Task 01- LO 01

1.1 purposes of financial management

Financial management is concern with the management of all matters associated with the cash flow of an organization both short term and long term. How the company uses its funds typically by buying noncurrent assets and funding its working capital and where the funds came from typically from the shareholders or by borrowing money from third parties. There are five main purposes of Financial Management.

  1. To ensure regular and adequate supply of funds to the concern.
  2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders.
  3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost.
  4. To ensure safety on investment, as a example funds should be invested in safe ventures so that adequate rate of return can be achieved.
  5. 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.

1.2 Roles of financial manager

Financial managers mainly perform data analysis and advise senior managers on profit-maximizing ideas. Financial managers are responsible for the financial health of an organization. They produce financial reports, direct investment activities, and develop strategies and plans for the long-term financial goals of their organization. Financial managers typically perform following roles

Raising of Funds

In order to meet the obligation of the business it is important to have enough cash and liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a financial manager to decide the ratio between debt and equity. It is important to maintain a good balance between equity and debt.

Allocation of Funds

Once the funds are raised through different channels the next important function is to allocate the funds. The funds should be allocated in such a manner that they are optimally used. In order to allocate funds in the best possible manner the following point must be considered the size of the firm and its growth capability,status of assets whether they are long term or short term,mode by which the funds are raised like that.

Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning is important for survival and sustenance of any organization. Profit planning refers to proper usage of the profit generated by the firm.Therefore financial manager has a special task to planning profits correctly.

Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and purchase of securities. Hence a clear understanding of capital market is an important function of a financial manager. When securities are traded on stock market there involves a huge amount of risk involved. Therefore a financial manger understands and calculates the risk involved in this trading of shares and debenture.

Importance and roles of the corporate finance

Importance of the corporate finance

Decision Making:

There are several decisions that have to be done on the basis of available capital and limited resources. If an organization has to start a new project, then it has to consider whether it would be financially viable and if it would yield profits. So while investing in a new project or a new venture, a company has to consider several things like availability of finances, the time taken for its completion, etc. and then make decisions accordingly.

Fulfilling Long Term and Short Term Goals:

Every organization has several long term goals in order to survive in the market. The short term goals may include paying the salaries of employees, managing the short term assets, acquiring corporate finances like bank drafts, trade credit from suppliers, purchase of raw materials for production

Depreciation of Assets:

When a company invest in a new software or a new equipment, company would require to keep aside some amount to maintain it and upgrade it in the long run. Only then company could be assured that it would yield good results over a period of time.

Minimizing Cost of Production:

Corporate finance helps in minimizing the cost of production. With the rising cost of prices of raw materials and labor, the management has to come up with innovative measures to minimize the cost of production.

Raising capital

When an organization has to invest in a new venture, it is very important that it has to raise capital. This cab be done by selling bonds and debentures, stocks of the company taking loans from the banks etc

Expansion and Diversification:

Before an organization decides to expand or diversify in to a new arena, it has to consider various aspects like the capital available, risks involved, the amount to be invested for purchase of new equipment etc. All this can be done by experts and this would be very beneficial for the organization.

Roles of corporate finance

Role of corporate finance is critical to the success of a company. Once a company decides to acquire an asset, then the role of corporate finance to track and manage the asset, even deciding when it is time to sell the asset, in order to maximize the return on investment of the asset.

The role of corporate finance is to raise the money that the company needs to operate.Then, the department is responsible for controlling these funds, and growing them through investing and other ventures in order to cover the liabilities and expenses.

The corporate finance department may play in raising funds or money can vary from company to company.

In addition, if the corporate finance department does not properly manage the assets and finances and fundraising efforts of the company, then it can mean the demise of the company.

Importance of finance planning

Financial Planning is the process of estimating the capital required and determining it’s competition.

Financial Planning is process of setting objectives, policies, procedures, programs and budgets regarding the financial activities of a concern. This ensures effective and adequate financial and investment policies. The importance are;

Adequate funds have to be ensure, which help to Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is maintained.Also the suppliers of funds are easily investing in companies which exercise financial planning. Financial Planning helps in making growth and expansion programs which helps in long-run survival of the company.

Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily through enough funds. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the company. This helps in ensuring stability an d profitability in concern.

Task 02- LO 03

3.1 Importance of investment rules

Payback

  1. It involves a quick and simple calculation
  2. An easily understandable concept
  3. It shows an initial risk of project, long payback means capital tied up and high investment risk
  4. It improves investment conditions. When investment conditions are expected to improve in the near future, attention is directed to those project that will release funds soonest, to take advantage of the improving climate.
  5. It uses cash flows, not subjective accounting profit.

ARR

  1. Simplicity- as with the payback period, it is easily understood and easily calculated
  2. Widely used and accepted method
  3. It considers the whole life of the project

NPV

  1. Considers the time value of money
  2. It is an absolute measure of return
  3. It is based on cash flows not profits
  4. Considers the whole life of the project
  5. It should lead to maximization of shareholder wealth

IRR

  1. IRR considers the time value of money
  2. It is a percentage and therefore easily understood
  3. IRR uses cash flow not profits
  4. IRR considers the whole life of the project
  5. The IRR can be calculated when the cost of capital is unknown

3.2 Calculations

NAV

Y

E

A

R

Discount factorProposal 01Proposal 02Proposal03Proposal 04
Cash flowDiscounted cash flowCash flowDiscounted cash flowCash flowDiscounted cash flowCash flowDiscounted cash flow
01(120) 

(120)

(95)(95)(80)(80)(160)(160)
10.9098072.72109.093027.273027.27
20.8266049.564033.044033.045041.30
30.7514030.044030.043022.539067.59
40.6832013.666040.983020.498054.64
50.621(40)(24.84)5534.152012.4210061.10
NAV =21.1452.30535.7591.10

Discounted Payback period

Proposal 01 = (47.28/49.56)*12= 11.44

1 year and 11 months

Proposal 02 = (22.83/40.98)*12 = 6.68

3 years and 6 months

Proposal 03 = (19.69/22.52)*12 = 10

2 years 10 months

Proposal 04 = (23.84/54.64)*12 = 5.23

3 years and 5 months

Working

YearDF 10%Proposal 01Proposal 02
NCFDCFCumulative

DCF

NCFDCFCumulative

DCF

01(120)(120)(120)(95)(95)(95)
10.9098072.72(47.28)109.09(85.91)
20.8266049.564033.04(52.87)
30.7514030.044030.04(22.83)
40.6832013.666040.98
50.62140(24.84)5534.15
YearDF 10%Proposal 03Proposal 04
NCFDCFCumulative

DCF

NCFDCFCumulative

DCF

01(80)(80)(80)(160)(160)(160)
10.9093027.27(52.73)3027.27(132.73)
20.8264033.04(19.69)5041.30(91.43)
30.7513022.529067.59(23.84)
40.6833020.498054.64
50.6212012.4210062.10

ARR

ARR = Average Profit / Average investment

Proposal 01

ARR = [(160-120)/5] / [120/2] *100

= 13.33%

Proposal 02

ARR = [(200-95)/5] / [100/2] *100

= 42%

Proposal 03

ARR = [(150-80)/5] / [80/2] *100

= 35%

Proposal 04

ARR = [(310-160)/5] /[100/2] *100

= 60%

IRR

IRR = L + [NL / ( NL – NH )] * ( H-L)

Proposal 01

NPV @ 10% = 21.14

NPV @ 15% = 12.782

IRR = 10% + [21.14 /(21.14- 12.782)] *(5%)

= 27.65%

Proposal 02

NPV @ 10 % = 52.305

NPV @ 15 % = 31.894

IRR = 10% + [52.305 / (52305-31.894)] *(5%)

= 22.81%

Proposal 03

NPV @ 10% = 35.75

NPV @ 15% = 23.15

IRR = 10% + [35.75 / (35.75-23.15)] *(5%)

= 24.19%

Proposal 04

NPV @ 10% = 91.90

NPV @15% = 58.53

IRR = 10% + [91.90 / (91.9-58.53)] *(5%)

= 23.77%

3.3 Findings

NPV

A positive NPV indicates that the rate offered exceed the required return and so shareholder wealth increases. A negative NPV indicates that the project does not earn an acceptable rate of return and so it would reduce shareholder wealth.

According to above four proposals all have positive NPV.The proposal that has highest NPV is the best proposal among all proporsals.So proposal number 4 is the best proposal.

Discounted payback

All proposals that have positive discounted payback are viable. Same as NPV.According to the above proposals all are having positive discounted payback period. So all are acceptable. The proposal that has lowest discounted payback period is the best proposal among all proporasals.so proposal 1 is the best proposal.

ARR

ARR calculates as percentage return provided by the accounting profits. The ARR for a product may be compared with the company’s target return and if the higher the project should be accepted. So 4 project proposal should be accepted.

IRR

The percentage return on the investment must be the rate of discount at which the NPV equals zero. If the IRR greater than the cost of capital the project should be accepted. If the IRR is less than the cost of capital the project should be accepted. If the IRR is less than the cost of capital the cost of capital, the project should be rejected, So proposal 1 should be accepted.

Task 03-LO 04

4.1 Importance of capital market

Link between Savers and Investors

The capital market functions as a link between savers and investors. It plays an important role in mobilizing the savings and diverting them in productive investment. In this way, capital market plays a vital role in transferring the financial resources from surplus units to deficit units. It also encourage to save.

Encouragement to Investment

The capital market facilitates lending to the businessmen and the government and therefore encourages investment. It provides facilities through banks and nonbank financial institutions. Various financial assets, e.g., shares, securities, bonds.

Promotes Economic Growth

The capital market not only reflects the general condition of the economy, but also smoothens and accelerates the process of economic growth. Various institutions of the capital market, like nonbank financial intermediaries, allocate the resources rationally in accordance with the development needs of the country.

Stability in Security Prices

The capital market tends to stabilize the values of stocks and securities and reduce the fluctuations in the prices to the minimum. The process of stabilization is facilitated by providing capital to the borrowers at a lower interest rate and reducing the speculative and unproductive activities

4.2 Relationship between risk and return

There is a positive correlation between risk and return. There is no guarantee that taking greater risk results in a greater return. Rather, taking greater risk may result in the loss of a larger amount of capital. A higher risk investment has a higher potential for profit but also a potential for a greater loss.

On the low-risk, there are short-term government bonds with low yields. The middle of the spectrum may contain investments such as rental property or high-yield debt. On the high-risk end of the spectrum are equity investments, futures and commodity contracts, including options. Investments with different levels of risk are often placed together in a portfolio to maximize returns, while minimizing the possibility of volatility and loss.

In the following graph shows the relationship between risk and returen.

4.3 Difference between stock valuation and bond valuation

There are many similarities between stock and bond valuation, there are also a few differences in how the valuation process relates to each type of asset. These differences focus on factors that are unique to each asset, including the structure of dividends and interest payments, the duration or maturity date involved with the assets, and the projection of future cash flows. By understanding how stocks and bonds differ, it becomes easier to approach valuations using strategies that are relevant to each asset

Bond

Valuation is often considered a quicker and easier process than attempting a stock valuation. This is because bonds are often structured with a fixed rate of interest to provide returns to investors. Even when the issue carries a variable rate of interest, there is usually a minimum interest rate that will apply for the life of the bond. Along with more or less stable and predictable interest payments, a bond also has a formal ending in the form of a maturity date.

Stock

Valuation calls for taking into consideration factors that are somewhat more complicated. The differences between stock and bond valuation include the facts that stocks do not have a set maturity date that calls for settlement of the issue, and the amount of dividends generated will depend on how well the issuing company performs in the marketplace, including regarding generating sales, earning profits, and seeing a steady increase in the value of the issued shares. With a greater range of variables to consider, this means the valuation of stocks can be more complicated.

Stock and bond valuation may differ in some features, but the ultimate goal of the valuation is the same. In each scenario, the goal is to accurately assess the overall worth of the asset to the investor. This includes considering the amount of the original purchase, the current market value of the asset, and what investors would be willing to pay in order to purchase the asset if it were offered for sale.

Task 04 –LO 05

5.1 Financing methods

There are various methods to finance to a business. Some of them are,

The Government

If the bank cannot approve in the traditional manner, you may qualify for a small business administration loans (SBA) Business would still apply to the bank but, if you qualified, the SBA would guarantee your loan. If company’s credit is not good, there are different methods to finance a business that might work for you. Here are some places to look for alternative business financing.

Personal Investors

Company may have friends or family members that would be willing to finance its venture. Set up a contract with those willing to help to company with your business financing.

Finance Companies

Another method to finance your business is through specific finance companies. Loans from finance companies work similarly as bank loans, but they typically have less rigid requirements and much higher interest rates.

Credit Cards

This should be on the short list of “methods of last resort” for financing a business. If company only need a relatively small amount and could handle the payments even if the business did not work out, then it is something company could consider.

Savings

Again, this is not a best idea for funding a business. Company have worked long and hard to build its savings. It is an option, but be careful about the amount of your saving you use on business financing. You should certainly never use all of your savings. That could destroy you financially should something unexpected happen.

5.2 Implications of financing methods

Public financing

Public finance describes finance as related to sovereign states and sub-national entities and related public entities or agencies. It usually encompasses a long-term, strategic perspective regarding investment decisions that affect public entities. These long-term, strategic periods usually encompass five or more years. Public finance is primarily concerned with

  1. Identification of required expenditure of a public sector entity
  2. Sources of that entity’s revenue
  3. The budgeting process
  4. Debt issuance (municipal bonds) for public works projects
  5. Central bank

Personal financing

Personal finance may involve paying for education, financing some long term assets, buying insurance Personal finance may also involve paying for a loan, or debt obligations. The six key areas of personal financial planning, as suggested by the Financial Planning Standards Board

Corporate financing

Capital budgeting may employ standard business valuation techniques of even extend to real options valuations and it is related to how these investment are to be funded. Investment capital can be provided through different sources .Such as by shareholders, creditors, and bank like that.

5.3 The best financial option

Debt capital is better than other financing method .Because when we compare the cost of debt of loan to that cost of equity that we need to consider how the interest company would pay over the lifetime of a loan would compare to the portion of profits company would sacrifice over the lifetime of the company. If the interest would be greater than an investor’s cut of your profits, then debt would be more expensive, and vice versa.

Given that the cost of debt is essentially finite, it will generally be cheaper than equity for companies that expect to perform well. In other words, the more the company expect to profit, the most costly sacrificing equity will be and the more beneficial it will be to simply keep the profits to yourself and pay interest on a loan. For example, if the company is going to be making $100k next year, company much rather pay $ 10k in interest than give up 10% of company’s profits forever. This is especially true when company consider that interest paid on loans is tax deductible.

It’s obviously difficult to forecast earnings with any certainty, which is why large companies with steady cash flow that are in stable industries tend to make greater use of debt, while less-established companies or those in risky fields may not only find equity to be less risky, but easier to acquire as well.

Task 05- Lo 06

Purposes of derivatives

There are various types of derivative products such as options, forwards contracts, futures contracts and swaps. It is interesting to understand the role of derivative markets. Following are few key purposes of the derivative markets.

1. Risk Management

2. Price discovery

3. Operational advantages

4. Market efficiency

Risk Management

As derivative prices are related to the underlying spot market goods, they can be used to reduce or increase the risk of owing the spot items. For example, buying the spot item and selling a futures contract or call option reduces the investor’s risk. If the goods price falls, the price of the futures or options contract will also fall. The investor can then repurchase the contract at the lower price, affecting a gain that can at least partially offset the loss on the spot item. All investors however want to keep their investments at an acceptable risk level. Derivative markets enable those wishing to reduce their risk to transfer it to those wishing to increase it, whom we call speculators.

Price discovery

Forward and futures markets are an important source of information about prices. Futures markets in particular are considered a primary means for determining the spot price of an asset. Futures and forwards prices also contain information about what people expect future spot prices to be. In most cases the futures price is more active hence, information taken from it is considered more reliable than spot market information.

Therefore futures and forward market are said to provide price discovery. Option markets do not directly provide forecasts of future spot prices. They do, however provide valuable information about the volatility and hence the risk of the underlying spot asset.

Operational advantages

They entail lower transaction costs. This means that commission and other trading costs lower for traders in these markets And Derivative markets, particularly the futures and exchanges have greater liquidity than the spot markets and also the derivative markets allow investors to sell short more easily. Securities markets impose several restrictions designed to limit or discourage short if not applied to derivative transactions. Consequently many investors sell short in these markets in lieu of selling short the underlying securities.

Market efficiently

Spot markets for securities probably would be efficient even if there were no derivative markets. There are important linkages among spot and derivative prices. The ease and low cost of transacting in these markets facilitate the arbitrage trading and rapid price adjustments that quickly eradicate these opportunities. Society benefits because the prices of the underlying goods more accurately reflect the goods true economic value.

Therefore the derivative markets provide a means of managing risk, discovering prices, reducing costs, improving liquidity, selling short and making the market more efficient

6.2 Common derivatives

Options

These are the binding contracts between the parties to buy or sell a particular security, commodity, metal etc., at a given price. Options give the right to buy to the buyer and does not bring any obligation. An option to buy certain security at certain price is a “call option” and the other one which gives the right to sell a security is “put option”.

Futures

It is a derivative where two parties enter into a contract to buy or sell a security or any property at certain agreed price for a “future delivery”. There will be an agreement to buy or sell a specified quantity securities or any commodities y in a designated future month at a price agreed upon by the buyer and seller. They facilitate the trading on future exchange.

Forward contracts

Most of the difference between forwards and futures lies in terms of liquidity, trading platform and settlement. Forward contracts are customized bilateral contracts between two parties where settlement takes place in future on a specific date at a price agreed today. They are less liquid than futures.

Swaps

They are the agreements between the parties to exchange the financial instruments or the resulted future cash flows in future based on agreed criteria such as rate of interest, stock indices etc.

Hedging

A hedge is an investment that protects your finances from a risky situation. Hedging is done to minimize or offset the chance that your assets will lose value and it is a strategy intended to protect an investment or portfolio against loss. It usually involves buying securities that move in the opposite direction than the asset being protected.

Most investors who use hedge derivatives. These are financial contracts that derive their value from an underlying real assets, such as a stock. An option is the most commonly used derivatives. It gives you the right to buy or sell a stock at a specified price within a window of time.

Hedging employs various techniques but, basically, Involves taking equal and opposite positions in two different markets such as cash and futures markets. Hedging is also used in protecting one’s capital against effects of inflation through investing in high-yield financial instruments (bonds, notes, and shares), real estate, or precious metals.

As an example, Gold is a hedge if you want to protect yourself from the effects of inflation. That’s because gold keeps its value when the dollar falls. In other words, if the prices of most things you buy rises, then so will the price of gold. Gold is attractive as a hedge against a dollar collapse. That’s because the dollar is the world’s global currency, and there’s no other good alternative right now. If the dollar were to collapse, then gold might become the new unit of world money. That’s unlikely because there is such a finite supply of gold. The dollar’s value is primarily based on credit, not cash. But it wasn’t too long ago that the world was on the gold standard. That means most major forms of currency were backed by their value in gold. Gold’s historical association as a form of money is the reason it’s a good hedge against hyperinflation or a dollar collapse.

Conclusion

After doing this assignment I was able to identify the main purpose of financial management, also the role of the finance manager. The role of corporate finance and the importance of financial manager.

Next I was able to understand importance of financial planning and importance of the investment decision rules, thereby we can predict the future and will take corrective actions in future. Next I was able to identify applicability of NPV, Payback period, PI and IRR calculations and the relevance of these methods and how to select best investment proposal. I got a clear understanding about the relationship between risk and return. There is a positive relationship between risk and return and if we want high risk actually we should bear a risk also.

Also possible financing methods to a business is identified, and debt financing is the better financing option than others. And implication for each financial method. Now I have a clear idea about the best financing options, the purposes of derivatives. As a summary of information that included in this assignment I got a pure knowledge about financial management and its applicability.

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