Essence of financial management

Preferred stock dividend

- __

_ -___

18,000

Earning available to common stockholders

51,000

42,000

40,000

Earnings per share è

2.91

4.20

5.33

From the above table, we see that the third alternative is the best which will give us the highest EPS at P5.33.

Next, we have to determine the weighted average cost of this capital structure. Assuming that the cost of common stock is 14% and that of preferred stock is 10%. The cost of debt is .10 (1 – 0.4) or 6%, 40% or 0.4 is tax rate.

*Weighted average cost of capital

Suppose, the project has a ten year life and with annual cash inflow of P150,000. This cash inflow should be discounted at the WACC at 9.6% which should be considered as the hurdle rate. The project must earn at least the cost of financing it. At 9.6% hurdle rate, the present value of P150,000 annual cash inflow for 10 years is P937,710 (150,000 x 6.2514). The net present value therefore of this project is P437,710 (P937,710 – project cost of P500,000).

Various alternative projects will be analyzed in terms of net present value (NPV). The project with the highest NPV will be chosen as the most profitable project.

Sometimes funds available would be able to finance more than one project. The problem is how to ration this available fund. The following are projects with different costs but all with 10-year lives. Their cash inflows are discounted at the same rate of 9.6%.

* Profitability Index = Cash Inflow / Cost

If available funds amounts to P900,000, then the possible combination are A & B and C, D & E. Which of these combinations is better is determined by using as basis the weighted average profitability index (WAPI):

A & B: WAPI = 500,000 (1.88) + 400,000 (1.15) = 1.555

900,000 900,000

C, D & E: WAPI = 250,000 (1.88) + 350,000 (1.11)

900,000 900,000

+ 300,000 (1.08) = 1.1056

900,000

Sources

Amount

Proportion

Cost

WACC*

Debt

200,000

40%

6%

2.4%

Common

150,000

30%

14%

4.2%

Preferred

150,000

30%

10%

3.0%

Total

500,000

100%

9.6%

Project

Costs

PV of Cash Inflow

NPV

PI*

A

500,000

937,710

437,000

1.88

B

400,000

460,000

60,000

1.15

C

250,000

282,500

32,500

1.13

D

350,000

388,500

38,000

1.11

E

300,000

324,000

24,000

1.08

From the above, the better combination is A & B where WAPI is 1.555.

A project can be gauged as acceptable not only through a positive ―NPV‖ but also through its internal rate of return (IRR) which should be higher than the hurdle rate or the required rate of return (Cleary, (1999). The IRR is that rate which if the cash inflows or cash income of a project are discounted by said rate, will result in a present value of cash inflows equal to the cost of the project.

Projects with the same lives and hurdle rates are comparable in terms of net present value. This is our assumption for investment evaluation and capital rationing purposes. Under capital rationing, it is assumed that the projects have different EBITs and cash incomes but with the same capital structure for financing or hurdle rate.

Projects with different lives and hurdle rates are also comparable for investment evaluation and capital rationing purposes. This can be done by deriving the NPV of the infinite lived alternative (NPV).

8. Leasing

Leasing an equipment or a real estate property (land and building) is an alternative in order to have the rightful use of an asset. Instead of buying the property, leasing may be a better alternative (Grenadier, (1996). The analysis involves the comparison of the resultant total cash outflow for the alternative to buy and the alternative to lease.

The lease payment is an operating outlay and thus would contribute in the decrease of net income which in turn would mean a saving in tax. This tax saving is called tax shield on lease payments. The lease payment per period net of the tax savings will be discounted at whatever is the cost of fund in order to determine its present value. Thus, the total present value of all lease payments during the term of the lease will be determined and compared with the present value of the cash outflows involved in buying the asset.

The money for the lease payments may be borrowed from banks or may come from the company’s retained earnings account. Thus, the cost of fund may be at the bank’s interest rate or at the cost of common stock or equity since the cost of retained earnings is the same as the cost of common equity.

When the company borrows money in order to buy the property, the company will pay interest for the borrowed money, for insurance, and will incur depreciation expense during the useful life of the asset. These payments on interest and insurance and depreciation expense will decrease net income, thus tax savings will be obtained. The tax savings is the tax rate multiplied by the total expenses. The net cash outflow for each of the period of the loan term is the loan amortization net of this tax saving. The net cash outflows will be discounted at the interest rate of the loan. Thus the total present value of all the net cash outflows is determined.

The alternative with the lower total present value of cash outflows will be chosen as the better alternative.

If the payment for the purchase price of the property will not be borrowed but will come from the coffers of the company. Then the purchase price will be the basis for comparison with the lease alternative.

9. Merger and Acquisition

A company may decide to acquire another company if it foresees that this acquisition would increase profitability in the future to be reflected in an increasing earning per share (EPS).

The company will acquire the common stock of another firm at a certain price usually t a price higher than its market price in order to attract the other firm’s stockholders to sell (Kaplan and Michael, (1992). The ratio between the acquiring firm’s stock price and offered price for the stock of the firm to be acquired is determined in order to derive the number of common shares that will be exchanged for the common shares of the firm to be acquired. The combined earnings of the two firms will be divided by the resulting number of common shares after the merger to determine the EPS of the merged company.

Unless the EPS after merger is expected in the future to be higher than the EPS without the merger, then it is not desirable to merge.

10. Dividend Policy

The consideration in formulating the dividend policy of the firm is the trade off involved between availability of funds for investment to increase earnings and the dilution of ownership if the investment project will be financed through flotation of additional common shares if long-term debt financing is not available or not viable. Common stockholder will allow the reinvestment of retained earnings instead of declaring dividends for themselves in expectation of future higher earning per share and in order to avoid dilution of ownership (Barclay, Clifford and Ross (1995).

11. Conclusion

The owners of a corporation are normally distinct from its managers. Actions of the financial manager should be taken to achieve the objectives of the firm’s owners, its stockholders. In most cases, if financial managers are successful in this endeavor, they will also achieve their own financial and professional objectives. Financial managers actively manage the financial affairs of any type of businesses—financial and nonfinancial, private and public, large and small, profit-seeking and not-for-profit. They perform such varied financial tasks as planning, extending credit to customers, evaluating proposed large expenditures, and raising money to fund the firm’s operations. In recent years, changing economic, competitive, and regulatory environments have increased the importance and complexity of the financial manager’s duties. Today’s financial manager is more actively involved in developing and implementing corporate strategies aimed at ―growing the firm‖ and improving its competitive position. As a result, many top executives have come from the finance area.

References

Anthony, R, Glenn A, Welsch and James S. Reece, (1985), Fundamentals of Management Accounting, Homewood, Illinois: Richard D. Irvin, Inc, p.407.

Barclay, Michael J., Clifford W. Smith and Ross L. Watts (1995), ―The Determinants of Corporate Leverage and Dividend Policies‖ Journal of Applied corporate Finance 7, p.8

Cleary, Sean (1999), ―The Relationship between Firm Investment and Financial Status, ―Journal of Finance 54, p.79

Gitman, Lawrence J. (1987), Basic Managerial Finance, New York: Harper and Row publishers, p.13.

Grenadier, Steven R. (1996), ―Leasing and Credit Risk‖, Journal of Financial Economics 42, p.348

Harris, Milton and Artur Raviv (1996), ―The Capital Budgeting process: Incentives and Information.‖ Journal of Finance 51, p.1148

Kaplan, Steven N., and Michael S. Weisbach (1992), ―The Success of Acquisitions: Evidence from Divestitures.‖ Journal of Finance 47, p.112

Ran, D. L. (1964), The Limitations of Profit Graphs, Breakeven Analysis and Budgets, Accounting Review 39, p.928

Van Horne, James C. (2002), Financial Management and policy. New Jersey: Prentice Hall, p.449.

Weston, J. Fred and Eugene F. Brigham (1981), Managerial Finance, Illinois: The Dryden Press, p.233. 

Financial Management

Financial Management is the process of managing the financial resources, including accounting and financial reporting, budgeting, collecting accounts receivable, risk management, and insurance for a business.

The financial management system for a small business includes both how you are financing it as well as how you manage the money in the business.

In setting up a financial management system your first decision is whether you will manage your financial records yourself or whether you will have someone else do it for you. There are a number of alternative ways you can handle this. You can manage everything yourself; hire an employee who manages it for you; keep your records inhouse, but have an accountant prepare specialized reporting such as tax returns; or have an external bookkeeping service that manages financial transactions and an accountant that handles formal reporting functions. Some accounting firms also handle bookkeeping functions. Software packages are also available for handling bookkeeping and accounting.

Bookkeeping refers to the daily operation of an accounting system, recording routine transactions within the appropriate accounts. An accounting system defines the process of identifying, measuring, recording and communicating financial information about the business. So, in a sense, the bookkeeping function is a subset of the accounting system. A bookkeeper compiles the information that goes into the system. An accountant takes the data and analyzes it in ways that give you useful information about your business. They can advise you on the systems needed for your particular business and prepare accurate reports certified by their credentials. While software packages are readily available to meet almost any accounting need, having an accountant at least review your records can lend credibility to your business, especially when dealing with lending institutions and government agencies.

Setting up an accounting system, collecting bills, paying employees, suppliers, and taxes correctly and on time are all part of running a small business. And, unless accounting is your small business, it is often the bane of the small business owner. Setting up a system that does what you need with the minimum of maintenance can make running a small business not only more pleasant, but it can save you from problems down the road.

The basis for every accounting system is a good Bookkeeping system. What is the difference between that and an accounting system? Think of accounting as the big picture of how your business runs -- income, expenses, assets, liabilities -- an organized system for keeping track of how the money flows through your business, keeping track that it goes where it is supposed to go. A good bookkeeping system keeps track of the nuts and bolts -- the actual transactions that take place. The bookkeeping system provides the numbers for the accounting system. Both accounting and bookkeeping can be contracted out to external firms if you are not comfortable with managing them yourself.

Even if you outsource the accounting functions, however, you will need some type of Recordkeeping Systems to manage the day-to-day operations of your business - in addition to a financial plan and a budget to make certain you have thought through where you are headed in your business finances. And, your accounting system should be producing Financial Statements. Learning to read them is an important skill to acquire.

Another area that your financial management system needs to address is risk. Any good system should minimize the risks in your business. Consider implementing some of these risk management strategies in your business. Certainly, insurance needs to be considered not only for your property, office, equipment, and employees, but also for loss of critical employees. Even in businesses that have a well set up system, cash flow can be a problem. There are some tried and true methods for Managing Cash Shortages that can help prevent cash flow problems and deal with them if they come up. In the worst case you may have difficulties meeting all you debt obligations. Take a look at Financial Difficulties to learn more about ways to manage situations in which you have more debt than income.

It is possible you may even be at the a point where you want to sell the business or simply close it and liquidate assets. There are financial issues involved for these circumstances too. So, be certain that you know what steps you need to take in order to protect yourself financially in the the long run.

Clearly, financial management encompasses a number of crucial areas of your business. Take time to set them up right. It will make a significant difference in your stress levels and in the bottom line for your business.

Financial Management: Levels

Broadly speaking, the process of financial management takes place at two levels. At the individual level, financial management involves tailoring expenses according to the financial resources of an individual. Individuals with surplus cash or access to funding invest their money to make up for the impact of taxation and inflation. Else, they spend it on discretionary items. They need to be able to take the financial decisions that are intended to benefit them in the long run and help them achieve their financial goals.

From an organizational point of view, the process of financial management is associated with financial planning and financial control. Financial planning seeks to quantify various financial resources available and plan the size and timing of expenditures. Financial control refers to monitoring cash flow. Inflow is the amount of money coming into a particular company, while outflow is a record of the expenditure being made by the company. Managing this movement of funds in relation to the budget is essential for a business.

At the corporate level, the main aim of the process of managing finances is to achieve the various goals a company sets at a given point of time. Businesses also seek to generate substantial amounts of profits, following a particular set of financial processes.

Financial managers aim to boost the levels of resources at their disposal. Besides, they control the functioning on money put in by external investors. Providing investors with sufficient amount of returns on their investments is one of the goals that every company tries to achieve. Efficient financial management ensures that this becomes possible.

Strong financial management in the business arena requires managers to be able to: 

• Interpret financial reports including income statements, Profits and Loss or P&L, cash flow statements and balance sheet statements  
  
• Improve the allocation of working capital within business operations 
  
• Review and fine tune financial budgeting, and revenue and cost forecasting  
  
• Look at the funding options for business expansion, including both long and short term financing
• Review the financial health of the company or business unit using ratio analyses, such as the gearing ratio,profit per employee and weighted cost of capital
• Understand the various techniques using in project and asset valuations
• Apply critical financial decision making techniques to assess whether to proceed with an investmtn
• Understand valuations frameworks for businesses, portfolios and intangible assets