Month: June 2010

Statement of Cash Flow

Conventional financial statements i.e. income statement and balance sheet do not give true picture of the cash flows of the firm. Because income statement incorporates many non-cash expenditures and revenues for the sake of ascertaining profitability. Similarly balance sheet tells us the overall financial position with respect to firms’ assets and liabilities and includes monetary and non-monetary items. In reality the business is a matter of earning cash therefore firms receive and spend cash on daily basis. The shareholder must be in loop regarding the cash receipts and disbursements of the firm. Cash flow statement summarizes the firms’ cash flows over a given period of time under a universally accepted and understood format. The preparation of cash flow statement is a matter of ascertaining cash inflows and outflows with in a given period mainly one year. It summarizes the cash inflows and outflows. Cash inflows means the sources of cash or cash receipts and cash outflow means the uses of cash or cash payments. For example, if a firm’s accounts payable increased by $1000 during a period, the change would be an inflow of cash. Few points need to be understood for the good insight of cash flow statement. • The cash invested in assets is treated as funds tied up in those assets therefore any decrease in assets is referred to as cash inflow. On the contrary enhancement...

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Stock Valuation

The shareholders buy shares with the expectations of receiving dividends and increase in the value of the shares. A conscious investor buys shares when they are undervalued and sell them when they are overvalued. Under valuation means the shares’ true value is more than their market value and overvaluation means their true value is less than the market value. The true value of a share is the present value of all future dividends over an indefinite time period. As the future dividends keep on growing therefore it’s become imperative to compute the value of the share with respect to expected growth pattern of future dividends. According to growth theory the valuation models can be categorized into three broad categories. • Zero Growth Model • Constant Growth Model • Variable Growth Model Zero Growth Model If a firm pays constant dividend every year the value of the share is calculated under the zero growth model. This model assumes no growth in dividend and value of share would equal the present value of perpetuity of dividends discounted at the required rate of return. Symbolically, P = D1 / Ke Where, P   = Price of the share D1 = Constant dividend per share Ke = required rate of return for investors Example A firm pays dividend of $10 constantly over an indefinite time horizons. Required rate of return for investors is 16%....

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Kinds of Interest Rates

Just like a person working for some one expects remuneration or a landlord expects rent from tenant, the provider of funds also expects return. Two types of funds providers exist. One who takes the risk and provides funds for sharing profit or loss. The average expectancy of profit or loss is relatively high in this case. The other one who does not take risk of sharing loss and expects a fixed return over the usage of his money for a certain time period and after its usage gets back the whole sum in a similar way the landlord gets back building or piece of land after the expiry of lease agreement. This expected return on the part of funds providers is called interest rate. The interest rate is often determined before the debt covenant takes place and usually quoted on the debt instrument. Interest rates are higher over the funds meant for longer period of time as compared to those for the short span of time. Moreover interest rates play significant role in the monetary policy of country therefore determined by the central banks. Though look quite simple but interest rates outline many different forms according to time, functions, and nature of loan agreements. Each of such type has its own implications and complexities. •    Fixed Interest Rate •    Fluctuating Interest Rate •    Nominal Interest Rate •    Real Interest...

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Average Cost Method

Average a simple but important tool for decision making which is used by almost every individual, businessman, and even institutions on daily basis. It would be hard to find a person on this planet who ever have not been used averages to know daily, monthly, or yearly income and expenses or to analyze any information involving values. Average cost is the weighted average cost of different periods, products, departments, divisions, or so many objects as per the requirements or specifications. In finance the use of average cost is almost a routine matter and often used in approximations, feasibility studies, comparisons, and analysis. Simply the cost or expenses on individual periods or objects are added and the sum is divided on the number of items used in the analysis. For a layman the concept of average cost can be best understood by the following example. A person’s weekly expenses are as follows: Average weekly expenses = $704 / 7 = $100.57 It can be described that person’s average weekly cost of living is $100.57 In statistical terms the average cost is called the mean value of costs over a certain period or mean value of the cost of production of different products. The concept of average is basically the derivation of statisticians who used it for the analysis of vide spread data. From statistics the concept of average penetrated into...

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Financial Markets

In general terms financial market is a mechanism of delivering savings from the households, governments, and corporations to the users of these funds. Financial markets and financial assets exist in an economy because the savings of various individuals and institutions during a period of time differ from their investment in real assets. By real assets, we mean things such as houses, buildings, equipments, inventories, and durable goods. If savings equaled investment in real assets for all economic units in an economy over all periods of time, there would be no external financing, no financial assets, and no money and no financial markets. In this case each economic unit would be self sufficient. A financial asset is created only when the investment of an economic unit in real assets exceeds its savings, and it finances this excess by borrowing or issuing equity securities. Of course, another economic unit must be willing to lend. This as a whole, savings-surplus economic units provide funds to savings deficit units. This exchange of funds is evidenced by pieces of paper representing a financial asset to the holder and a financial liability to the issuer.  The purpose of financial markets in an economy is to allocate savings efficiently during a period of time to parties who use funds for investment in real assets or for consumption. If those parties that saved were the same as...

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Mutual Fund

A fund managed by an investment company which lifts up capital from financier and invests in a pool of assets. Just like a listed company the mutual funds also raise money by selling shares of the fund and purchase various investment securities such as stocks, bonds and money market instruments. In return to the investment in fund the investors become equity holders and called shareholders in each of its underlying securities. Depending upon the performance of the fund the price of the share will remain fluctuating on daily basis and shareholders are also free to sell their shares at any time they feel appropriate. Mutual fund investments showed a tremendous improvement over the last twenty years particularly in advanced countries. Most people now believe that it’s better to invest in mutual funds than simply letting their cash waste in banks. The reason of such a large attraction is also due to its appeal that every common person can understand the theory of mutual funds in the sense that a group of people bring together their savings and invest in a joint venture. Each individual holds the share of his/her ownership and receive the return. The institutionalization of this concept takes the form of mutual fund where some trustees acknowledge their responsibility towards the safety and security of the money and also that of payment of return to those who...

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FIFO – First in, First Out

First in first out is the method of inventory valuation. As the name implies under FIFO method the first unit of raw material received in the stock is to be issued first to manufacturing department. In other words it assumes that the material is issued from the oldest supplies. FIFO follows the belief that each unit of material should carry actual cost of the specific units. More clearly this method presumes that cost of those units when placed in stocks is the cost of those same units when issued. In some cases due to its practicability FIFO costing method is used though physical movement order of the inventory take place under different method. Following advantages are associated with the use of FIFO method of inventory costing. • FIFO represents a systematic and logical order of withdrawal of inventory items from the inventory records. • Material or inventory management becomes an easygoing job. • Deterioration or decay of material is minimized due to early use of the items. In practice FIFO method is not used everywhere. It is recommended in the following circumstances: • When the size and cost of units of materials are large • Lots of the materials are easily identifiable to bring the order of issuance under FIFO method. • At one point of time at the material bin card receipts are not too many in the...

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NPV – Net Present Value

Management and shareholders are mainly concerned for the long term returns over investment. In a stable economy where some degree of certainty prevails companies prefer to invest in long term projects which require heavy investments initially and return is expected after or in many years to come. In a situation where inflation rates are high simple calculation of payback often give deceiving results because it does not consider time value of money. To calculate the exact return one must know the value of one dollar return today to be received after two or three years. The deteriorating value of money poses low value to one dollar after three years than its value today. The question arises how this deteriorating value of money should be dealt in evaluating the viability of long term projects. Various techniques are adopted in this regard like Internal Rate of Return, Profitability Index, and Net Present Value. [adsense1]Net Present Value is the most superior of all techniques which discounts the expected cash flows over the period of the project by taking into account companies required rate or WACC. This is also called the discounted cash flow technique to the capital budgeting. Though Internal Rate of Return is also a discounted cash flow technique but it has some practical limitations therefore considered inferior to Net Present Value method. With the present value method, all cash flows...

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WACC – Weighted Average Cost of Capital

The capital structure of a firm comprises of three financing components i.e. shareholders’ funds (including retained earnings), borrowed funds, and preference shareholders funds. All capital components have one feature in common i.e. the investors who provided the funds expect to receive return on their investments. The companies have to bear cost of using these funds as return to investors, which varies under different financing heads and also called specific costs. Cost of shareholders fund is the investors’ required rate of return and cost of borrowed funds is the after tax interest rate. Though all of these costs are often looked and managed separately by the financial managers but it is also required to determine the overall cost of financing that is especially useful in establishing the viability of capitalizing upon the long-term investment opportunities. A project’s rate of return has to be in excess of the cost to finance it before allowing for being acceptable. The overall cost of capital is found by considering the weighted average cost of individual financing sources through taking into account their respective share in the overall capitalization. This by and large cost of financing is called weighted average cost of capital or WACC for which the terms of cost of capital, composite cost of capital, and combined cost of capital are also used. The determination of WACC involves simple mathematical computations if the...

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