Marginal Costing &Break Even Analysis
Marginal Cost & Marginal Costing
Acc to ICMA
Marginal cost represents "the amount of any given volume of output by which aggregates costs are changed if the volume of output is increased by one unit"
In practice it is measured by total variable cost attribute to one unit
Marginal Cost & Marginal Costing
Acc to Blocker & weltmore
"marginal cost is the increase or decrease in total cost which results from producing or selling additional or fewer unit of product or from a change in the method of production or distribution such as the use of improved machinery ,addition or exclusion of a product or territory"
Marginal Cost & Marginal Costing
ICMA
Marginal costing as " the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed & variable cost"
Marginal costing is also know as "variable costing"
Characteristics of marginal costing
Analysis & presentation
Classification of cost (fixed, variable, semi variable)
Variable cost are regarded as cost of product
Fixed cost is treated as period cost
Finished goods & work in progress are valued as marginal cost
Contribution = sales or SP – marginal cost of sales
Assumption of marginal costing
Variable cost remain constant per unit of output
SP per unit remain unchanged
Fixed cost remain unchanged

Contribution
It is difference between sales & variable cost or marginal cost
Excess of SP over variable cost per unit
Also know as contribution margin or gross margin

If SP = 20/-
Variable cost = 15/-
Fixed exp = 50000/-
Total no of unit sold 8000
C = 20-15 = 5
Total contribution = 8000*5 = 40000
Advantages
Fixing selling prices
Assist break even point
Suitable product mix
Alternative method of production
Purchase or manufacture
Adding new product
Marginal costing equation
Sales – variable cost = contribution
Sales = variable cost + contribution
Sales = variable cost + fixed cost + profit/loss
Sales – variable cost = fixed cost + profit/loss
S-V = F + P
Cost – Volume profit analysis
Studying the relationship between cost , volume & profits.
Cost of manufacture , volume of sales ,SP of product
In words of Herman C. Heiser
"the most significance single factor in profit planning of the average business is the relationship between the volume of business , cost & profits"
Break-Even Analysis
In two senses
Narrow senses
Broad senses
In broad sense break even analysis refers to the study of relationship between cost , volume , and profit at different levels of sales or production
In narrow sense it refers to a technique of determining that level of operation where total revenue equal total expenses no profit no loss point.
Assumptions
All element of cost
Variable cost remain constant per unit
Fixed cost remain constant
SP remain unchanged
Volume of factor is only influence cost
No change in general price level
Break even point
Point of sales volume at which total revenue is equal to total cost.
No profit no loss point
Total sales is equal to total cost
Also called as Critical point or Equilibrium point or balancing point
Managerial application of marginal costing
Pricing decision
Profit planning
Make or but decision
Selection of suitable sales mix
Effect of change in sales price
Alternative method of production
Optimum level of activity
Capital investment decision
Advantages of marginal costing
Simple to operate
Removes complexities
Help management in production planning
No possibility of fictitious profits
BEP calculation
Decision making
Helpful in cost control
Profit planning
Management reporting
Limitation
SP don’t remain constant
Ignores time factor

Budgeting & Budgetary Control
Introduction
Planning is basic managerial function
Achieving goal
Control is to check
Budget & Budgeting
Budget is monetary and quantitative expression of business plan & polices to be pursued in future time period
Budgeting is used for preparing budgets & other procedures for planning, coordinating and controlling of business enterprises

Budget & Budgeting
Acc to CIMA , Official terminal
"Budget is a financial and quantitative statement prepared prior to be defined period of time"

Budgetary Control
Process of determining various budgeted figures for the enterprises for the future period
then comparing the budgeted figures with the actual performance for calculating variance

Acc to J.Batty
"A system which uses budgets as a means of planning and controlling all aspect of producing and selling commodities and services"

Budgetary involves
Objects are set by preparing budgets
Business is divided into various responsibility centres
Actual figures are recorded
Comparison
Action
Budget , Budgeting , Budgetary control
Budget is a blue print expressed in quantitative term
Budgeting is technique for formulating budget
Budgetary control refers to principles , procedures and practice of achieving given objective through budgets
Objectives of budgetary control
Ensure planning for future
Co ordinate the activities
Operate various cost centres & departments
Elimination of wastage
Centralize the control system
Fixation of responsibilities of various individuals
Characteristics of Good Budgeting
Involve person at different level
Proper fixation of authority & responsibility
Target of budget should be realistic
Good system of accounting
Support of top management
Impart budgeting education


Elements of budget
Plan
Operations & Resources
Financial term
Specified future period
Coordination
Comprehensiveness (Master Budget)
Purpose of Budget
Explicit statement of expectation
Communication
Coordination
Expectation as a framework of judging performance
Advantages
Maximization of profits
Co-ordination
Specific aim
Tool of measuring performance
Determining weakness
Corrective action
Reduces cost
Introduction of incentives schemes
Limitation
Uncertain future
Revision required
Conflict among departments
Depends upon support of top management
Classification & Types
Classification according to time
Long term budgets
short term budgets
Current budgets
Classification on the basis of function
Operating budget
Financial budget
Master budget
Classification on the basis of flexibiltiy
Fixed budget
Flexible budget
Acc to time
Long term budgets
Between 5 to 10 years
Short term budget
1 to 2 years
Current budget
Months or weeks
On basis of function
Operating budget
Sales budget , production budget , purchase budget , raw material budget ,
Financial budget
Cash budget , working capital budget , capital expenditure budget
Master Budget
On the basis of flexibilty
Fixed budget
Flexibility budget
Performance Budget
Budget based on functions , activities & projects.
The budgeting system in which input costs are related to the performance i.e. end result
System which provides appraisal & measures
Conventional budgets
"The performance budget is a budget based on function , activities and projects which focus attention on the accomplishments , the general and relative importance of the work to be done and the services to be rendered rather than upon the means of accomplishments such as personnel , service , supplies , equipments. Under this system the function of various org unit would be split into programmes of activities and estimated would be presented for each"
Establish relationship between inputs and their direct output
It involves
Developments of performance criteria for various programmes
Assessment of performance of each programme
Assessment of performance of each responsibility unit
Comparison of the actual performance with budget
Undertake periodic review
Zero Based budgeting
Latest technique of budgeting
First introduced in America in 1962
It starting from scratch
Normal technique use previous year cost level
Inefficiencies
Last year as a guide and what to be done
In zero based budgeting every year is taken as new year
Zero Based budgeting
Justified acc to present situation
Manager is to justify why he want to spend
Spending on various will depend upon their justification
Traditional budgeting Vs Zero based budgeting
Traditional
More accounting oriented then decision oriented
Monitoring toward expenditure
Inc. or Dec. in expenditure
Vertical communication
Zero base
Decision oriented
Towards achievement of objective
Cost benefit analysis
Vertical & horizontal communication
Process or steps
Objective of budgeting should be determined
Extent should be decided
Decision packages
Cost & benefit analysis
Selecting ,approving decision , finalising the budget
Benifits
Allocate funds
Efficiency of management
Identify wasteful & economical areas
Optimum use of resources
Evaluate the performance
Organizational goals
Limitations
Is not possible in non financial matters
Difficult in formulation & ranking of decision packages
Lot of time
Lot of cost

Tapen Gupta: Business Writting

Tapen Gupta: Business Writting

Business Writting

INTRODUCTION

In business communication writing plays a very crucial role because written communication is a creative as well as critical activity

it depends upon proper palnning and hard work

A sitable business writting necessitate suitable information

Business writting namely , Letters , Reports & Memorandums

Business Letter

It is the means to maintain contacts iwht the external world including other business man , customers , govt.

Purpose of business letter

specvfic information to the reader

propose your idea

promote or advertise a product

promote or advertise yourself

Essentials of an effective business letter or Do's of Business Writting

Clear

Concise

correct

Courteous

convincing

complete

considerate

concrete

prompt

You attitutde

orderly arranged

professional

emphasize the positive attitude

use of strong words

use of familiar word

Dont's of Business Writting

resist the tendency to be formal

avoiding the old language of business

dont use rubber stamp

avoiing anger

avoid intimacy

avoiding humour

Writting an effective Business Letter or Planning a business letter

Determine the purpose

Audience analysis

establish facts

get to the point early

Recipient freindly language

creates a sample copy

use of active voice

use of parallel structure

edit for grammar , punctuation and spelling

final draft

Business Reports

Business Reports
Statement prepared to present facts relating to
Planning
Coordinating
Performance
the general state of work in the organization
It is the summary of managerial peformance

Defination
Acc to Lesikar
"A Business reports is an orderly and objective communication of factual information that serves a business purpose"

Characteristics
Orderly : Carefully & Orderly
Objective : Avoid human bias & seek truth
Communication : All ways of transmitting
Factual information : based on events , facts , records
Business Purpose : Research, Scientist, doctors . Serves business purpose

Objectives & Purpose
Enables preparation of various budgets
Determine the requirement of personnel
Quality of production
Information regarding the market
Knowledge of labour unrest
Decline in sales

Importance & function
Decision Making : systematic , reliable & useful information
Performance evaluation
Vehicle of communication
Information of planning
Information for controlling
Helpful in coordinating
Managing the changes : opinions of workers

Qualities
Accuracy : to ensure accuracy
Check the facts
Describe the events in concrete terms
Record all the relevant facts
Evidence for your conclusion
Objectivity : free from personal feelings ,
A report based on hard facts not on opinions
Precision :No vagueness
No scope for misinterpretation
No scope for misunderstanding
Clearly defined purpose:Providing a revealing information
Solving a problem
Recommending measures to accomplish org. goals
Audience Centered:Audience level of understanding
Audience’s expectation & preferences
Estimation of audience’s probable reaction
Good Judgment:True facts & avoid incomplete
Complete :objectives
Facts
Conclusions
suggestion
You attitude : reader friendly use of you & yours instead of I , am , mine
Well organised
Brief : not unnecessarily long & brevity not at cost of clearity

Classification
On the basis of form of communication
Oral report:(communication of an Impression & Observation)
Written Report:(communication in written)

On the basis of length
Short Report : (for internal use ,formal & informal)
Long Report : (comprehensive & Detailed , always formal)

On the basis of degree of importance
Formal report
Informal reports

Formal & informal Reports

Formal report : These are written in accordance with an established procedure

Statutory reports prepared acc to procedure laid down by law

Non-Statutory reports not required under any lawInformal

Informal report: These are used generally for internal use & for dealing with routine issue Progress reports

Trip reports

Meeting minutes

On the basis of nature & frequency
Routine Reports:(Daily , weekly , Monthly)
Special Reports :(particular assignment)

On the basis of function

Informative reports:(mere dissemination Of information
Analytical reports : (makes Recommendation)

On the basis of no of persons involved
Individual report : (report by branch Manager)
Report by committee

On the basis ofsource
Voluntary report :(own initiative)
Authorized report : (superior Reqiurement)


On the basis of target audience
Internal report
External report
Internal report & External report
Internal
It is used within organization
If this report is below 10 pages , then it is
written as memo format
External
These are sent to outside parties
It is in letter format if it is not long

Planning of short report
Format
For brief external report ,use letter format including title or subject line
For brief internal report use memo
Single space in the text
Double space between paragraph
Use heading where helpful
Include visual aid
Opening
For short routine memos use the subject line of the memo
For all other short reports cover these topics
Purpose, scope , restriction, sources& methods of research , conclusions & recomendations
Body (Finding & Supporting details)
Ending
In informal reports summarize the findings at end
Summarize the points in the same manner in the text
Consider using list format
Avoid introducing new material in Summary

Planning of long report
Define the problem
Keep notes
Make a report outline
Identify the reader and write to their level
As you work ,check , change your outline
As you work label your research paper
Make a rough draft
Revise your rough draft
Compile & complete report
Format of repot
Prefatory part
cover page
title page
letter of authorization
letter of acceptance
table of contents
list of illustration 3
executive summary

Text of the report
Introduction
Body
Summary
Conclusions
Recommendations
Notes

Supplementary part
Appendixes
Bibliography
Index

cost of capital

Cost of CapitalTapen GuptaHIM Kala Amb




Introduction
The project’s cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows.
The firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects.
Minimum rate of return expected by its investor
Weighted average cost of various sources of finance used by firm
Minimum rate of return expected by investors , maintain the market value of the share at its present level
To achieve the wealth maximization
Definitions
Cost of obtaining funds
"The rate that must be earned on the net proceeds to provide the cost element of the burden at the time they are due" by Hunt , William , Donaldson
" The minimum required rate of earning or the cut off rate of capital expenditure" by Solomon Ezra
"The rate of return the firm requires from investor in order to increase the value of the firm in the market place" by Hampton Jhon
Three basic aspect
Cost of capital is not a cost as such
Minimum rate of return
Comprises of 3 components
The expected normal rate of return at zero risk level (rate of int. allowed by bank)
Premium of business risk
Premium of financial risk

Significance of the Cost of Capital
Evaluating investment decisions
Designing a firm’s debt policy, (capital structure)
Appraising the financial performance of top management
The Concept of the Opportunity Cost of Capital
The opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk.
General Formula for the Opportunity Cost of Capital
Opportunity cost of capital is given by the following formula:

where Io is the capital supplied by investors in period 0 (it represents a net cash inflow to the firm), Ct are returns expected by investors (they represent cash outflows to the firm) and k is the required rate of return or the cost of capital.
The opportunity cost of retained earnings is the rate of return, which the ordinary shareholders would have earned on these funds if they had been distributed as dividends to them.
Classification of cost
Historical cost & Future cost
Specific cost & Composite cost
Average cost & Marginal cost
Weighted Average Cost of Capital Vs. Specific Costs of Capital
The cost of capital of each source of capital is known as component, or specific, cost of capital.
The overall cost is also called the weighted average cost of capital (WACC).
Relevant cost in the investment decisions is the future cost or the marginal cost.
Marginal cost is the new or the incremental cost that the firm incurs if it were to raise capital now, or in the near future.
The historical cost that was incurred in the past in raising capital is not relevant in financial decision-making.
Computation of cost of capital
Cost of specific source of finance
Weighted average cost of capital
Computation of cost of specific source of finance
Cost of Debt
Rate of interest payable on debt
1) Co issues Rs 100000 10% Deb at par; the before tax cost of this debt will also be
10%
Before tax cost Kdb = I
P
Where Kdb = before tax cost of debt
I = Interest
P = Principal
When debt is raised at premium or discount
Kdb= I
NP Where NP= Net Proceeds
Computation of cost of specific source of finance
Kda = Kdb (1-t)=I (1-t)
NP
Where Kda = After cost of debt
t = Rate of Tax
Cost of Redeemable Debt
Before tax cost of debt
Kdb = I+(P-NP)
n
P+NP
2
I=Interest
N=Number of years in which debt to be redeemed
P= Proceeds at par
NP= Net Proceeds
After tax cost of debt Kda = Kdb (1-t)
Kdb = I+(P-NP)
n
(P+NP)
2
X ltd issues Rs. 50000 8% Deb at par. The tax rate applicable to the company is 50%
Y Ltd. Issues Rs. 50000 8% deb @ 10% premium Tax rate 60%
A Ltd. Issues Rs. 50000 8% deb @ 5% discount Tax Rate 50%
B ltd. Issues 100000 9% deb @ 10% premium cost of floatation 2% Tax Rate 60%
Kda = I(1-t) = 4000 (1-.50)
NP 50000
= 4%
Kda= I(1-t) =4000/55000(1-.60)
NP = 2.91%
Kda = 4000/47500(1-.50) = 4.21%
Kda = 9000/107800(1-.60) = 3.34%
100000+10000-(2/100*110000)=107800
Cost of redeemable at premium
Before tax cost of debt
Kdb = I+(RV-NP)/n
(RV+NP)/2
I=interest
RV = Redeemable value of debt
n=no of years in which debt redeemed
NP=Net Proceeds
After tax cost of debt
Kda= Kdb(1-t)
t = tax rate
Cost of preference capital
1) Co issues Rs 100000 10% preference share at par
Kp = D
P
where Kp = cost of preference capital
D = Annual preference Dividend
P = Principal share capital
When Preference capital is raised at premium or discount
Kp = D
NP Where NP= Net Proceeds
Dividends are not allowed to be deducted in computation
Of tax , no adjustment is required for taxes
Cost of redeemable P.share
Kpr = D+(MV-NP)/n
(MV+NP)/2
D=Dividend
MV = Maturity value
n=no of years in which debt redeemed
NP=Net Proceeds

X ltd issues Rs. 50000 8% P.share capital at par. cost of floatation 2%
Y Ltd. Issues Rs. 50000 8% P.share capital @ 10% premium cost of floatation 2%
A Ltd. Issues Rs. 50000 8% P.share capital @ 5% discount cost of floatation 2%
B ltd. Issues 100000 9% P.share capital @ 10% premium cost of floatation 2%
Kp = D = 4000 * 100
NP 50000-1000
= 8.16%
Kp = D =4000/55000-1100*100
NP = 7.42%
Kp = 4000/47500--950 = 8.59%
Kda = 9000/107800 = 8.35%
100000+10000-(2/100*110000)=107800
Cost of equity share capital
Dividend yield method or dividend / price ratio method
Ke = D or D
NP MP
Ke = cost of equity capital
D = Expected dividend per share
NP = Net Proceeds
MP = Market price per share
1000 share @ 100 per share
Premium 10 %
Dividend 20 % for past 5 years
Cost of capital
Will it changes if MP 160
Ke= 20/110*100=18.18%
Ke= 20/160*100=12.5%
Dividend yield plus growth in dividend method
Ke = D +G or D +G
NP MP
Ke = cost of equity capital
D = Expected dividend per share at end of year
NP = Net Proceeds
MP = Market price per share
G = Growth rate
1000 share @ 100 per share at par
Floatation cost 5 %
Dividend 10 % for initial year
Growth in dividend 5 %
Cost of capital
Will it changes if MP 150
Ke = (10 /100-5)+5%=15.53%
Ke = (10/150)+5%=11.67%
Earning yield method
Ke = earning per share/net proceeds
Ke = EPS/NP or EPS/MP
Cases
When earning per share remain constant
Retention ratio is zero
MP is influenced by only EPS
No of equity share 10 lakhs
MV of exisiting share 60
Net earning 90 lakhs
New share price 52
Cost of issue new share 2 per share
EPS= 9000000/1000000=9
Ke=9/60*100=15%
Cost of new equity= {9/(52-2)}*100=18%
Realised yield method
Not easy to estimate future earning
Actual rate realised in past
Assumptions
Firm will remain in same risk
Shareholder expectation depend on past earnings
MP doesn’t change significantly
Cost of retained earnings
Kr=(D/NP)+G
To make the tax adjustment & cost of purchasing of new security
Kr= {(D/NP)+G}*(1-t)*(1-b)
T= tax rate
B=cost of purchasing of new sec.
Kr=Ke*(1-t)*(1-b)
Weighted average cost of capital
Kw=Sum of XW / Sum of W
X cost of specific source of finance
W weight , proportion of specific source of finance
Tax rate 50%
Source amount proportion B.tax A.tax Wcost
E.share 20 Lac 50% 15.09 15.09 7.55
10% P S 8 lac 20% 10.00 10.00 2.00
12% Deb 12lac 30% 12.00 6.00 1.80
11.35
Book Value Versus Market Value Weights
Managers prefer the book value weights for calculating WACC:
Firms in practice set their target capital structure in terms of book values.
The book value information can be easily derived from the published sources.
The book value debt—equity ratios are analysed by investors to evaluate the risk of the firms in practice.
Book Value Versus Market Value Weights
The use of the book-value weights can be seriously questioned on theoretical grounds:
First, the component costs are opportunity rates and are determined in the capital markets. The weights should also be market-determined.
Second, the book-value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus, they do not reflect economic values.
Book Value Versus Market Value Weights
Market-value weights are theoretically superior to book-value weights:
They reflect economic values and are not influenced by accounting policies.
They are also consistent with the market-determined component costs.
The difficulty in using market-value weights:
The market prices of securities fluctuate widely and frequently.
A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm changes.
The Capital Asset Pricing Model (CAPM)
As per the CAPM, the required rate of return on equity is given by the following relationship:
Equation requires the following three parameters to estimate a firm’s cost of equity:
The risk-free rate (Rf)
The market risk premium (Rm – Rf)
The beta of the firm’s share (b )
Cost of Equity: CAPM Vs. Dividend—Growth Model
The dividend-growth approach has limited application in practice
It assumes that the dividend per share will grow at a constant rate, g, forever.
The expected dividend growth rate, g, should be less than the cost of equity, ke, to arrive at the simple growth formula.
The dividend–growth approach also fails to deal with risk directly.
Cost of Equity: CAPM Vs. Dividend—Growth Model
CAPM has a wider application although it is based on restrictive assumptions:
The only condition for its use is that the company’s share is quoted on the stock exchange.
All variables in the CAPM are market determined and except the company specific share price data, they are common to all companies.
The value of beta is determined in an objective manner by using sound statistical methods. One practical problem with the use of beta, however, is that it does not probably remain stable over time.

business firm objective

Objective of business firmTapen GuptaHIM Kala Amb




Objective of firm
Profit maximization
Sales or revenue maximization
Maximization of satisfaction
Security of profit
Growth maximization
Managerial utility maximization
Customer satisfaction
Wealth maximization
Profit maximization
TR-TC
TR = Total revenue
TC = Total cost
Essential for the survival of business
Greater predictive ability
Strongest motive
Common goal
Sales or revenue maximization
Financial institution (index of performance)
Profit fig. annually
Salaries & slack earning of the top mgr. are linked with sales
Routine personal problems are more easily handed
Sales growing (growing mkt. share & greater competitive strength
Maximization of satisfaction
Society
Customers
Employees
Security of profit
Higher the risk higher the profit
Steady flow of porfit
Growth maximzation
Maximization of promoting rate
Expansion of the firm
Managerial utility maximization
Mgr. seeks to maximise their own utility
Minimum level of profit
Satisfy shareholder keep mrg. Unchanged
Expansion of staff


Customer satisfaction
King of the mkt.
Wealth maximaization

Capital Budgeting

Capital BudgetingTapen GuptaHIM Kala Amb




Introdction

Assets acquired 2 categories
Short term or current assets
Long term or fixed assets

Short term
Current assets mgt. (working capital mgt.)
Long term
Capital budgeting (capital expenditure decisions)

Meaning of capital budgeting
Process of making investment decision in capital expenditure
The expenditure the benefits received over period of time
Cost of acquisition of permanent assets
Cost of addition & expansion
Cost of replacement of permanent assets
Non flexible long term commitment

Meaning of capital budgeting
Non flexible long term commitment of fund
Planning & control of capital expenditure
Also know as
Investment decision making
Capital expenditure decision
Planning capital expenditure
Analysis of capital expenditure
Definitions
" It is long term planning for making & financing proposed capital outlays" by charles
" It involves the planning of expenditures for assets the returns from will be realized in future time periods" by Spencer
" It consists in planning the deployment of available capital for the purpose of maximizing the long term profitability of the firm" by R.M. lynch
Features
Funds are invested in long term assets
Funds are invested in present times in anticipation of future profits
The future profits will occur to the firm over a series of years
It involves a degree of risk
They are irreversible decisions
Large funds
Importance
Such decisions affect the profitability of firm
Long time periods
Irreversible decisions
Involvement of large amount of funds
Risk
Most difficult to make
Difficulties of investment decisions
Capital budgeting process
Kinds of capital budgeting decisions
2 basis categories
Those which inc. revenue
Those which reduce cost
For investment proposal point
Accept Reject decisions
Mutually exclusive project decisions
Capital rationing decisions

Accept – Reject Decisions
Independent projects
Decisions on minimum basis of return
Higher accepted
Lower rejected
Mutually exclusive project decisions
Acceptance of one will lead to rejection of other
X acceptance will lead to y rejection
Capital rationing decisions
Limited funds to invest
Combination Greatest profitability

Methods of capital budgeting / evaluating of investment proposals
Number of proposals
Limited funds
Selective highest benefits project
Allocation of available resources to various proposals
Consideration both profitability & risk
Methods of evaluating profitability
Traditional methods
Time – adjusted method or discounted methods
Traditional methods
Pay – back period method
Improvement of traditional approach to pay back period method
Rate of return method
Pay – Back period method
Also called as pay out or pay off period method
Period in which the total investment in assets pays back itself
Measures the period of time for the original cost
Project are ranked according to the length of their pay back period
Pay – Back period method
Calculate annual net earnings before dep. & after taxes
Divide the initial outlay of the project by the annual cash inflows
pay – back period=
cash outlay of the project or original cost of assets
annual cash inflows
Pay – Back period method
Project cost Rs. 100000
Annual cash inflows Rs. 20000
For 8 years
Pay back period
= 100000 = 5 years
20000
Pay – Back period method
When the annual cask inflows are unequal the pay back period can be found by adding up the cash inflows until the total equal to initial cash outlay of the project
Pay – Back period method
Project X
Investment = 20000
Years profits
1st 1000
2nd 2000
3rd 4000
4th 5000
5th 8000
Ppm=1000+2000+4000+5000+8000=
20000
5 years
Project Y
Investment = 20000
Years profits
1st 2000
2nd 4000
3rd 6000
4th 8000
5th -
Ppm= 2000+4000+6000+8000=
20000
4 years
Advantages
Simple to understand
Easy to calculate
Saves cost
Lesser time & labour
Reduces loss through obsolescence

shortcoming
Non consideration of inflows after pay back period
Ignores time value of money
Non consideration of cost of capital
Difficult to determine the minimum acceptable pay back period
Improvement in traditional approach to pay back period method
Post pay back profitability method
Post pay back profitability index=
post pay-back profits*100
investment
Post pay back profitability method
A) Initial outlay 50000
Annual cash inflow (ATBD) 10000
Estimated life 8 years
B) Initial outlay 50000
Annual cash inflow (ATBD)
1st three years 15000
Next five years 5000
Estimated life 8 years
Salvage 8000
Post pay back profitability method
A) i) pay – back period =
= 50000 = 5 years
10000
ii) Post pay back profitability =
= 10000 (8-5) = 30000
iii) Post pay back profitability index=
= 30000 *100=60%
50000
Post pay back profitability method
B) pay back period
1st year 15000
2nd year 15000
3rd year 15000
4th year 5000
50000
post pay back profitability = 5000*4=20000
Post pay back profitability index= 20000*100
50000
= 40%
Pay-back reciprocal method
Pay-back reciprocal method
pay back reciprocal= annual cash inflow
Total investment
Two condition to be satisfied
Equal cash inflows are generated ever year
The project under consideration has along life which must be at least twice the pay back period
Post pay back period method
Ignores the life of the project beyond the pay back period
Also know as surplus life over pay back method
Greatest post pay back period accepted
Discounted pay back method
Pay back period method ignores time value of money
Discounted rate
Cost of project 600000
Life of the project 5 years
Annual cash inflows 200000
Cut off rate 10 %

Calculation present value of cash inflows
Discounted pay back period=
3 years+ 102800 = 3.75
136600
Rate of return method
Also know as accounting Rate of return
Accounting concept of profit (net profit after tax & dep.)
Ranked acc to rate of earning
Higher rate of return selected
Average rate of return method
Average profit after tax & dep.
Divide it by total capital outlay
Average rate of return method =
Total profit (after dep. & taxes) * 100
net investment in project * no of years
Or
Average annual profits * 100
Net investment in the project
Investment 500000
Scrap value 20000
Profit after dep. & taxes
40000
60000
70000
50000
20000
Total profit
40000+60000+70000+50000+20000= 240000
Average profit= 240000/ 5 =
48000
Net investment = 500000-20000= 480000
ARR= 48000/480000*100=
10%
Rate on average investment method
Consideration of Dep.
Machine cost Rs 100000
No scrap value after 5 years (straight line method)

Beginning of the first year 100000
End of 1st year 80000
End of 2nd year 60000
End of 3rd year 40000
End of 4th year 20000
End of 5th year --------------
300000
Average investment = 300000/6=
50000
Average return on average investment method
Average profit after dep. & taxes
Divide by the average amount of investment
Average return on average investment =
Average annual profit after dep & taxes *100
average investment
Or
= Average Annual Profit * 100
Net investment
2
= 48000 *100
480000
= 48000 *100=20%
240000
Advantages / Disadvantages
Advantages
Simple to understand
Easy to operate
Use entire earning
Accounting concept of profits
Disadvantages
Ignores time value of money
No consideration cash flow
Cannot applied where projects is there in parts
Time – adjusted or Discounted cash flow method
Don’t take care of time value of money
Take into account the profitability & time value of money
Modern methods
Types
Net present value method
Internal rate of return method
Profitability index method or benefit cost ratio
Net present value method
Time value of money
Entire life of the project
Following steps to be followed
Select app. Or minimum required Rate of return know as cut off rate or discount rate
Present value of total investment outlay
Present value of total investment proceeds
Calculate net present value subtracting iii – ii
Project ranked acc to value
Calculate formula
Initial investment (X) 20000
Estimated life 5 years
Scrap value 1000
Profit BDAT
Year 1st 5000
Year 2nd 10000
Year 3rd 10000
Year 4th 3000
Year 5th 2000
Initial investment (y) 30000
Estimated life 5 years
Scrap value 3000
Profit BDAT
Year 1st 20000
Year 2nd 10000
Year 3rd 5000
Year 4th 3000
Year 5th 2000

Yr cash dis present
inflow 10% value
1 5000 .909 4545
2 10000 .826 8260
3 10000 .751 7510
4 3000 .683 2049
5 2000 .621 1242
1000 .621 621
24227
Less present initial inv. 20000
Present value 4227
Yr cash dis present
inflow 10% value
1 20000 .909 18180
2 10000 .826 8260
3 5000 .751 3775
4 3000 .683 2049
5 2000 .621 1242
2000 .621 1242
34728
Less present initial inv. 30000
Present value 4728
Advantages / Disadvantages
Advantages
Recognizes time value of money
Unequal profit for years
Entire life time profits
Obj maximum profitability
Disadvantages
More difficult to understand
With unequal life
Not easy to determine discount rate
Internal rate of return
Time value of money
Also know as time adjusted rate of return , yield method , trail & error yield method
Predetermined cut off rate in NPV
Hit & trail method

Internal rate of return
A) when annual net cash flows are equal over the life of the assets
Present value factor = initial outlay / annual cash flow
Initial outlay 50000
Life of the assets 5 years
Estimated annual cash flow 12500
Present value factor = 50000/12500= 4
Then search value in net present value table
Which is equal to 8%
When the annual cash inflows are not equal
Yr cash dis present dis value dis value dis value
inflow 10% value 12% 14% 15%
1 15000 .909 13635 .892 13380 .877 13155 .869 13035
2 20000 .826 16520 .797 15490 .769 15380 .756 15120
3 30000 .751 22530 .711 21330 .674 20220 .657 19710
4 20000 .683 13660 .635 12700 .592 11840 .571 11420
66345 63350 60595 59285
The rate is to be between 14% & 15% so it is going to be 14.5%
Advantages / Disadvantages
Advantages
Time value of money
Uneven cash inflow
Entire economic life
Obj of maximum profitability

Disadvantages
Difficult to understand
Result may diff of NPV & IRR (size, life, timings)
Profitability index method
Also know as benefit cost ratio or desirability factor
Profitability index = present value of cash inflows
present value of cash outflows or PI = PV of cash inflows
Initial cash outlay
or PI = NPV
initial cash outlay
Net profitability index = PI - 1
Comparison between NPV & IRR
Time value of money
Discounted cash inflow techniques
Difference between NPV & IRR
Discounting rate
Market rate of return
Reinvested at cut off rate Vs IRR
More reliable cut off rate
Factor influencing capital expenditure decision
Urgency
Degree of certainty
Intangible factor (safety , welfare of worker)
Legal factor
Availability of funds
Future earnings
Obsolescence
Cost considerations
Limitation of capital budgeting
Projects are mutually exclusive
Future uncertain , estimation of cash inflow & outflow
Urgency
Uncertainty & risk
Capital expenditure control
Non flexible long term commitment
Economic health of enterprise
Inc profitability of concern
Objective of control
Properly sanctioned
Time cash inflow
Estimate of capital expenditure
Properly co-ordinate
Fix priorities among various project
Measure of performance of project
Sufficient amount of capital
Steps involved in controlling of CB
Preparation of capital expenditure budget
Proper authorization of capital expenditure
Recording & control of expenditure
Evaluation of performance of the project

Financial ManagementTapen GuptaHIM Kala Amb


Financial Management

Financial +Management
(Finance)
Finance
Provision of money at the time when it is required
Public & Private
Public : Govt , State , Central
Private : Personal Finance
Business Finance
Non Profit Org.
Corporation
Acc to chief justice marshall
" It is an artificial being , invisible , intangible & existing only in contemplation of the law. Being a mere creation of law it possess only the properties which the charter of its creation confers upon its either expressly or as incidentally to its very existence "
Corporation finance / Financial Management
It is a process of raising , providing & administering of all money / funds
Corporation finance / Financial Management
" It is acquiring & utilising funds by business" By R.C. Osborn
" The activity concerned with the planning , raising , controlling & administering the funds used in the business" By Guthman & Dougall
" It is the area of finance decision making harmonizing individual motive & enterprise goal"
By Weston & Brigham
" Activity which is concerned with the acquisition & conservation of capital funds in meeting the financial need & overall objective of business enterprises" By Wheelers
Corporation finance / Financial Management
In simple words
Financial Management as practiced by corporate firms can be called corporation finance
Evolution of corporate finance
Early part of this century , emphasis on study of sources
In 1930 economic recession difficulties in finance
World war II Reorganization of industries & need of selecting financial structure
In 1950 Profitability to liquidity & Institutional finance to day to day operation of finance
Mid fifties modern phase concept of FM become more analytical
In 1960 witnessed advances in the theory of portfolio
In 1980 role of taxation in personal & corporate Finance
Importance of corp. finance
Life blood & nerve centre of business
Universal lubricant
Academician
Developing stage
Crucial decision
Inc. in size , wide distribution of corporate ownership
Window dressing ( to investor , bankers)
Approaches to finance function
Traditional Approach
Modern Approach
Traditional Approach
1920 – 1930 (corporate finance)
Procure & administer fund for the corporation
Institutional source of finance
Issue of financial instrument
Legal & accounting relationship
Limitations
One sided approach (raising of funds)
More emphasis on the financial problem of corporation
More concerned about special event
Non emphasis on day to day operation
Modern Approach
1950’s
Technological improvement
Inc. size of business enterprises
Broader analytical viewpoint
Procurement of funds as well as administering funds
Investment decision
Financing decision
Dividend decision
Features of FM
More emphasis on financial decision
Continuous function
Broader view / wide scope
Less descriptive & more analytical
Different from accounting function
Accounting generates information
Finance data analysis & decision making
Measurement of performance
Applicable to all types of org.
Aim of finance function
Acquiring sufficient funds
Proper utilization of funds
Increase profitability
Maximizing firm value
Scope of finance function / FM
Estimating financial requirement
Deciding capital structure
Selecting source of finance
Selecting pattern of investment
Proper cash management
Proper use of surplus
Objectives / goals
Concrete framework within which optimum financial decision can be made
Profit maximization
Include the profit activities
Avoided dec. profit activities
Favor
Profit is a test economic efficiency
Leads to efficient allocation & utilization of scare resources
Profitability *(social goals)
Major source of finance
Limitations
Ambiguity
Time value of money
Risk factor
Wealth maximization approach
Net present worth / value
Worth of asset is measured in terms of benefits rewind from its uses less cost of acqauation cost
w= A1 + A2 + A3 + ----------An – c
1+k (1+k)2 (1+k)3 (1+k)n
Criticism
Prescriptive idea
Obj. is not necessarily socially desirable
Maximise the stock holder or wealth of the firm
Difficulties in ownership & Management
Functional area of FM
Determining the financial need
Selecting sources of fund
Financial analysis
Capital budgeting
Working capital mangement
Profit planning & control
Dividend policy
Importance of FM
Acquiring sufficient fund
Proper utilization of resources
Proper cash management
Proper use of profits
Maximization of wealth
Useful for shareholder
Useful for investor
Function of FM
Financial planning
Financial decision
Investment decision
Dividend decision
Financial control
Incidental function
Function of financial manager
Financial planning
Procurement of funds
Coordination
Control
Business forecasting
As an treasurer
Provision of finance
Banking function
Custody
Cash management
Investment
As an controller
Planning
Accounting
Auditing
Reports
Govt. reporting
Tax administration
Economic appraisal