 1990s. Spreadsheet-based modelling can have its own problems [14] ("Spreadsheet Shortcomings"), and several standardizations and "best practices" have been proposed. "Spreadsheet risk" is increasingly studied and managed.[15] One critique here, is that model outputs, i.e. line items, often incorporate unrealistic implicit assumptions and internal inconsistencies [16] (for example, a forecast for growth in revenue but without corresponding increases in working capital, fixed assets and the associated financing, may imbed unrealistic assumptions about asset turnover, leverage and / or equity financing). What is required, but often lacking, is that all key elements are explicitly and consistently forecasted. An extension of this is that modellers often additionally "fail to identify crucial assumptions" relating to inputs, "and to explore what can go wrong".[17] Here, in general, modellers "use point values and simple arithmetic instead of probability distributions and statistical measures"[18] - i.e., as mentioned, the problems are treated as deterministic in nature - and thus calculate a single value for the asset or project, but without providing information on the range, variance and sensitivity of outcomes; [19]. Other critiques discuss the lack of adequate spreadsheet design skills,[20] and of basic computer programming concepts. [21] (More serious criticism, in fact, relates to the nature of budgeting itself, and its impact on the organization. [22][23])

[edit] Quantitative finance

In quantitative finance (and generally in the U.S. [24][citation needed]), financial modelling entails the development of a sophisticated mathematical model. Models here deal with asset prices, market movements, portfolio returns and the like. Applications include:

Option pricing and "Greeks"; other derivatives Modeling the term structure of interest rates (short rate modelling) and credit spreads; Interest rate derivatives Credit scoring and provisioning Portfolio problems Real options Risk modeling and Value at risk.

These problems are often stochastic and continuous in nature, and models here thus require complex algorithms, entailing computer simulation, advanced numerical methods (such as numerical differential equations and Numerical linear algebra), and / or the development of optimization models. The general nature of these problems is discussed under Modeling and analysis of financial markets, while specific techniques are listed under Outline of finance: Mathematical tools.

Modellers are generally referred to as "quants" (quantitative analysts), and typically have strong (Ph.D. level) backgrounds in quantitative disciplines such as physics, engineering, computer science, mathematics or operations research. Alternatively / additionally they have completed a finance masters with a quantitative orientation, such as the Master of Quantitative Finance, or the more specialized Master of Computational Finance or Master of Financial Engineering. Although spreadsheets are widely used here also (almost always requiring extensive VBA), custom C++ or numerical analysis software such as MATLAB is often preferred, particularly where stability or speed is a concern. [25] Additionally, for many derivative and portfolio applications, commercial software is available, and the choice as to whether the model is to be developed in-house, or whether existing products are to be deployed, will depend on the problem in question. [26] The complexity of these models may result in incorrect pricing or hedging or both. This Model risk is the subject of ongoing research by finance academics,[27] and is a topic of great, and growing, interest in the risk management arena. [28] Criticism of the discipline (often preceding the Financial crisis of 2007-2008 by several years) emphasizes the differences between the mathematical and physical sciences and finance, and the resultant caution to be applied by modelers, and by traders and risk managers using their models. Notable here are Emanuel Derman [29] and Paul Wilmott [30]; see the Financial Modelers' Manifesto. Some go further and question whether mathematical and statistical modeling may be applied to finance at all, at least with the assumptions usually made (for options; for portfolios). In fact, these may go so far as to question the "empirical and scientific validity... of modern financial theory" [31]. Notable here are Nassim Taleb [32] and Benoit Mandelbrot [33].

[edit] See also

Economic model Financial engineering Financial forecast Financial Modelers' Manifesto Financial planning Integrated business planning Model audit Modeling and analysis of financial markets

[edit] Selected books

Benninga, Simon (1997). Financial Modeling. Cambridge, MA: MIT Press. ISBN 0-585-13223-2. Benninga, Simon (2006). Principles of Finance with Excel. New York: Oxford University Press. ISBN 0-195-30150-1.

Clewlow, Les; Chris Strickland (1998). Implementing Derivative Models. New Jersey: Wiley. ISBN 0471966517. Day, Alastair (2007). Mastering Financial Modelling in Microsoft Excel. London: Pearson Education. ISBN 0-273-70806-6. Fabozzi, Frank J.; Sergio M. Focardi, Petter N. Kolm (2004). Financial Modeling of the Equity Market: From CAPM to Cointegration. Hoboken, NJ: Wiley. ISBN 0-471-69900-4. Fusai, Gianluca; Andrea Roncoroni (2008). Implementing Models in Quantitative Finance: Methods and Cases. London: Springer Finance. ISBN 3540223487. Haug, Espen (2006). The Complete Guide to Option Pricing Formulas. New York: McGraw-Hill. ISBN 0071389970. Jackson, Mary; Mike Staunton (2001). Advanced modelling in finance using Excel and VBA. New Jersey: Wiley. ISBN 0471499226. Jondeau, Eric; Ser-Huang Poon, Michael Rockinger (2007). Financial Modeling Under Non-Gaussian Distributions. London: Springer. ISBN 1-846-28419-9. Ongkrutaraksa, Worapot (2006). Financial Modeling and Analysis: A Spreadsheet Technique for Financial, Investment, and Risk Management, 2nd Edition. Frenchs Forest: Pearson Education Australia. ISBN 0-733-98474-6. Proctor, Scott (2009). Building Financial Models with Microsoft Excel: A Guide for Business Professionals, 2nd Edition. Hoboken, NJ: Wiley. ISBN 978-0-47048174-5. Swan, Jonathan (2007). Financial Modelling Special Report. London: Institute of Chartered Accountants in England & Wales. Swan, Jonathan (2008). Practical Financial Modelling, 2nd Edition. London: CIMA Publishing. ISBN 0-750-68647-2. Tjia, John (2003). Building Financial Models. New York: McGraw-Hill. ISBN 0071-40210-1. Vladimirou, Hercules (2007). Financial Modeling. Norwell, MA: Springer. ISBN 0-585-13223-2.

[edit] External links

Best Practice: Spreadsheet Modelling Standards, Spreadsheet Standards Review Board Best Practice, European Spreadsheet Risks Interest Group FAST Modeling Standard, The FAST Modelling Standard Eliminating Risks in Spreadsheets A useful article on how to avoid common spreadsheet modeling errors Best practice of financial modelling - An article for finance professionals by Arixcel Ltd Articles on Financial Modeling by Pristine - A useful set of blog articles and free financial models (open sourced) by Pristine

[hide]v d eCorporate finance and investment banking Senior secured debt Senior debt Second lien debt Subordinated debt Mezzanine debt Convertible debt Exchangeable debt Preferred equity Warrant Shareholder loan Common equity Pari passu Initial public offering (IPO) Secondary Market Offering (SEO) Follow-on offering Rights issue Private Equity offerings placement Spin out Equity carveout Greenshoe (Reverse) Book building Bookrunner Underwriter Mergers andTakeover acquisitionsReverse takeover Tender offer Proxy fight Poison pill Staggered Board Squeeze out Tagalong right Dragalong right Preemption right Control premium Due diligence Divestment Sell

Capital structure

Transactions (terms / conditions)

side Buy side Demerger Supermajority Pitch book Leveraged buyout Leveraged recap Financial sponsor Private equity Leverage Bond offering High-yield debt DIP financing Project finance Debt restructuring Financial modeling Free cash flow Business valuation Fairness opinion Stock valuation APV DCF Net present value (NPV) Cost of capital (Weighted average) Comparable company analysis Accretion/dilution analysis Enterprise value Tax shield Minority interest Associate company EVA MVA Terminal value Real options valuation

Valuation

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Financial economics
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Economics

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Financial economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment".[1] It is additionally characterised by its "concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a trade".[2] The questions within financial economics are typically framed in terms of "time, uncertainty, options and information".[2]

Time: money now is traded for money in the future.

Uncertainty (or risk): The amount of money to be transferred in the future is uncertain. Options: one party to the transaction can make a decision at a later time that will affect subsequent transfers of money. Information: knowledge of the future can reduce, or possibly eliminate, the uncertainty associated with future monetary value (FMV).

The subject is usually taught at a postgraduate level; see Master of Financial Economics.

Contents
[hide]

1 Subject matter 2 Models in Financial economics 3 See also 4 References 5 External links o 5.1 Theory o 5.2 Context and history
o

5.3 Links and portals

[edit] Subject matter

Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance. It studies:

Valuation - Determination of the fair value of an asset o How risky is the asset? (identification of the asset appropriate discount rate) o What cash flows will it produce? (discounting of relevant cash flows) o How does the market price compare to similar assets? (relative valuation) o Are the cash flows dependent on some other asset or event? (derivatives, contingent claim valuation) Financial markets and instruments o Commodities - topics o Stocks - topics o Bonds - topics o Money market instruments- topics o Derivatives - topics

Financial institutions and regulation

Financial Econometrics is the branch of Financial Economics that uses econometric techniques to parameterise the relationships.

[edit] Models in Financial economics

Financial economics is primarily concerned with building models to derive testable or policy implications from acceptable assumptions. Some fundamental ideas in financial economics are portfolio theory, the Capital Asset Pricing Model. Portfolio theory studies how investors should balance risk and return when investing in many assets or securities. The Capital Asset Pricing Model describes how markets should set the prices of assets in relation to how risky they are. The Modigliani-Miller Theorem describes conditions under which corporate financing decisions are irrelevant for value, and acts as a benchmark for evaluating the effects of factors outside the model that do affect value. A common assumption is that financial decision makers act rationally (see Homo economicus; efficient market hypothesis). However, recently, researchers in experimental economics and experimental finance have challenged this assumption empirically. They are also challenged - theoretically - by behavioral finance, a discipline primarily concerned with the limits to rationality of economic agents. Other common assumptions include market prices following a random walk, or asset returns being normally distributed. Empirical evidence suggests that these assumptions may not hold, and in practice, traders and analysts, and particularly risk managers, frequently modify the "standard models".

[edit] See also

Book: Finance
Wikipedia Books are collections of articles that can be downloaded or ordered in print.

List of economics topics List of economists List of finance topics List of master's degrees in financial economics Deutsche Bank Prize in Financial Economics

[edit] References
This article includes a list of references, but its sources remain unclear because it has insufficient inline citations. Please help to improve this article by introducing more precise citations where appropriate. (October 2009)

1. ^ "Robert C. Merton - Nobel Lecture" (PDF).

http://nobelprize.org/nobel_prizes/economics/laureates/1997/merton-lecture.pdf. Retrieved 2009-08-06. 2. ^ a b "Financial Economics". Stanford.edu. http://www.stanford.edu/~wfsharpe/mia/int/mia_int2.htm. Retrieved 2009-08-06.

[edit] External links

This article's use of external links may not follow Wikipedia's policies or guidelines. Please improve this article by removing excessive and inappropriate external links. (October 2009)

[edit] Theory

Foundations of Finance, Theory of Finance, Eugene Fama, University of Chicago Graduate School of Business Macro-Investment Analysis, Professor William Sharpe, Stanford Graduate School of Business Lecture Notes in Financial Economics, Antonio Mele, London School of Economics Great Moments in Financial Economics I, II, "III". Archived from the original on 2007-09-27. http://web.archive.org/web/20070927123024/http://www.in-themoney.com/artandpap/III+Short-Sales+and+Stock+Prices.doc.; IVa; "IVb". Archived from the original on 2007-09-27. http://web.archive.org/web/20070927123021/http://www.in-themoney.com/artandpap/IV+Fundamental+Theorem+-+Part+II.doc.. Prof. Mark Rubinstein, Haas School of Business Microfoundations of Financial Economics Prof. Andr Farber Solvay Business School Handbook of the Economics of Finance, G.M. Constantinides, M. Harris, R. M. Stulz Financial economics, International Encyclopedia of the Social & Behavioral Sciences, Oxford: Elsevier, 2001. Financial economics topics with Abstracts, The New Palgrave Dictionary of Economics, 2008. An introduction to investment theory, Prof. William Goetzmann, Yale School of Management Notes on General Equilibrium Asset Pricing, Prof. Paulo Brito, ISEG, Technical University of Lisbon

[edit] Context and history

Finance Theory, The History of Economic Thought Website, The New School The Scientific Evolution of Finance Prof. Don Chance, Prof. Pamela Peterson 50 Years of Finance Prof. Andr Farber, Universit Libre de Bruxelles "A Short History of Investment Forecasting". Archived from the original on 200710-12.

http://web.archive.org/web/20071012112134/http://roundtable.informs.org/public -access/min061a.htm., Professor Michael Phillips, California State University, Northridge Pioneers of Finance, Prof. Larry Guin, Murray State University

[edit] Links and portals

Financial Economics Links on WebEc JEL Classification Codes Guide Financial Economics Links on RFE SSRN Financial Economics Network "Books on Financial Economics": list on economicsnetwork.ac.uk v d eEconomics Adaptive expectations Aggregate demand Balance of payments Business cycle Capital flight Capacity utilization Central bank Consumer confidence Currency Demand shock DSGE Economic indicator Effective demand General Theory of Keynes Great Depression Growth Hyperinflation Inflation Investment Interest rate IS/LM model Lending rate Microfoundations Money Monetary policy National accounts NAIRU Profit rate PPP Rational expectations Recession Savings rate Stagflation Supply shock Unemployment Macroeconomic publications Aggregation Budget Consumer Convexity Cost Costbenefit analysis Distribution Deadweight loss Duopoly Equilibria Economies of scale Economies of scope Elasticity Exchange Expected utility Externality Firms General equilibria Household Information Indifference curve Intertemporal choice Marginal cost Market failure Market structure Monopoly Monopsony Non-convexity Oligopoly Opportunity cost Preferences Prices Production Profit Public goods Returns to scale Risk Scarcity Shortage Social choice Sunk costs Supply & demand Surplus Uncertainty Utility theory Welfare Microeconomic publications International Development Labor Environmental

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Pecking Order Theory

From Wikipedia, the free encyclopedia

Jump to: navigation, search In the theory of firm's capital structure and financing decisions, the Pecking Order Theory or Pecking Order Model was first suggested by Donaldson in 1961 and it was modified by Stewart C. Myers and Nicolas Majluf in 1984 [1]. It states that companies prioritize their sources of financing (from internal financing to equity) according to the Principle of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued.

Contents
[hide]

1 Evidence 2 Profitability and debt ratios 3 See also 4 References

[edit] Evidence
Tests of the Pecking Order Theory have not been able to show that it is of first-order importance in determining a firm's capital structure. However, several authors have found that there are instances where it is a good approximation of reality. On the one hand, Fama and French[2], and also Myers and Shyam-Sunder[3] find that some features of the data are better explained by the Pecking Order than by the Trade-Off Theory. Goyal and Frank show, among other things, that Pecking Order theory fails where it should hold, namely for small firms where information asymmetry is presumably an important problem. [4]

[edit] Profitability and debt ratios

The Pecking Order Theory explains the inverse relationship between profitability and debt ratios: 1. Firms prefer internal financing. 2. They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden changes in dividends. 3. Sticky dividend policies, plus unpredictable fluctuations in profits and investment opportunities, mean that internally generated cash flow is sometimes more than capital expenditures and at other times less. If it is more, the firm pays off the debt

or invests in marketable securities. If it is less, the firm first draws down its cash balance or sells its marketable securities, rather than reduce dividends. 4. If external financing is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In addition, issue costs are least for internal funds, low for debt and highest for equity. There is also the negative signaling to the stock market associated with issuing equity, positive signaling associated with debt.

[edit] See also

Capital structure Capital structure substitution theory Corporate finance Cost of capital Market timing hypothesis Trade-Off Theory

[edit] References
1.
^ Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics, 1984 2. ^ Testing Trade-Off and Pecking Order Predictions About Dividends and Debt, Review of Financial Studies, 2002 3. ^ Testing static trade-off against pecking order models of capital structure, Journal of financial Economics, 1999 4. ^ Testing the pecking order theory of capital structure, Journal of Financial Economics, 2003

[hide]v d eCorporate finance and investment banking Senior secured debt Senior debt Second lien debt Subordinated debt Mezzanine debt Convertible debt Exchangeable debt Preferred equity Warrant Shareholder loan Common equity Pari passu Equity offeringsInitial public offering (IPO) Secondary Market Offering (SEO)

Capital structure

Transactions (terms / conditions)

Follow-on offering Rights issue Private placement Spin out Equity carveout Greenshoe (Reverse) Book building Bookrunner Underwriter Takeover Reverse takeover Tender offer Proxy fight Poison pill Staggered Board Squeeze out Tagalong right DragMergers and acquisitionsalong right Preemption right Control premium Due diligence Divestment Sell side Buy side Demerger Supermajority Pitch book LeverageLeveraged buyout Leveraged recap Financial sponsor Private equity Bond offering High-yield debt DIP financing

Project finance Debt restructuring Financial modeling Free cash flow Business valuation Fairness opinion Stock valuation APV DCF Net present value (NPV) Cost of capital (Weighted average) Comparable company analysis Accretion/dilution analysis Enterprise value Tax shield Minority interest Associate company EVA MVA Terminal value Real options valuation List of investment banks List of finance topics This business-related article is a stub. You can help Wikipedia by expanding it. Retrieved from "http://en.wikipedia.org/wiki/Pecking_Order_Theory" Categories: Business stubs | Financial economics | Business theory Personal tools

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Weighted average cost of capital

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Jump to: navigation, search The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC. Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.[1]

Contents
[hide]

1 Calculation 2 See also 3 References 4 External links

[edit] Calculation
In general, the WACC can be calculated with the following formula[2]:

where N is the number of sources of capital (securities, types of liabilities); ri is the required rate of return for security i; MVi is the market value of all outstanding securities i. Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one type of shares with the total market value of MVe and cost of equity Re and one type of bonds with the total market value of MVd and cost of debt Rd, in a country with corporate tax rate t is calculated as:

[edit] See also

Beta coefficient Cost of capital Discounted cash flow Economic Value Added Internal rate of return Minimum acceptable rate of return Modigliani-Miller theorem Net present value Opportunity cost

[edit] References
1. 2.
^ G. Bennet Stewart III (1991). The Quest for Value. HarperCollins. ^ J. Miles und J. Ezzell. "The weighted average cost of capital, perfect capital markets and project life: a clarification." Journal of Financial and Quantitative Analysis, 15 (1980), S. 719-730.

[edit] External links

Video about practical application of the WACC approach Velez-Pareja, Ignacio and Tham, Joseph, "A Note on the Weighted Average Cost of Capital WACC" (August 7, 2005). Available at SSRN: http://ssrn.com/abstract=254587. Unpublished. Cheremushkin, Sergei Vasilievich, How to Avoid Mistakes in Valuation Comment to 'Consistency in Valuation: A Practical Guide' by Velez-Pareja and Burbano-Perez and Some Pedagogical Notes on Valuation and Costs of Capital (December 21, 2009). http://papers.ssrn.com/sol3/papers.cfm? abstract_id=1526681. Unpublished. WACC calculator A more realistic valuation: APV and WACC with constant book leverage ratio

calculate the WACC with your own values to understand the equation Find the WACC of any publicly traded company by entering the firm's stock ticker symbol Paper describing a method for generating the WACC curve when there is default risk - spreadsheet available [hide]v d eCorporate finance and investment banking Senior secured debt Senior debt Second lien debt Subordinated debt Mezzanine debt Convertible debt Exchangeable debt Preferred equity Warrant Shareholder loan Common equity Pari passu Initial public offering (IPO) Secondary Market Offering (SEO) Follow-on offering Rights issue Private Equity offerings placement Spin out Equity carveout Greenshoe (Reverse) Book building Bookrunner Underwriter Mergers andTakeover acquisitionsReverse takeover Tender offer Proxy fight Poison pill Staggered Board Squeeze out Tagalong right Drag-

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List of investment banks List of finance topics Retrieved from "http://en.wikipedia.org/wiki/Weighted_average_cost_of_capital" Categories: Capital | Mathematical finance Personal tools

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Dansk Deutsch Espaol Franais Italiano Latvieu Nederlands Polski Portugus Slovenina Svenska This page was last modified on 14 June 2011 at 19:50. Text is available under the Creative Commons Attribution-ShareAlike License; additional terms may apply. See Terms of use for details. Wikipedia is a registered trademark of the Wikimedia Foundation, Inc., a nonprofit organization. Contact us Privacy policy About Wikipedia Disclaimers