FBK221: MANAGERIAL FINANCE

The Objective this Course is to provide students with a sound Theoretical Knowledge on
principles and Practices of finance.

1. Introduction: The Function of Financial Manager; The Goal of firms, Value Maximization
as a goal. The Agency Problem Financial Decisions – Functions of the Financial executives.
2. Financial Environment: Financial Markets; primary vs. Secondary Markers; Financial
Intermediaries; Financial Intermediaries; Financial Instruments; Fiscal Policy of
Bangladesh.
3. The time value of Money: Future Value; present value; Future value vs. Future Value of
an annuity; present value of an annuity; installment Payment for Accumulation of a future
sum.
4. Risk and Return: Risk, Uncertainty and return, probability distribution and Expected
return Total Risk analysis for assets in isolation: Variance Standard Deviations and
coefficient of variation, Introduction to portfolio theory and Capital Asset pricing
Model (CAPM) to analyze risk.
5. Working Capital Policy: Working Capital Terminology, The Requirements for External
Working Capital Finance. The Cash Conversion Cycle-Working Capital Investment and
Financing Policy-Advantages and Disadvantages of Short-term Financing'-Cash, Credit and
Inventory Management.
6. Short term Financing: Spontaneous Financing –Trade Credit and overdraft advantage &
Disadvantages; various terms of sales; Accrued Expenses; unsecured. Loads; secured loans;
Secured loans and other sources; pledging accounts Receivables and Factoring.
7. Long term financing: Types of long-term debt instruments; how much should a firm brow?
Debt financing: valuing risky Debt Kind of Debts Hedging Financial Risk, Bonds and their
Features Retirement of bonds; Preferred Stocks (Preference Share) and its Features;
Common Stock (Ordinary Shares) and its feature; Rights of common shareholders; issuing
Securities to the public.

Books Recommended:

1. Van Horne, James C and Wachowicz Jr: Fundamentals of Financial Management.

2. E.F.Brigham and Joel E. Houston: Fundamentals of Financial Management.
3. Bringhan, Eugene F. and Louis C. Gapenski: Intermediate Financial Management.
4. Ghosh, S.N; Sukladas J.C & Ahmed, M.: Choice of Banks, Customer Service & Credit
Policy.
Reference Books

1. S. B. Bloke & G. A. Hirt:Foundation of Financial Management.

2. R. B. Howard and M. Upton :Introduction to Business Finance.
3. R. L. Johnson: Financial Decision Making.
Chapter 1: Introduction

Definition of finance:

“Finance is concerned with the process institutions, markets and instruments involved in the
transfer of money among individuals, business and governments.” –Gitman

“Finance is concerned with decision about money or more appropriately cash flows.” –Scott and
Brigham

General areas of finance:

 Financial Markets and Institutions: Financial institutions, which include banks, insurance
companies, savings and loans, and credit unions, are an integral part of the general financial
services marketplace.
 Investments: The decisions made by businesses and individuals as they choose securities for
their investment portfolios.
 Financial Services: Financial services refer to functions provided by organizations that
operate in the finance industry.
 Managerial (Business) Finance: Managerial finance deals with decisions that all firms
make concerning their cash flows. As a consequence, managerial finance is important in all
types of businesses, whether they are public or private, deal with financial services, or
manufacture products.

Finance vs. Accounting:

Accounting’s primary function is to develop and provide data measuring the performance of the
firm, assessing its financial position, and paying taxes. The accountant is responsible for
preparing financial statements such as the income statement, balance sheets, and cash flows. The
financial manager or consultant places primary emphasis on decision making. It uses the
financial statements prepared by accountants to make decisions about the firm’s financial
condition and to advise others about possible losses and profits. In some cases, finance is more a
type of leadership position.

Finance, Economics and Accounting:

Key points:
Finance is the study of how to optimally allocate assets. Finance is fundamentally a forward
looking field, concerned with what an asset will be worth in the future.
Economics is the social science that analyzes the production, distribution, and consumption of
goods and services.
Accounting is the process of communicating financial information about a business. Accounting
is fundamentally a backward-looking field.
Finance
Finance is the study of how to optimally allocate assets—how individuals and organizations
should invest assets in order to get the highest possible return given changing conditions over
time. Finance is fundamentally a forward looking field, concerned with what an asset will be
worth in the future.

Economics
Economics is a social science that analyzes the production, distribution, and consumption of
goods and services. It focuses on how economic agents (people, businesses, and government)
interact and make decisions. Economics is fundamentally the study of cause and effect. It tries to
figure out how one variable affects economic agents or the economy as a whole.

Accounting
Accounting focuses on communicating a businesses' financial information. Accounting is
fundamentally a backward-looking field, concerned with what has already happened financially
and what position that leaves the company in today.

Overlap
Finance, economics, and accounting overlap in a lot of areas. For example, an investor will use
accounting to see whether a company has shown past financial success and finance to predict
what the company will look like in the future. Part of that prediction incorporates economics.
The investor wants to know what the overall economy will look like in the future and wants to
know how the company will interact with its competitors. The investor can use finance to figure
out what his or her investment will be worth in the future.

As noted above, finance itself is a subset of economics that is focused on money-related

information, while financial management needs the information accounting generates. The
principles of each are different as well; finance makes decisions according to recorded
information, economics analyzes those decisions and accounting makes the actual records of the
information. Lastly, while economics is based upon assumptions, finance and accounting are
based upon facts.

The functions of financial manager:

The important role of financial manager in modern business is as follows:
 Provision capital
 Investor relation
 Short and long term financing
 Investment decisions
 Maintaining Insurance
 Asset protection
Alternative forms of business organizations:
 Proprietorship: A proprietorship is an unincorporated business owned by one individual. It
is easily and inexpensively formed. It is taxed like an individual not a corporation; thus
earnings are taxed only once.
 Partnership: A partnership is the same as a proprietorship, except that it has two or more
owners.
 Corporation: A legal entity created by a state, separate and distinct from its owners and
managers, having unlimited life, easy transferability of ownership, and limited liability.

Hybrid Business Forms—LLP, LLC, and S Corporation: Alternative business forms that
include some of the advantages, as well as avoid some of the disadvantages, of the three major
forms of business have evolved over time.
Limited Liability Partnership (LLP): A partnership wherein one (or more) partner is
designated the general partner(s) with unlimited personal financial liability and the other
partners are limited partners whose liability is limited to amounts they invest in the firm. A
business organization that allows limited partners to enjoy limited personal liability while
general partners have unlimited personal liability.
A limited partnership is similar to a general partnership except that it has two classes of partners.
The general partner(s) have full management and control of the partnership business but also
accept full personal responsibility for partnership liabilities. Limited partners have no personal
liability beyond their investment in the partnership interest. Limited partners cannot participate
in the general management and daily operations of the partnership business without being
considered general partners in the eyes of the law.

 Limited Liability Company (LLC): A limited liability company, commonly called an

"LLC," is a business structure that combines the pass-through taxation of a partnership or
sole proprietorship with the limited liability of a corporation. Like owners of partnerships or
sole proprietorships, LLC owners report business profits or losses on their personal income
tax returns; the LLC itself is not a separate taxable entity. Like owners of a corporation,
however, all LLC owners are protected from personal liability for business debts and claims -
- a feature known as "limited liability." This means that if the business owes money or faces
a lawsuit, only the assets of the business itself are at risk. Creditors usually can't reach the
personal assets of the LLC owners, such as a house or car. (Both LLC owners and corporate
shareholders can lose this protection by acting illegally, unethically, or irresponsibly.)
 S Corporation: A corporation with no more than 75 stockholders that elects to be taxed the
same as proprietorships and partnerships so that business income is taxed only once. This
gives a corporation with 100 shareholders or less the benefit of incorporation while being
taxed as a partnership. This means that any profits earned by the corporation are not taxed at
the corporate level, but rather at the level of the shareholders. Also known as "S corporation".
The goal of firms:
A myopic person or business is mostly concerned about short term benefits. A short term horizon
can fulfill objective of earning profit but may not help in creating wealth. It is because wealth
creation needs a longer term horizon Therefore, financial management emphasizes on wealth
maximization rather than profit maximization. For a business, it is not necessary that profit
should be the only objective; it may concentrate on various other aspects like increasing sales,
capturing more market share etc, which will take care of profitability. So, we can say that profit
maximization is a subset of wealth and being a subset, it will facilitate wealth creation.
Giving priority to value creation, managers have now shifted from traditional approach to
modern approach of financial management that focuses on wealth maximization.
This leads to better and true evaluation of business. For e.g., under wealth maximization, more
importance is given to cash flows rather than profitability. As it is said that profit is a relative
term, it can be a figure in some currency, it can be in percentage etc. For e.g. a profit of say
$10,000 cannot be judged as good or bad for a business, till it is compared with investment, sales
etc. Similarly, duration of earning the profit is also important i.e. whether it is earned in short
term or long term.
In wealth maximization, major emphasizes is on cash flows rather than profit. For e.g. to
measure the worth of a project, criteria like: “present value of its cash inflow – present value of
cash outflows” (net present value) is taken. This approach considers cash flows rather than
profits into consideration and also use discounting technique to find out worth of a project. Thus,
maximization of wealth approach believes that money has time value.
Value of business = EPS / Capitalization rate
At times, wealth maximization may create conflict, known as agency problem.

Agency Problem

In corporate finance, the agency problem usually refers to a conflict of interest between a
company's management and the company's stockholders. The manager, acting as the agent for
the shareholders, or principals, is supposed to make decisions that will maximize shareholder
wealth. However, it is the manager's own best interest to maximize his own wealth. A situation
in which agents of an organization (e.g. the management) use their authority for their own
benefit rather than that of the principals (e.g. the shareholders). The agency problem also refers
to simple disagreement between agents and principals. For example, a publicly-traded company's
board of directors may disagree with shareholders on how to best invest the company's assets. It
especially applies when the board wishes to invest in securities that would favor board members'
outside interests.

In finance, there are two primary agency relationships:

Managers and stockholders: Managers may make decisions that conflict with the best interests of
the shareholders. For example, managers may grow their firms to escape a takeover attempt to
increase their own job security. However, a takeover may be in the shareholders' best interest.

Managers and creditors: Since stockholders will make decisions based on their best interests, a
potential agency problem exists between the stockholders and creditors. For example, managers
could borrow money to repurchase shares to lower the corporation's share base and increase
shareholder return. Stockholders will benefit; however, creditors will be concerned given the
increase in debt that would affect future cash flows.

Short Notes:

Earnings per share (EPS): Net income (NI) divided by the number of outstanding shares of
common stock (Shares)—that is, NI/Shares.
Business Ethics: A company’s attitude and conduct toward its stakeholders— employees,
customers, stockholders, and so forth. Business ethics is the study of business situations,
activities, and decisions where issues of right and wrong are addressed. Business ethics/
corporate ethics are a form of applied ethics or professional ethics that examines ethical
principles and moral or ethical problems that arise in a business environment. It applies to all
aspects of business conduct and is relevant to the conduct of individuals and entire organizations.

Corporate Governance: The system of rules, practices and processes by which a company is
directed and controlled. Corporate governance essentially involves balancing the interests of the
many stakeholders in a company - these include its shareholders, management, customers,
suppliers, financiers, government and the community.

Proxy votes: Voting power that is assigned to another party, such as another stockholder or
institution.
Chapter 02: Financial Environment

Financial markets: A system consisting of individual and institutions, instruments, and

procedures that brings together borrowers and savers.

Importance of Financial Markets:

1. Flow of funds.
2. Market efficiency
3. Economic efficiency: Funds are allocated to their optimal use at the lowest costs in the
financial markets.
4. Information efficiency: The prices of investments reflect existing information and adjust
quickly when new information enters the markets.
Abnormal returns: Returns that exceed those that are justified by the risk associated with the
environment.

Types of financial markets:

 Money markets: The segment of the financial markets in which the instruments that are
traded have maturities equal to one year or less.
 Capital markets: The segments of the financial markets in which the instrument that are
traded have maturities greater than one year.
 Debt markets: Financial markets in which loans are traded.
 Equity markets: financial markets in which corporate stocks are traded.
 Primary markets: Markets in which various organization raise funds by issuing new
securities.
 Secondary markets: Markets in which financial assets that have previously been issued by
various organizations are traded among investors.

Derivatives Markets: Financial markets in which option and futures are traded.

Call option: An option that allows the buyer to purchase stock from the option seller at a pre-
specified price during a particular time period.

Put option: An option that allows the buyer to sell stock from the option seller at a pre-specified
price during a particular time period.

Futures contract: A contract for the “future” delivery of an item where the price, amount,
delivery date, place of delivery, and so forth are specified.

Types of General stock market activities:

 Trading in the outstanding, previously issued shares of established, publicly owned
companies.
 Additional shares sold by established, publicly owned companies.
 New public offerings by privately held firms.

Going public: The act of selling stock to the general public for the first time by a corporation or
its principal stockholders.

Initial public offering: The market consisting of stocks of companies that have just gone public.

Demutualization: The process of converting a stock exchange from a mutual ownership

organization to a stock ownerships organization.

Listing requirements: Characteristics a firm must possess to be listed on an exchange.

Over –the- counter market: A collection of brokers and dealers, connected electronically by
telephones and computers that provides for trading in securities not listed on the physical stock
exchange.

Dual listing: when stocks are listed for trading in more than one stock market.

Securities and Exchange Commission (SEC): The U.S. government agency that regulates the
issuance and trading of stocks and bonds.

Insiders: Officers, directors, major stockholders, or other who might have inside information
about a company’s operations.

Investment banker: An organization that underwrites and distributes new issues of securities; it
helps business and other entities obtain needed financing.

Underwritten arrangement: Agreement for the sale of securities in which the investment bank
guarantees the sale by purchasing the securities from the issuer, thus agreeing to bear any risk
involved in the transaction.

Flotation costs: The costs associated with issuing new stocks or bonds.

Offering price: The price at which common stock is sold to the public.

Registration statement: A statement of facts filed with the SEC about a company that plans to
issue securities.

Prospectus: A document describing a new security issue and the issuing company.

Underwriting syndicate: A group of investment banking firms formed to spread the risk
associated with the purchase and distribution of a new issue of securities.
Euro land: The countries that comprise the European Monetary Union (EMU).

Financial intermediaries and their roles in financial markets:

Financial intermediaries: Specialized financial firms that facilitate the transfer of funds from
savers to borrowers.

Financial intermediation: The process by which financial intermediaries transforms funds

provided by savers into funds used by borrowers.

Benefits:

 Reduced costs
 Risk/diversification
 Funds divisibility/pooling
 Financial flexibility
 Related services

Types of financial intermediaries:

 Commercial banks.
 Credit Union.
 Thrift Institution.
 Mutual funds.

Money market mutual fund: A mutual fund that invests in short-term, low-risk securities and
allows investors to write checks against their accounts.

Chapter 3 Time value of money

Time value of money: The principle and Computations used to revalue cash payoffs at different
time so they are stated in dollar of the same time period; used to convert dollars from one time
period to those of another time period.

Cash flow time line: An important tool used in time value of money analysis; it is a graphical
presentation used to show the timing of cash flows.

Present value: The value today that is current value of a future cash flow or series of cash flow.
The current worth of a future sum of money of stream of cash flows given a specific rate of
return.

Future value: The amount to which a cash flow or series of cash flows will grow over a given
period of time when compounded at a given interest rate.
Formula: FV=𝑃𝑉(1 + 𝑟)𝑛
 PV=Present value or begging amount.
 r=Interest rate the bank pays on the account each year.
 n= Number of years.
Compound interest: Interest earned on interest that is reinvested. Compound interest rate added
to the principle of deposit or loan so that ate added interest also earns interest from then on.
Cash outflow: A payment or disbursement, of cash for expenses, investment and so forth. The
total outgoing funds from a company in a given period of time. Cash out flows including
expenses such as salaries and other costs.
Cash inflow: A receipt of cash from an investment, an employ or other source. Money received
by an organization as a result of its operating activities, investment activities, and financing
activities.
Opportunity cost rate: The rate of return on the best available alternative investment of equal
risk. The cost of an alternative that must be forgone in order to pursue a certain action. Put
another way the benefits you could have received by taking an alternative action.
Discounting: The process of determining the present value of a cash flow or a series of cash
flows received in future, the reverse of compounding.

1
Solution: PV=FV⟦ ⟧
(1+𝑟)𝑛

Annuity payments:
 Annuity: A series of payments of equal amount at fixed, equal intervals for a specified
number of periods.
 Ordinary annuity: An annuity with payments that occur at the end of each period.
 Annuity due: An annuity with payments that occur at the begging of each period.

Ordinary annuity cash flow time line: The series of deposits is an ordinary annuity and its cash
flows time line is called ordinary annuity cash flow time line.
Annuity due cash flow time line: The series of deposits is an due annuity and its cash flows
time line is called Annuity due cash flow time line

Future value of an annuity:

 Future value of an ordinary annuity: The future value an ordinary annuity over n periods.
Formula: (FVA) n=PMT ∑𝑛−1 𝑡=0 (1 + 𝑅)𝑡
 Future value of an annuity due: The future value of an annuity due over n periods.
Formula: FVA (DUE) n=: PMT ∑𝑛𝑡=0(1 + 𝑅)𝑡
Present value of an annuity:
 Present value of an ordinary annuity (PV) n: The Present value an ordinary annuity over n
payments.
 Future value of an annuity due PVA (DUE) n: The Present value of an annuity due over n
payments.

Perpetuities: Perpetuity is an annuity that has no end or stream of cash flow that continues for
ever. There are few actual perpetuity in existence.
Consol: A perpetual bond issued by the British government to consolidate past debts, in general
any perpetual bond.
Uneven cash flow streams: A series of cash flow in which the amount varies from one period to
the next.
 Present value of an uneven cash flow streams.
 Future value of an uneven cash flow streams.
Semiannual and other compounding periods:
 Annual compounding: The process of determining the future or present value of a cash
flow or a series of cash flows when interest is paid once per year.
 Semiannual compounding: The process of determining the future or present value of a
cash flow or a series of cash flows when interest is paid twice per year.
Comparison of different interest:
 Simple (quoted) interest rate: The rate of quoted by borrowers and lenders that is used to
determine the rate of earned per compounding per period.
 Annual percentage rate (APR): Another name for the simple interest rate , does not
consider the effect of interest compounding .
 Effective annual rate (rEAR): The annual rate of interest actually being earned as opposed
to the quoted rate, considering the compounding of interest.

Chapter-4 Risk and Rate of return

Definition of risk: The chance that an outcome other than the expected one will occur. This risk
may be related to Loss of capital, delay in repayment of capital, non-payment of interest, or
variability of returns. Uncertainty in the distribution of outcomes. Thus, risk can be defined in
terms of variability of returns. Risk is the potential variability of returns.
Non diversifiable risk: Non diversifiable risk is known as market risk or systematic risk. This
Type of risk cannot be diversified away. Unexpected changes in interest rates. Unexpected
Changes in cash flows due to tax rate changes, foreign competition, and the overall business
cycle.

Diversifiable risk: Diversifiable risk is known as company-unique risk or unsystematic risk.

This type of risk can be reduced through diversification. A company’s labor force goes on strike.
A company top management dies. A huge oil tank bursts and floods a company’s production
area.

Investment risk: There are two types of investment risk are given below:
 Stand-alone risk: The risk associated with an investment when it is held by itself or in
isolation not in combination with other assets.
 Portfolio risk: The risk associated with an investment when it is held in combination with
other assets, not by itself.

Probability distribution: A listing of all possible outcomes, or events, with a probability

assigned to each outcomes. An event’s probability is defined as the chance that the event
will occur.

Expected rate of return(r): The rate of return expected to be realized from an investment; the
mean value of the probability distribution of possible returns.
Formula: Expected rate of return=Pr1r1+ Pr2r2……………+ Prnrn
=∑𝒏𝒊=𝟏 𝑷𝒓𝒊𝒓𝒊
Continuous verses discrete probability distribution:
 Discrete probability distribution: The number of possible outcomes is limited or finite is
called discrete probability distribution.
 Continuous probability distribution: The number of possible outcomes is unlimited or
infinite is called continuous probability distribution.

Measuring total risk:

 Standard deviation (𝝈): A measure of the tightness, or variability of a set of outcomes.
Formula:√∑𝒏 ̂ )𝒑𝒓𝒊
𝒊=𝟏(𝒓𝒊 − 𝒓
 Variance (𝝈𝟐 ): The standard deviation squared; a measure of the width of a probability
distribution.
 Formula:∑𝒏𝒊=𝟏(𝒓𝒊 – 𝒓̂) 𝟐
Co-efficient of variation (CV): A standardized measure of the risk per unit of return. It is
calculated by dividing the standard deviation by the expected return.
𝑅𝑖𝑠𝑘
CV=Return
Risk aversion: Risk aversion investors required higher rate of return to invest higher risk
securities is called risk aversion.

Risk premium: The portion of expected return that can be attributed to the additional risk of an
investment. It is the different between the expected rate of return on a given risky asset and the
expected rate of return on a less risky asset.

Portfolio risk: Chances that combination of assets or units within individual group of
investment fail to meet financial objectives. In theory, portfolio risk can be eliminated by
successful diversification.
Portfolio return: The expected return on portfolio is simply the weighted average of the
expected returns on the individual stocks in the portfolio, with each weighted being the
proportion of the total portfolio invested in each stock.

Realize rate of return: The return that is actually earned is realized rate of return. The actual
return usually differs from the expected return.

Firm specific risk versus market risk:

 Firm specific (diversifiable) risk: The part of a security’s risk associate with random
outcomes generated by events, or behaviors, specific to the firm. It can be eliminated by
proper diversification.
 Market (no diversifiable) risk: The part of a security’s risk associate with economic, or
market, factors that systematically affects firms. It cannot be eliminated by diversification.
 Relevant risk: The portion of a security’s risk that cannot be diversified away; the security’s
market risk. It reflects the security’s contribution to the risk of a portfolio.
The concept of Beta: A measure of the volatility, or systematic risk, of a security or a portfolio
in comparison to the market as a whole. Beta is used in the capital asset pricing model(CAPM), a
model that calculate the expected return of an assets based on its Beta and expected market
return.
 Beta coefficient: A measure of the extent to which the return on a given stock move with the
stock market.
 Portfolio Beta coefficient: A portfolio consisting of low beta securities will itself have a low
beta because of any set of securities is a weighted average of the individual security’s betas.
Formula:𝛽𝑝 =𝑤1𝛽 +𝑤2𝛽 …………….𝑤𝑛𝛽
1 2 𝑛
=∑𝑛𝑗=1 𝑤𝑗 𝛽𝑗
The relationship between risk and rates of return:
 Capital Asset Pricing Model (CAPM): A model used to determine the required return on
an asset, which is based on the proposition that any asset’s return should be equal to the risk
free return plus a risk premium that reflects the asset’s nondiversifiable risk.
 Market risk premium (RPM): The additional return over the risk free rate needed to
compensate investors for assuming an average amount of risk.
 Security market line (SML): The line that shows the relationship between risk as
measured by beta and the required rate of return for individual securities.

Different types of risk:

 Quoted or nominal (r): Quoted or nominal rate of interest on a given security. There are
many different securities, hence many different quoted interest rates.
 Real risk free rate (r*): Real risk- free rate of interest, which is the interest rate that would
exist on a security with a guaranteed payoff if inflation is expected to be zero during the
investment period.
 Inflation premium risk (IP): Inflation risk premium which equals the average inflation rate
expected over the life of the security.
 Default risk premium (DRP): Default risk premium which reflects the chance that the
borrower will not pay the debts interest or principal on time.
 Liquidity risk premium (LP): Liquidity or marketable premium which reflects the fact that
some investments are more easily converted into cash on a short notice at a reasonable price
than are other securities.
 Maturity risk premium (MRP): Maturity risk premium which accounts for the fact that
longer-term bonds experience greater price reactions to interest rate changes than do short-
term bonds.

General types of risk:

Systematic risk: The impact of economic political and social changes is system-wide and that
portion of total variability in security returns caused by such system- wide factors is referred to
as systematic risk.
 Interest rate risk: Interest rate risk is a type of systematic risk that particularly affects
debt securities like bonds and debentures. A bond or debenture normally has a fixed
coupon rate of interest.
 Inflation risk: The primary reason short-term interest rate change is because investors
change their expectations about future inflation.
 Maturity risk: Long-term investments experience greater price reactions to interest rate
changes than do short-term bond.
 Liquidity risk: Reflects the fact that some investments are more easily converted into
cash on a short notice at a reasonable price than are other securities.
 Exchange rate risk: Multinational firms deal with different currencies, the rate at which
the currency of one country can be exchanged into the currency of another country that is
called exchange rate risk.
 Political risk: Any action by a government that reduces the value of an investment.
Unsystematic risk: The returns from a security may sometimes very because of certain factors
affecting only the company issuing such security. When variability of returns occurs because of
such firm- specific factors , it is known as unsystematic risk.
 Business risk: Risk that would be inherent in the firms operations, if it used no debt-
factors such as labor conditions, product safety, and quality of management, competitive
condition and so forth affect firm specific risk.
 Financial risk: Risk associated with how the firm is financed- that is credit risk.
 Default risk: Part of financial risk – the chance that the firm will not be able to service
its existing debt.
Combined risk: Some systematic risk and some unsystematic risk.
 Total risk: The combination of systematic risk and unsystematic risk. It is also called
stand-alone risk.
 Corporate risk: The riskiness of the firm without considering the effect of stock holder
diversification, based on the combination of assets held by the firm.

Chapter: 5 working capital policy

Working Capital: A firm’s investment in short-term assets- cash, marketable securities,

inventory and accounts receivable.

Working Capital Terminology: It is useful to begin the discussion of working capital policy by
reviewing some basic definitions and concepts:

 Working capital: A firm’s investment in short-term assets_ cash, marketable securities,

inventory, and accounts receivable.
 Net working capital: Current assets minus current liabilities-the amount of current assets
financed by long- term liabilities.
 Working capital policy: Working capital policy refers to the firm’s basic policies
regarding (a) target levels for each category of current assets and (b) how current assets will
be financed.

Cash conversion cycle: The concept of working capital management originated with the old
Yankee peddler who would borrow to buy inventory, sell the inventory to pay off the bank loan,
and then repeat the cycle. The following terms are used in the model:

 The Inventory Conversion Period: The amount of time a product remains in inventory in
various stages of completion.
Inventory
Inventory conversion period:
Cost of goods sold per day

 The Receivables Collection Period: The time it takes to collect cash following a sale.

Receivables
Receivables collection period:
Daily credit sales

 The Payables Deferral Period: The average length of time between the purchase of raw
materials and labor and the payment of cash for them.

Accounts payable
Payables deferral period (DPO) =
Credit purchases per day

 The cash conversion cycle: The length of time from the payment for the purchase of raw
materials to manufacture a product until the collection of accounts receivable associated with
the sale of the product.
Cash conversion cycle: (Inventory conversion period) + (Receivables collection period) –
(payable deferral period).

Working Capital Investment and Financing Policies: Working capital policy involves two
basic questions: (1) what is the appropriate level for current assets, both in total and by specific
accounts, and (2) How should current assets be financed.

Alternative Current Asset Investment policies:

 Relaxed Current Assets Investment policy: A policy under which relatively large amounts
of cash and marketable securities and inventories are carried and under which sales are
stimulated by a liberal credit policy that results in a high level of receivables.
 Restricted Current Asset Investment policy: A policy under which holdings of cash and
marketable securities, inventories, and receivables are minimized.
 Moderate current asset investment policy: A policy between the relaxed and restricted
policies.

Alternative Current Asset Financing policies:

 Permanent Current assets: Current assets balances that remains stable no matter the
seasonal or economic conditions, balances that exit no matter the type of business cycle.
 Temporary current assets: Current assets that fluctuate with season or cyclical variation in
a firms business.

Maturity matching or Self-liquidating: A financing policy that matches asset and liability
maturities. This would be considered a moderate current asset financing policy.

Aggressive Approach: A policy in which all of the fixed assets of a firm are financed with long
–term capital but some of the firms permanent current assets are financed with short-term
nonspontaneous sources of funds.

Conservative approach: A policy in which all of the fixed assets, all of the permanent current
assets, and some of the temporary current assets of a firm are financed with long- term capital.

Advantages and disadvantages of short term financing:

 Speed.
 Flexibility.
 Cost of long-term versus short-term debt.
 Risk of long-term versus short- term debt.

Chapter 6: Short term financing

Definition of short term financing: Short term financing, often referred to as bridging finance,
and usually refers to loans mostly offered on terms of up to 12 months. These loans have certain
features in common. Short term investments and financial plans usually involve less uncertainty
than long term.

Sources Of short-term financing: There are numerous sources of short-term funds, and in the
following sections we describe four major types:

 Accruals: Continually recurring short-term liabilities; liabilities such as wages and taxes
that increase spontaneously with operations.
 Spontaneous financing:
 Trade credit: The credit created when one firm buys on credit from another firm. The debt
is called account payable. It is also called trade credit.
 Overdraft: Almost all businesses have an account with a bank. All the deposits and
withdrawals are dealt by the bank. The depositors sometimes withdraw money for meet up
there short term financing.
 Components of Trade Credit: Trade credit can be divided into two components:
 Free Trade Credit: Credit t received during the discount period.
 Costly Trade credit: Credit taken in excess of “free “trade credit, whose cost is equal to
the discount lost.
 Types of trade credit: There are three types of trade credit:
 Open account: By far the most common type is the open-account arrangement. With this
arrangement, the seller ships goods to the buyer along with an invoice that specifies the
goods shipped the price, the total amount due, and the terms of the sale. Open-account
credit derives its name from the fact that the buyer does not sign a formal debt instrument
evidencing the amount that he owes the seller. The seller extends credit based upon his
credit investigation of the buyer.
 Trade acceptances: A trade acceptance is another arrangement by which the indebtedness
of the buyer is recognized formally. Under this arrangement, the seller draws a draft on the
buyer ordering him to pay the draft at some date in the future.
 Commercial paper: Commercial paper is a type of unsecured promissory note issued by
large, financially strong firms and it is sold primarily to other businesses, insurance
companies, pension funds, money market mutual funds and banks.

Short-Term Bank Loan:

 Promissory Note: A document specifying the terms and conditions of a loan, including
the amount, interest rate, and repayment schedule.
 Compensating balance: A minimum checking account balance that a firm must
maintain with a bank to borrow funds- generally 10 to 20 percent of the amount of loans
outstanding.
 Line of credit: An arrangement in which a bank agrees to lend up to a specified
maximum amount of funds during a designated period. When a line of credit is
guaranteed, it is called a revolving credit agreement.
 Revolving (line of) credit agreement: When a line of credit is guaranteed, it is called a
revolving (line of) credit agreement. A formal, committed line of credit extended by a
bank or other lending institution.
 Commitment fee: A fee charged on the unused balance of a revolving credit agreement
to compensate the bank for guaranteeing that the fund will be available when needed by
the borrower.
 The Cost of Bank Loan: The cost of bank loans varies for different types of borrowers at
any given point in time and for all borrowers over time.

Prime rate: A published rate of interest charged by banks to short-term borrowers (usually
large, financially secure corporations) with the best credit; rates on short-term loans generally are
“pegged” to the prime rate.

Choosing a Bank:

 Willingness to assume risks.

 Advice and counsel.
 Loyalty to customers
 Specialization.
 Maximum loan size.
 Merchant banking.
 Other services.

Commercial Paper: Unsecured, short-term promissory notes issued by large, financially sound
firms to raise funds.

Uses of commercial paper: The uses of commercial paper is restricted to a comparatively small
are exceptionally good credit risks. Using commercial paper permits a corporation to tap a wider
range of credit sources, including financial institutions outside its own area and industrial
corporations across the country and this can reduce interest costs.

Maturity and Cost: Maturities of commercial paper vary from one month to nine months, with
an average of about five month. Commercial paper is called a discount instrument because it is
sold at a price below its face, or maturity value

Computing The Cost of short-Term Credit: For short-term financing, the percentage cost of
using the funds for a given period, rPER , can be computed as

Percentage cost per period: 𝒓𝑷𝑬𝑹=

𝐷𝑜𝑙𝑙𝑎𝑟 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔⁄
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑢𝑠𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑠

Effective annual rate (EAR) = (1+𝑟𝑃𝐸𝑅 )𝑚 -1.0

Annual percentage rate: 𝑟𝑃𝐸𝑅 ×m=𝑟𝑆𝐼𝑀𝑃𝐿𝐸

Computing The Cost of Bank Loan: A bank loan can take the form of simple interest lo0an, a
discount loan, or an installment loan.

 Simple Interest Loan: The amount borrowed and interest charged on that amount is paid at
the maturity of the loan; there are no payments made before maturity.
Formula:
𝐷𝑜𝑙𝑙𝑎𝑟 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔⁄
𝒓𝑷𝑬𝑹= 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑢𝑠𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑠
Annual percentage rate: 𝑟𝑃𝐸𝑅 ×m=𝑟𝑆𝐼𝑀𝑃𝐿𝐸

 Face value: The amount of the loan or the amount borrowed; also called the principal
amount of the loan.
 Quoted (simple) interest rate, rEAR: The annual percentage rate (APR) that is used to
compute the interest rate per period (rPER).
Formula: Effective annual rate (EAR) = (1+𝑟𝑃𝐸𝑅 )𝑚 -1.0
 Discount interest loan: A loan in which the interest, which is calculated on the amount
borrowed (principal), is paid at the beginning of the loan period, interest is paid in advance.

Add-on interest: Interest that is calculated and then added to the amount borrowed to obtain the
total dollar amount to be paid back in equal installments.

Use of security in Short –term finance:

Secured loan: A loan backed by collateral, for short-term loans, the collateral often is inventory
receivables, or both. Thus far we have not address the question of whether loans should be
secured. Commercial paper is not secured, but all other types of loans can be secured if this is
deemed necessary.

Uniform commercial code: A systems of standards that simplifies procedures for establishing
loan security.

Accounting receivable financing:

 Pledging account receivables: Using accounts receivables as collateral for a loan.

Accounting receivable financing involves either the pledging of receivable or the selling of
receivables (call factoring). The pledging account receivable is characterized by the fact that
the lender not only has a claim against the receivable but also has recourse to the borrower.
 Factoring accounting receivable: Factoring, or selling accounts receivable, involves the
purchase of account receivable by the lender (call a factor), generally without recourse to the
borrower, which means that if a receivable account that is factored cannot be collected, the
lender, not the seller of goods (borrower), takes the loss.
 Procedure for pledging accounts receivable:
 First: Selection of sound invoices is one way the lender safeguards itself.
 Second: If the buyer of the goods does not pay the invoice, the lender still has recourse
against the seller.
 Third: Additional protection is afforded to the lender because the loan generally will be
less than 100% of the pledged receivable.
 Procedure for factoring accounts receivable: The factor normally performs three
functions:
 Credit checking.
 Lending and
 Risk bearing
 Cost of receivable financing: Both accounts receivable pledging and factoring are
convenient and advantageous, but they can be costly. The credit checking and risk bearing
fee is 1 percent to 5 percent of the amount of invoices accepted by the factor and it could be
even more if the buyers are poor credit risk.

Inventory Financing:

 Blanket liens.
 Trust receipts.
 Warehouse receipts.
 Acceptable product.
 Cost of financing.
 Evaluation of inventory financing.
Chapter -7 Long term financing

Definition of long term financing: Funding, obtained for a time frame exceeding one year in
duration. When a business borrows from a bank using long-term finance methods, it expects to
pay back the loan over more than a one year period. For example, this might include making
payments on a 20 year mortgage. Another long-term finance example would be issuing stock.
Sources of long term financing:
 Capital Market: Capital market is financial markets for the buying and selling of long term
debt or equity backed securities. These markets channel the wealth of savers to those who
can put it to long term productive use, such as companies or governments making long term
investments.
 Primary market/ new issue market: the primary market is that part of the capital markets
that deals with the issuance of new securities, companies, and government or public
sector institutions can obtain funding through the seal of a new stock or bond issue.
 Secondary market/ Stock market or stock exchange: The secondary market, also known
as the aftermarket, is the financial market where previously issued securities and
financial instruments such as stocks, bonds, options and futures are bought and sold.
 Special Financial Institutions: There are many specialized financial institutions
established by central and state governments which give long term loans at reasonable rate
of return.
 Mutual Funds:Mutual fund refers to a fund established in the form of a trust by a sponsor
to raise money through one or more schemes for investing in securities. It is a special type
of investment institution, which acts as an investment intermediary that collects or pools the
savings of a large number of investors and invests them in a fairly large and well diversified
portfolio of sound investments.
 Open ended funds: These funds have no fixed corpus and period.
 Close ended funds: In case of these funds, subscriptions from the investors are
collected during a specified time period and have a fixed corpus.
 Leasing Companies: Leasing facility is usually provided through the mediation of leasing
companies who buy the required plant and machinery from its manufacturer and lease it to
the company that needs it for a specified period on payment of an annual rent.

 Retained Earnings: For any company the amount of earnings retained within the
business has a direct impact on the amount of dividend. Profit reinvested as retain earning
ids profit that could have been paid as a dividend.
Obtaining Long-Term Funds Externally:
 Investment banking: When a company issues new securities to the public, it usually
avails itself of the services of an investment banker. The principal function of the
investment banker is to buy the securities from the company and then resell them to
investors.
Function of investment banker:
 Underwriting Commission.
 Divided and Undivided Accounts.
 Best Efforts Offering.
 Making a Market.
 Selling the securities.
 Advising.
 Pricing the issue.
 Stabilization of the market.
Types of bond:
 Serial Bonds: All sinking-fund bonds in an issue mature on the same date, although specific
bonds are retired before that date.
 Debenture: The term “debenture” usually applies to the unsecured bonds of a corporation;
the investor looks to the earning power of the corporation as his security.
 Subordinate debenture: Subordinated debentures represent debt that ranks behind other
unsecured debt with respect to the claim on assets.
 Mortgage bond: A mortgage bond issue is secured by a lien on specific assets of the
corporation—usually fixed assets. The specific property securing the bonds is described in
detail in the mortgage, which is the legal document giving the bondholder a lien on the
property.
 Income bond: With an income bond, a company is obligated to pay interest only when it is
earned.
 Convertible bond: A convertible bond is one that may be converted at the option of the
holder into a certain number of shares of common stock of the corporation.

Preferred stock: Preferred stock is a hybrid form of financing, combining features of debt and
common stock
.Feature of preferred stock:
 Cumulative feature: Almost all preferred stocks have a cumulative feature, providing for
unpaid dividends in any one year to be carried forward.
 Participating feature: A participating feature allows preferred stockholders to participate in
the residual earnings of the corporation according to some specified formula.
 Voting power: Because of their prior claim on assets and income, preferred stockholders
normally are not given a voice in management unless the company is unable to pay
preferred stock dividends during a specified period of time.
Common Stock: The common stockholders of a corporation are its residual owners;
collectively, they own the company and assume the ultimate risk associated with ownership.
Their liability, however, is restricted to the amount of their investment. In the event of
liquidation, these stockholders have a residual claim on the assets of the company after the
claims of all creditors and preferred stockholders are settled in full.

Feature of common stock: The common features of common stock are given below:
 Ownership: Common stock provides a share of ownership in the company, unlike other
types of securities like bond which do not.
 Voting right: Common stockholders have the right to vote at annual meetings, with each
share entitling the holder to one vote.
 Receive dividend payment: Common shareholders are entitled to receive dividend
payment, if there are authorized by the corporation’s board of directors.
 Preemptive right: When a company issues new shares, existing common stockholders have
the preemptive rights to buy additional shares directly from the company.

Right of common stockholders:

 Right to income: Common stockholders are entitled to share in the earnings of the company
only if cash dividends are paid. Stockholders prosper from the market value appreciation of
their stock, but they are entirely dependent upon the board of directors for the declaration of
dividends that give them income from the company.
 Voting power: Inasmuch as the common stockholders of a company are its owners, they are
entitled to elect a board of directors. In a large corporation, stockholders usually exercise
only indirect control through the board of directors they elect. The board, in turn, selects the
management; and management actually controls the operations of the company. With a
proprietorship, partnership, or small corporation, the owners usually control the operations of
the business directly.
 Proxies: Each common stockholder is entitled to one vote for each share of stock he owns.
Because most stockholders do not attend the annual meeting, they may vote by proxy. A
proxy is simply a form by which the stockholder assigns his right to vote to another person.
 Proxy contests: However, outsiders can seize control of a company through a proxy contest.
Obviously, outsiders would not attempt a take-over if management controlled a large
percentage of shares outstanding. When an outside group undertakes a proxy raid, it is
required to register its proxy statement with the Securities and Exchange Commission to
prevent the presentation of misleading or false information.
 Preemptive right: A preemptive right (see Chapter 11) entitles the common stockholder to
maintain his proportional ownership in the corporation. He is given the first opportunity to
purchase, on a pro rata basis, any new stock being offered or any new securities that are
convertible into common.
 Right to examine books: A stockholder legally is entitled to inspect the books and records
of a corporation. However, this access is limited, for most corporations feel that the audited
financial statement is sufficient to satisfy the requirement. To obtain more specific
information, the stockholder may have to take his case to court in order to prove the necessity
for obtaining this information.