Financial Planning

• Three Major Decision for Financial Manager

– How Big should be the corporate

• How much fund do I need, How do I Generate these funds

• Financing Decisions(Capital Structure Decisions)

– How to earn on the Funds ? Where to Invest

• Investing Decisions (Capital Budgeting Decisions)

– How to part with the profit

• Dividend Decisions

Financial Planning

• Meaning of Financial Planning

– Quantum of Financing

• How much fund do I need to generate

– Pattern of Financing

• Types of Securities

• Proportion of Securities

– Policy of Financing

• Timing

• Administration/Management of Funds

Financial Planning

• Principles to be kept in mind in preparation of a Financial Plan

– Simplicity

• Simple financial structure which can be managed easily

• Number of securities should manageable

– Long Term view

• Should be prepared keeping in mind the long term view of the organization

– Foresight

• Should be prepared keeping in view the future requirements of the corporation

• Technology, Economy, Resource Availability etc

Financial Planning

– Optimum Use

• Neither undercapitalized nor overcapitalized

• A proper balance between the long term and short term funds

– Liquidity

• Should be have adequate liquidity to have flexibility

– Economy

• The cost of raising the funds should be minimum

Financial Planning

• Estimating the capital Requirements

– Two Types of Capital Requirements of a corporate

• Fixed Capital Requirements

• Working Capital Requirements

– Meaning of Fixed Capital

• Fixed Capital is required to acquire – Tangible assets

» Building, Plant, Machinery, furniture

– Intangible

» Goodwill, Patents, copyrights etc

– Once invested, its for a long term

– Not only for new acquisition but also for expansion, diversification

Financial Planning

– Meaning of Working Capital

• Capital is required for – Day to day operations of the company

– Factors affecting the amount of fixed capital Requirement

• Nature of Business– Public utility companies

» Electricity, Gas, water supplies, Transportation

» Online trading, small manufacturing unit

– Types of Products

» Oil exploration ,Heavy Machinery

» Small toy manufacturing unit

Financial Planning

• Diversity of Product Line– Conglomerate vs. Single Product

• Method of Production– Whole Value chain vs. Vendor based

• Method of Acquisition– Hard Cash vs. Leasing (Airlines Industry)

Financial Planning

– Theories of Capitalization ( for new companies)

• The quantum of funding has been estimated

• How much securities needs to be issued.

• The theories of capitalization answer these questions– Cost Theory

– Earning Theory

– Cost Theory of Capitalization

• Total amount of capitalization of the company is arrived at by adding up the

1. Cost of fixed assets

2. Amount of working Capital

3. Cost of establishment( Book-Building,Underwriting, commissions etc)

4. Add up 1+2+3 to arrive at cost of Capitalization

Financial Planning

– Earning Theory of Capitalization

• True capitalization depends upon the earning capacity of the firm

• Worth of the company is not measured by the amount raised but by the productive usage of the capital raised

• Thus in order to estimate how much capital needs to be raised the company must know in advance the ROI of that particular industry

– Other companies

– Historical Data etc

– Example

• ROI is 10 %.Company expects to earn Rs 50000 in one year

• Capital to be raised = 50,000 /.10 = Rs 500,000

Financial Planning

– Earning Theory of Capitalization

• True capitalization depends upon the earning capacity of the firm

• Worth of the company is not measured by the amount raised but by the productive usage of the capital raised

• Thus in order to estimate how much capital needs to be raised the company must know in advance the ROI of that particular industry

– Other companies

– Historical Data etc

– Example

• ROI is 10 %.Company expects to earn Rs 50000 in one year

• Capital to be raised = 50,000 /.10 = Rs 500,000

Financial Planning

– Estimating Over/Under Capitalization

• ROI way

– A company is earning Rs 1,50,000 on an investment of Rs 15,00,000.What is the ROI of the company?

– The average ROI of this industry is also 10 %

» The company is ok

– What if the company was earning Rs 90,000

» Company ROI is 90,000/15,00,000 = 6%

» Avg ROI of the industry is 10 %

» The company is Over Capitalized

– What is the company was earning Rs 20,00,00

» Company ROI is 2,00,000/15,00,000 = 13.3%

» Avg ROI of the industry is 10 %

» The company is Undercapitalized

Financial Planning

– Estimating Over/Under Capitalization

• Book Value vs. Real Value

– Under Capitalization overcapitalization can be ascertained by comparing the Book value and Real value of the equity shares of the company

–What is Book Value of the equity share– Net Assets available to the equity share holders as per

the books

– What are Net Assets?

» NA= Total Assets –Total Liabilities

» BV = NA/n , where n = No of shares of the company

Financial Planning

–What is Real Value of the equity share– Calculated based on the earning capacity of the firm

– Real Value = Earnings / Capitalization Rate (ROI industry)

= E/k

– How to estimate Over/Under capitalization once both Book Value and Real Value has been calculated

Financial Planning

–Decision Criteria

–BV > Real Value• Firm is over capitalized

–BV < Real Value• Firm is Under capitalized

–BV = Real Value• Firm is Properly capitalized

Financial Planning

Liabilities Assets

Share Capital :1000 share @ Rs 10 each

Rs 10000 Sundry Assets Rs 40000

1000 Preference Share @10% of Rs 10 each

Rs 10000

Reserves and Surplus

Rs 10000

Sundry Creditors RS 10000

Total Rs 40000 40000

Balance Sheet of Company ABC ltd as on 31.12.2008

Financial Planning

–Calculating Book Value• BV = Net Assets/ no of shares

• Net Assets = Assets- Liabilities

• Assets = Sundry Assets

• Liabilities– Creditors

– Preference Share( Debt)

• What about reserves and surpluses?– Owners capital is represented on the liability side

• NA = Rs 40,000- (10,000+10000)

= Rs 20,000

BV = 20000/1000 = Rs 20

Financial Planning

–Calculating Real Value• What data do I need for calculating the Real Value

– Earnings

– ROI

– No of Shares

• Let earning capacity of the industry 15%

• Earning of ABC limited Rs 1000

• Assess Needed to Earn Rs 1000» 1000/.15 = Rs 6667

» Net Assets of the ABC = Rs 20,000

» RV = 6667/1000 = Rs 6.67

» BV> RV

• ABC is – Over capitalized

Financial Planning

–Do calculations for the following cases• Earning is Rs 5000 , earning capacity of the industry 15%

– BV = Rs 20

– RV = Rs 33.33

– BV< RV

– Undercapitalized

• Earning is Rs 3000 , earning capacity of the industry 15%– BV = Rs 20

– RV = Rs 20

– BV=RV

– Properly Capitalized

Financial Planning

Liabilities Assets

Share Capital :5000 share @ Rs 10 each

Rs 50000 Fixed Assets Rs 50000

Current Assets 40000

Reserves and Surplus

Rs 25000

Sundry Creditors RS 15000

Total Rs 90000 Rs 90000

Balance Sheet of Company ABC ltd as on

31.12.1998

Financial Planning

–What is the BV of the equity share• Rs 15

– Estimate whether the company is• Under, Over or properly capitalized

• earning capacity of the industry 15%

• Earning is Rs 6000– BV = Rs 15

– RV = Rs 8

– BV> RV

– Overcapitalized

• Earning is Rs 7500– BV = Rs 15

– RV = Rs 10

– BV>RV

– Over Capitalized

Financial Planning

• Earning is Rs 10000 and earning capacity is now 8%– BV = Rs 15

– RV = Rs 25

– BV<RV

– Undercapitalized

• Read pages B-13 to B-15 from the text book regarding the Under and Overcapitalization