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CS Executive Financial and Strategic Management Notes

CS Executive Financial and Strategic Management Notes

CS Executive Financial and Strategic Management Notes Applicable for 2019 Exams.

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Nature, Significance and Scope of Financial Management

  • Financial Management deals with procurement of funds and their effective utilizations in the business and concerned with investment, financing and dividend decisions in relation to objectives of the company.
  • Investment decisions are essentially made after evaluating the different project proposals with reference to growth and profitability projections of the company.
  • Financing decisions are concerned with the determination of how much funds to procure from amongst the various avenues available i.e. the financing mix or capital structure.
  • Dividend decision is to decide whether the firm should distribute all profits or retain them or distribute a portion and retain the balance.
  • Profit maximization ensures that firm utilizes its available resources most efficiently under conditions of competitive markets.
  • Wealth maximization means the management of an organization maximizes the present value not only for shareholders but for all including employees, customers, suppliers and community at large.
  • Economy value added is the after cash flow generated by a business minus the cost of capital it has deployed to generate that cash flow.
  • Liquidity means ability of the business to meet short-term obligations. It shows the quickness with which a business/company can convert its assets into cash to pay what it owes in the near future.
  • Profitability ratio reflects on the ability of management to earn a return on resources put in by the shareholders evaluating the performance of the company in different spheres
  • Affairs of the firm should be managed in such a way that the total risk – business as well as financial borne by equity shareholders is minimised and is manageable.




Capital Budgeting

  • Capital Budgeting refers to long-term planning for proposed capital outlays and their financing. Capital Budgeting may also be defined as “the firms’ decision to invest its current fund more efficiently in longterm activities in anticipation of an expected flow of future benefit over a series of years.
  • Capital Rationing helps the firm to select the combination of investment projects that will be within the specified limits of investments to be made during a given period of time and at the same time provide greatest profitability.
  • Pay Back technique estimates the time required by the project to recover, through cash inflows, the firm’s initial outlay.

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  • Average Rate of Return method is designated to consider the relative profitability of different capital investment proposals as the basis for ranking them – the fact neglected by the payout period technique
  •  Average Rate of Return

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  • Net Present Value: The cash outflows and inflows associated with each project are ascertained first and both are reduced to the present values at the rate of return acceptable to the management. The rate of return is either cost of capital of the firm or the opportunity cost of capital to be invested in the project.

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  • Internal Rate of Return: The internal rate of return refers to the rate which equates the present value of cash inflows and present value of cash outflows.

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  • Profitability Index (PI): Profitability Index is defined as the ratio of present value of the future cash benefits at the required rate of return to the initial cash outflow of the investment.

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  • Sensitivity Analysis treats risk and uncertainty in capital budgeting decisions.
  • Cost of equity capital is the minimum return that the investors would like to get on their investments in Company’s Shares.
  • Composite cost of Capital is calculated as combined weighted average of the cost of all different sources of capital




Capital Structure

  • Capital Structure of a firm is a reflection of the overall investment and financing strategy of the firm. It shows how much reliance is being placed by the firm on external sources of finance and how much internal accruals are being used to finance expansions.
  • Optimal capital structure means arrangement of various components of the structure in tune with both the long-term and short term objectives of the firm.
  • The four Capital Structure Theories are—Net Income Approach, Net Operating Income Approach, Traditional Approach and Modigliani Miller Approach.
  • Net income approach provides that the cost of debt capital, Kd and the cost of equity capital Ke remains unchanged when the degree of leverage, varies.
  • Net Operating Income approach states that cost of the capital for the whole firm remains constant, irrespective of the leverage employed in the firm.
  • Traditional Approach to capital structure advocates that there is a right combination of equity and debt in capital structure, at which market value of the firms is maximum.
  • Modigliani and Miller have restated the net operating income position in terms of three basic propositions:
    • Proposition I – The total value of a firm is equal to its expected operating income divided by the discount rate appropriate to its risk class.
    • Proposition II – The expected yield on equity, Ke is equal to Ko plus a premium.
    • Proposition III – The cut off rate for investment decision making for a firm in a given risk class is not affected by the manner in which the investment is financed.
  • Leverage refers to relationship between two variables as reflected in a unit change in one variable consequent upon a unit change in another variable.
  • Two major types of Leverages are: Financial leverage and operating leverage.
  • Financial leverage measures the extent to which the cost of project has been funded by borrowed money as compared to owner’s equity.
  • EBIT –EPS Analysis indicates the projected EPS for different financial plans.

Sources of Raising Long Term Finance and Cost of Capital

  • Funds required for a business may be classified as long term and short term.
  • – Long term finance is required to Finance fixed assets, finance the permanent part of working capital, finance growth and expansion of business.
  • The two main sources of long term finance are Ownership Capital and Borrowed capital.
  • 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 company’s existing securities”.
  • Cost of capital is used to evaluate new projects of a company and it is the minimum return that investors expect for providing capital to the company
  • 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.
  • There are four main factors which mainly determine the cost of Capital of a firm. General economic conditions, the marketability of the firm’s securities (market conditions), operating and financing conditions within the company, and the amount of financing needed for new investments.
  • There are factors affecting cost of capital that the company has control over and includes Capital
    Structure Policy, Dividend Policy, Investment Policy etc.
  • There are some factors affecting cost of capital that the company has not control over and these
    factors includes Level of Interest Rates, Tax Rates.
  • Cost of Debt is calculated after tax because interest payments are tax deductible for the firm. Cost of capital is denoted by the term Kd.
    Kd after taxes = Kd (1 – tax rate)
  • Irredeemable preference shares are those shares issuing by which the company has no obligation to pay back the principal amount of the shares during its lifetime. The only liability of the company is to pay the annual dividends. The cost of irredeemable preference shares is:

eq5

  • Redeemable preference shares are those shares which have a fixed maturity date at which they
    would be redeemed. The cost of redeemable preference shares is calculated by under given formulae.

eq6

Where Kp= Cost of preference Shares

RV- Redemption value

SV= Sale value

N= No of years to Maturity

D= Annual Dividend

  • The cost of equity capital is the minimum rate of return that a company must earn on the equity
    financed portion of its investments in order to maintain the market price of the equity share at the current level. The cost of equity capital is rather difficult to estimate because there is no definite commitment on the part of the company to pay dividends. However, there are various approaches for computing the cost of equity capital. They are:

    1. CAPM model : This is a popular approach to estimate the cost of equity. According to the SML, the cost of equity capital is:
      Ke = Rf + ß (Rm – Rf)
      Where:
      Ke = Cost of equity
      Rf = Risk-free rate
      Rm = Equity market required return (expected return on the market portfolio)
      ß = beta- Systematic Risk Coefficient.
    2. – Bond Yield Plus Risk Premium Approach
      This approach is a subjective procedure to estimate the cost of equity. In this approach, a judgmental risk premium to the observed yield on the long-term bonds of the firm is added to get the cost of equity.
      Cost of equity = Yield on long-term bonds + Risk Premium.
    3. Dividend Growth Model Approach
      The price of an equity stock depends ultimately on the dividends expected from it. According to this approach P0 =D1/(r-g) and r = D1/P0 + g. here
      P0 = Current price of the stock
      D1 = Expected dividend at the end of year 1
      r = Equity shareholders’ required rate of return
      g = Growth rate
    4. Earnings-Price Ratio approach
      According to this approach, the cost of equity capital is:

 eq7

Where:
E1 = Expected earnings per share for the next year

P0 = Current market price per share

E1 = (Current EPS) * (1 + growth rate of EPS)

  • The weighted average cost of capital (WACC), as the name implies, is the weighted average of the costs of different components of the capital structure of a firm. WACC is calculated after assigning different weights to the components according to the proportion of that component in the capital structure.
  • Marginal Cost of Capital (MCC) can be defined as the cost of additional capital introduced in the
    capital structure since we have assumed that the capital structure can vary according to changing requirements of the firm.




Project Finance

  • Project decisions are taken by the management with basic objective to maximize returns on the
    investment being made in a project.
  • Project report is a working plan for implementation of project proposal after investment decision by a company has been taken.
  • Project appraisal should be analyzed for determining the project objects, accuracy of method and measurement, objective of the proposal, reliability of data and project statements.
  • A careful balance has to be stuck between debt and equity. A debt equity ratio of 1:1 is considered ideal but it is relaxed up to 1.5:1 in suitable cases.
  • Economic Rate of Return is a rate of discount which equates the real economic cost of project outlay to its economic benefits during the life of the project.
  • Domestic Resource Cost measures the resource cost of manufacturing a product as against the cost of importing/exporting it. The output from any project adds to domestic availability implying a notional reduction in imports to the extent of output of the project or an addition to exports if the product is being exported.
  • Effective Rate of Protection attempts to measure the net protection provided to a particular stage of manufacturing
  • The Loan agreement is an agreement expressed in writing and entered into between the borrower and the lender bank, institution or other creditors. It envisages a relationship taking into account the commitment made at that time and the conduct of the parties carrying legal sanctions.
  • Loan syndication involves obtaining commitment for term loans from the financial institutions and banks to finance the project. Basically it refers to the services rendered by merchant bankers in arranging and procuring credit from financial institutions, banks and other lending and investment organization or financing the client project cost or working capital requirements
  • In Social Cost-Benefit Analysis, a project is analyzed from the point of view of the benefit it will generate for the society as a whole.

Dividend Policy

  • Dividend Policy determines what portion of earnings will be paid out to stockholders and what portion will be retained in the business to finance long term growth
  • The amount of dividend payout  fluctuates from period to period in keeping with fluctuations in the amount of acceptable investment opportunities available to the firm. If the opportunities abound, percentage of payout is likely to be zero; on the other hand, if the firm is unable to find out profitable investment opportunities, payout will be 100 per cent.
  • Walter’s Model: Prices reflect the present value of expected dividend in the long run. A firm is able to earn a higher return on earnings retained than the stockholder is able to earn on a like investment then it would appear beneficial to retain these earnings all other things being equal. Walter’s model is as under:

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  • Dividend Capitalization model projects that dividend decision has a bearing on the market price of the share

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  • Modigliani Miller Approach: According to MM, the discounted value per share before and after a  dividend payment will be same as if earnings had been retained.

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  • Dividend Policy is determined by the Board of Directors having taken into consideration a number of factors which include legal restrictions imported by the Government to safeguard the interest of various parties or the constituents of the company.
  • An appropriate dividend policy must be evaluated in the light of the objectives of the firm.




Working Capital

  • Gross Working Capital is the total of all current assets. Networking capital is the difference between current assets and current liabilities.
  • Permanent Working Capital is that amount of funds which is required to produce goods and services necessary to satisfy demand at its lowest point.
  • Various factors such as nature of firm’s activities, industrial health of the country, availability of material, ease or tightness of money markets affect the working capital.
  • Factors which influence cash balance include credit position of the company, status of receivables and inventory accounts, nature of business enterprise and management’s attitude towards risk.
  • The amount of time needed for inventories to travel through the various process directly affect the amount of investment. The investment in inventories is guided by minimization of costs and
    management’s ability to predict the forces that may cause disruption in the follow of inventories like strikes or shifts in demand for the product.
  • Factors influencing investment in receivables are mainly the cost and time values of funds.
  • The operating cycle is the length of time between the company’s outlay on raw materials, wages and other expenditures and the inflow of cash from the sale of the goods.
  • In deciding company’s working capital policy, an important consideration is trade-off between profitability and risk.
  • Working capital leverage may refer to the way in which a company’s profitability is affected in part by its working capital management.
  • Funds flow represent movement of all assets particularly of current assets because of movement in fixed assets is expected to be small except at times of expansion or diversification.
  • Cash management means management of cash in currency form, bank balance and reality marketable securities.
  • As John Maynard Keynes put, these are three possible motives for holding cash, such as transaction motive, precautionary motives and speculative motive
  • Inventory management has at its core the objective of holding the optimum level of inventory at the lowest cost.
  • There are various technical tools used in inventory management such as ABC analysis, Economic Order Quantity (EOQ) and inventory turnover analysis.
  • ABC analysis is based on paid to those item which account for a larger value of consumption rather than the quantity of consumption.
  • EOQ determines the order size that will minimize the total inventory cost

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  • Factoring is a type of financial service which involves an outright sale of the receivables of a firm to a financial institution called the factor which specializes in the management of trade credit.




Security Analysis

  • Investment may be defined as a conscious act on the part of a person that involves deployment of money in securities issued by firms with a view to obtain a target rate of return over a specified period of time.
  • Investment is conscious act of deployment of money in securities issued by firms. Speculation also involves deployment of funds but is not backed by a conscious analysis of pros and cons.
  • Investment is the employment of funds on assets with the aim of earning income or capital appreciation.
  • Speculation also involves deployment of funds but it is not backed by a conscious analysis of pros and cons.
  • Both gambling and betting are games of chance in which return is dependent upon a particular event happening.
  • Risk in security analysis is generally associated with the possibility that the realized returns will be less than the returns that were expected.
  • Risk can be classified under two main groups, viz., systematic risk and unsystematic risk
  • Return is the primary motivating force that drives investment. It represents the reward for undertaking investment.
  • The main objective of security analysis is to appraise are intrinsic value of security.
  • The Fundamental approach suggests that every stock has an intrinsic value which should be equal to the present value of the future stream of income from that stock discounted at an appropriate risk related rate of interest.
  • Technical approach suggests that the price of a stock depends on supply and demand in the market place and has little relationship with its intrinsic value.
  • Efficient Capital Market Hypothesis (ECMH) is based on the assumption that in efficient capital markets prices of traded securities always fully reflect all publicly available information concerning those securities.
  • Performance of a company is intimately related to the overall economic environment of the country because demand for products and services of the company would under normal circumstances be directly related to growth of the country’s economy.
  • Industry level analysis focuses on a particular industry rather than on the broader economy.
  • Dow Jones theory shows that share prices demonstrate a pattern over four to five years and these patterns can be divided into primary, secondary and minor trends.
  • Charts and Indicators are two major tools of Technical Analysis.

Portfolio Management

  • Portfolio management refers to managing efficiently the investment in the securities by professionals for both small investors and corporate investors who may not have the time and skills to arrive at sound investment decisions.
  • Portfolio Analysis seeks to analyze the pattern of return emanating from a portfolio of securities.
  • Risk means that the return on investment would be less than the expected rate. Risk is a combination of possibilities because of which actual returns can be slightly different or greatly different from expected returns.
  • Portfolio theory was originally proposed by Harry Markowitz in 1950s, and was the first formal attempt to quantify the risk of a portfolio and develop a methodology for determining the optimal portfolio
  • As per Markowitz Model, a portfolio is efficient when it yields highest return for a particular level of risk or minimizes risk for a specified level of expected return. .
  • Covariance and correlation are conceptually analogous in the sense that both of them reflect the degree of comovements between two variables.
  • According to Sharpe Index Model, return on a security is correlated to an index of securities or an index or an economic indicator like GDP or prices and the return for each security can be given by:
    Ri = αi +ßi RM + ei
  • CapitalAsset Pricing Model provides that if adding a stock to a portfolio increases its standard deviation, the stock adds to the risk of the portfolio. This risk is the un-diversified risk that can not be eliminated.
  • Beta is the measure of the non- diversifiable or systematic risk of an aaet relative to that of the market portfolio

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  • The equation of the capital market line (connecting the risk less asset with risky portfolio) is

eq13

  • A security market line describes the expected return for all assets and portfolios of assets, efficient or not.
  • The sharpe ratio is a risk adjusted measure of return that is often used to evaluate the performance of a portfolio.
  • EVA measures the firm’s ability to earn more than the true cost of capital.
  • EVA combines the concept of residual income with the idea that all capital has a cost, which means that it is a measure of the profit that remains after earning a required rate of return on capital.

Introduction to Management

  • Management is a process containing a human element and makes most ef cient use of resources through and with people.
  • Management is a Process that comprises of four key functions, viz., Planning, Organising, Directing and Controlling.
  • Be it home, business, educational, charitable and religious and other non-profit institutions, management is a must for all activities and organisations, and therefore, it is all-pervasive.
  • At the beginning of the last century (1916), the French engineer Henri Fayol shelled out the first
    ever 14 principles of ‘classical management theory’ formally. While developing fourteen principles of management, Fayol also defined the five core functions of management.
  • The first and foremost managerial function is ‘planning’. Planning means looking ahead and chalking out future courses of action to be followed.
  • Organizing is the function of the management which follows the first function of management i.e. planning. It is a function which brings together human, physical and financial resources of the organisation.
  • The managerial function of staffing involves manning the organization structure through proper and effective recruitment, selection, appraisal and development of the personnel to  ll the roles assigned to the employers/workforce.
  • In field of management, direction is said to be all those activities which are designed to encourage the subordinates to work effectively and efficiently.
  • Controlling measures the deviation of actual performance from the standard performance, discovers the causes of such deviations and helps in taking corrective actions.




Introduction to Strategic Management

  • Strategic Management is a discipline that deals with long-term development of an organisation with a clear-cut vision about organisational purpose, scope of activities and objectives.
  • The strategic management process is defined as the process by which the managers’/decision makers’ are able to make a choice of a set of strategies for the organization that will enable it to accomplish improved performance. There are four indispensable phases of every strategic management process.
  • Strategic leadership refers to a manager’s potential to articulate the strategic vision for the organization, and to motivate, guide and influence his subordinates to attain the objectives of that vision.
  • Strategic leadership refers to a manager’s potential to articulate the strategic vision for the organization, and to motivate, guide and influence his subordinates to attain the objectives of that vision.
  • The internal strengths represent its internal environment. These consist of financial, physical, human and technological resources.
  • Porter’s five forces model is an analysis tool that uses five industry forces to determine the intensity of competition in an industry and its profitability level.

Business Policy and Formulation of Functional Strategy

  • Business policies are the guidelines developed by an organization to govern the actions of those who are a part of it. They define the potential limits within which decisions must be made.
  • The origins of business policy can be traced back to the year 1911, when Harvard Business School introduced an integrative course in management aimed at the creation of general management capability.
  • Vision serves the purpose of stating what an organization wishes to achieve in the long run.
  • A mission statement defines the basic reason for the existence of that organization. Such a statement reflects the corporate philosophy, identity, character, and image of an organization.
  • Corporate Strategy highlights the pattern of business moves and goals concerning strategic interest, in different business units, product lines, customer groups, etc. It defines how the firm will remain sustainable in the long run.
  • Where SBU concept is applied, each SBU sets its own strategies to make the best use of its resources (its strategic advantages) given the environment it faces.
  • Functional strategy, relates to a single functional operation and the activities involved therein. Decisions at this level within the organization are often described as tactical.

Strategic Analysis and Planning

  • Strategic analysis and planning involves careful formulation of the strategies and goals taken by a company’s top management on behalf of the organization.
  • A situational analysis takes into account the internal and external environment of an entity or organization and clearly identifies its own capabilities, customers, potential customers, competitors and the business environment and the impact they are going to have on the entity or organization.
  • SWOT is a tool for strategic analysis of any organization, which takes into account both examination of the company’s internal as well as of its external environment.
  • TOWS analysis scans opportunities and threats existing in external environment of any organization, and then generates, compares and selects strategies based on internal strengths and weakness to utilize such opportunities and reduce threats.
  • PERT and CPM two complementary statistical techniques utilized in Project management. These two are network based scheduling methods that exhibit the flow and sequence of the activities and events.
  • The tool to identify the strengths and weaknesses of a company is a Product Portfolio Analysis.
  • The BCG Matrix was developed by the Boston Consulting Group (BCG) and is used for the evaluation of the organization’s product portfolio in marketing and sales planning.
  • GE McKinsey Matrix is conceptually similar to BCG analysis, but somewhat more complicated that BCG Matrix as in BCG analysis, a two-dimensional portfolio matrix is created, while, with the GE model the dimensions are multi-factorial.
  • Strategic planning is an organization’s process of defining its strategy, or direction, and making decisions on allocating its resources to pursue this strategy.
  • There are many strategic alternatives that can be adopted by an organisation to attain its objectives. The most famous ones are Glueck & Jauch Generic Strategic Alternative and Porter’s Generic Strategies.




Strategic Implementation and Control

  • The implementation of policies and strategies is concerned with the design and management of
    systems to achieve the best integration of people, structures, processes and resources in reaching organization objectives.
  • An effective implementation of strategy in an organization needs multiple supporting factors.
  • An organization is confronted with a number of issues in the process of strategy implementation.
  • McKinsey developed the 7-S framework management model which organize seven factors to organize a company in an holistic and effective way
  • Structural implementation involves the designing of organizational structure and interlinking various departments and units of the organization created as a result of the organizational structure.
  • Behavioural implementation is concerned with those aspects of strategy implementation which have influence on the behaviour of the people in the organization.
  • Effective strategic control process should ensure that an organization is setting out to achieve the right things, and that the methods being used to achieve these things are working.

Analysing Strategic Edge

  • BPR is another form of process innovation because it attempts to re-create processes.
  • The underlying principle of BPR is that the managers must demolish such components of work that do not make any value addition and further automating it if possible.
  • Bench-marking is used to compare the performance of the business processes and products of a company with that of the best performances of other companies inside and outside the industry which the company is a part of.
  • TQM is a management philosophy that views an organization as a collection of processes such as marketing, finance, design, engineering, and production, customer service, etc, thereby, focusing on meeting customer needs and organizational objectives.
  • TQM is mainly concerned with continuous improvement in all work, from high level strategic planning and decision-making, to detailed execution of work elements on the shop floor.

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